U.S.
SECURITIES AND EXCHANGE COMMISSION


Washington,
D.C. 20549




FORM
10-Q




(Mark
      One)x
            QUARTERLY
      REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934




For
      the quarterly period ended: December 31,
2008




OR




o
            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.)




10411
Motor City Drive, Suite 650, Bethesda, Maryland 20817


(Address of principal executive
offices and zip code)





(301)
767-2810


(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 o





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting
company.




Large accelerated
      filer       o
            Accelerated
      filer                         oNon-accelerated
      filer         o
            Smaller reporting
      company       x




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




As of
February 9, 2009, there were 20,676,211 shares of common stock, $0.001 par
value, of the registrant issued and outstanding.













TECHNEST
HOLDINGS, INC.




FORM
10-Q


TABLE
OF CONTENTS


DECEMBER
31, 2008






PagePART
      I.     FINANCIAL INFORMATION
            1


Item
      1.Financial
      Statements (Unaudited)


Consolidated
      Balance Sheets as of December 31, 2008 and June 30, 2008
            1Consolidated
      Statements of Operations for the Six Months Ended December 31, 2008 and
      2007
            3Consolidated
      Statements of Operations for the Three Months Ended December 31, 2008 and
      2007
            4Consolidated
      Statement of Changes in Stockholders’ Equity for the Six Months Ended
      December 31, 2008
            5Consolidated
      Statements of Cash Flows for the Six Months Ended December 31, 2008 and
      2007
            6Notes
      to Condensed Consolidated Financial Statements
            8


Item
      2.Management’s
      Discussion and Analysis or Plan of Operation
            18Item
      4T.Controls
      and Procedures
            24PART
      II.OTHER
      INFORMATION
            24Item
      1.Legal
      Proceedings
            24Item
      1A.Risk
      Factors
            25Item
      6.Exhibits
            33Signatures
            
            34




STATEMENTS
CONTAINED IN THIS FORM 10-Q, 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-Q 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 OURANNUAL REPORT ON FORM
10-KSB FOR THE YEAR ENDED JUNE 30, 2008, INCLUDING, BUT NOT LIMITED TO, THE
SECTION THEREIN ENTITLED "RISK FACTORS."









PART
I.     FINANCIAL INFORMATION


TECHNEST
      HOLDINGS, INC.CONSOLIDATED BALANCE SHEETSDECEMBER
      31, 2008 AND JUNE 30, 2008







December
      31, 2008
            
            
            June
      30,
              2008(unaudited)ASSETSCurrent
      AssetsCash
      and cash equivalents
            
            $
            114,051
            
            
            $
            76,761Accounts
      receivable
            
            
            272,127
            
            
            
            600,908Unbilled
      receivables
            
            
            -
            
            
            
            23,888Inventory
            
            
            66,652
            
            
            
            36,542Restricted
      cash
            
            
            218,658
            
            
            
            237,288Prepaid
      expenses and other current assets
            
            
            20,993
            
            
            
            74,233Receivable
      from sale of EOIR
            
            
            23,000,000
            
            
            
            23,000,000Total
      Current Assets
            
            
            23,692,481
            
            
            
            24,049,620Property and Equipment–
      Net of accumulated depreciation of $118,144
    and $109,467
            
            
            52,620
            
            
            
            78,413Other
      AssetsDeposits
            
            
            28,525
            
            
            
            28,525Definite-lived
      intangible assets – Net of accumulated amortization of $1,258,369 and
      $1,095,999
            
            
            481,383
            
            
            
            635,111Goodwill
            
            
            4,876,038
            
            
            
            4,876,038Total
      Other Assets
            
            
            5,385,946
            
            
            
            5,539,674Total
      Assets
            
            $
            29,131,047
            
            
            $
            29,667,707LIABILITIES,
      REDEEMABLE PREFERRED STOCK AND STOCKHOLDERS’ EQUITYCurrent
      LiabilitiesAccounts
      payable
            
            $
            658,166
            
            
            $
            379,710Accrued
      expenses and other current liabilities
            
            
            3,119,142
            
            
            
            3,796,502Accrued
      state income taxes
            
            
            127,000
            
            
            
            127,000Deferred
      tax liability
            
            
            494,400
            
            
            
            732,000Total
      Current Liabilities
            
            
            4,398,708
            
            
            
            5,035,212Total
      Liabilities
            
            
            4,398,708
            
            
            
            5,035,212





See notes
to condensed consolidated financial statements.




1




TECHNEST
HOLDINGS, INC.


CONSOLIDATED
BALANCE SHEETS (concluded)






December
      31,
              2008
            
            
            June 30,
              2008(unaudited)Non-controlling
      interest
            
            
            -
            
            
            
            -Series D Redeemable,
      Convertible Preferred Stock - $.0001 par value;3,000
      shares authorized; 1,300 and 0 shares issued and outstanding
      atDecember
      31, and June 30, 2008, respectively (preference in liquidation
      of$1,316,431
      at December 31, 2008)
            
            
            1,316,431
            
            
            
            -Commitments
      and ContingenciesStockholders’
      EquitySeries
      A Convertible Preferred Stock - $.001 par value; 150 shares
      authorized;64.325
      shares issued and outstanding (preference in liquidation
of$64,325
      at December 31, 2008)
            
            
            -
            
            
            
            -Series
      C Convertible Preferred Stock - $.001 par value; 1,149,425
      sharesauthorized;
      402,301 issued and outstanding (preference in liquidationof
      $875,005 at December 31, 2008)
            
            
            402
            
            
            
            402Common
      stock - par value $.001 per share; 495,000,000 shares
      authorized;20,676,211
      and 20,505,335 shares issued and outstanding
            
            
            20,675
            
            
            
            20,504Additional
      paid-in capital
            
            
            37,233,600
            
            
            
            37,792,582Accumulated
      deficit
            
            
            (13,838,769
            )
            
            
            (13,180,993
            )Total
      Stockholders’ Equity
            
            
            23,415,908
            
            
            
            24,632,495Total
      Liabilities, Redeemable Preferred Stock and Stockholders’
      Equity
            
            $
            29,131,047
            
            
            $
            29,667,707





See notes
to condensed consolidated financial statements.


2





TECHNEST
      HOLDINGS, INC.CONSOLIDATED
      STATEMENTS OF OPERATIONSFOR
      THE SIX MONTHS ENDED DECEMBER 31, 2008 AND 2007
              (Unaudited)






2008
            
            
            2007Revenues
            
            $
            1,215,163
            
            
            $
            1,323,573Cost
      of Revenues
            
            
            675,899
            
            
            
            729,234Gross
      Profit
            
            
            539,264
            
            
            
            594,339Operating
      ExpensesSelling,
      general and administrative
            
            
            1,157,068
            
            
            
            2,547,952Research
      and development
            
            
            111,935
            
            
            
            -Amortization
      of intangible assets
            
            
            162,370
            
            
            
            162,370Total
      Operating Expenses
            
            
            1,431,373
            
            
            
            2,710,322Operating
      Loss from continuing operations
            
            
            (892,109
            )
            
            
            (2,115,983
            )Other
      Income (Expenses), NetOther
      income (expense)
            
            
            (3,267
            )
            
            
            152Interest
      expense
            
            
            -
            
            
            
            (11,329
            )Total
      Other Expenses, Net
            
            
            (3,267
            )
            
            
            (11,177
            )Loss
      from continuing operations before non-controlling interest
            
            
            (895,376
            )
            
            
            (2,127,160
            )Non-controlling
      interest in net loss of subsidiary
            
            
            -
            
            
            
            -Net
      Loss from continuing operations before income taxes
            
            
            (895,376
            )
            
            
            (2,127,160
            )Income
      tax benefit
            
            
            237,600
            
            
            
            -Net
      Loss from continuing operations
            
            
            (657,776
            )
            
            
            (2,127,160
            )Net
      Loss from discontinued operations(including
      loss on disposal in 2007 of $7,949,039)
            
            
            -
            
            
            
            (9,211,778
            )Net
      Loss
            
            
            (657,776
            )
            
            
            (11,338,938
            )Deemed
      Dividend on Series D Redeemable Preferred Stock
            
            
            1,121,431
            
            
            
            -Net
      Loss Applicable to Common Shareholders
            
            $
            (1,779,207
            )
            
            $
            (11,338,938
            )Basic
      and Diluted Loss Per Common ShareFrom
      continuing operations
            
            $
            (0.09
            )
            
            $
            (0.11
            )From
      discontinued operations
            
            $
            -
            
            
            $
            (0.49
            )Net
      Loss per share - basic and diluted
            
            $
            (0.09
            )
            
            $
            (0.60
            )Weighted
      Average Number of Common Shares OutstandingBasic
      and diluted
            
            
            20,662,486
            
            
            
            19,025,636See
      notes to condensed consolidated financial statements.




3




TECHNEST
      HOLDINGS, INC.CONSOLIDATED
      STATEMENTS OF OPERATIONSFOR
      THE THREE MONTHS ENDED DECEMBER 31, 2008 AND 2007
              (Unaudited)






2008
            
            
            2007Revenues
            
            $
            767,959
            
            
            $
            761,800Cost
      of Revenues
            
            
            401,359
            
            
            
            520,316Gross
      Profit
            
            
            366,600
            
            
            
            241,484Operating
      ExpensesSelling,
      general and administrative
            
            
            633,885
            
            
            
            530,481Research
      and development
            
            
            38,691
            
            
            
            -Amortization
      of intangible assets
            
            
            81,185
            
            
            
            81,185Total
      Operating Expenses
            
            
            753,761
            
            
            
            611,666Operating
      Loss from continuing operations
            
            
            (387,161
            )
            
            
            (370,182
            )Other
      Income (Expenses), NetOther
      income (expense)
            
            
            (4,438
            )
            
            
            20Interest
      expense
            
            
            -
            
            
            
            (3,270
            )Total
      Other Expenses, Net
            
            
            (4,438
            )
            
            
            (3,250
            )Loss
      from continuing operations before non-controlling interest
            
            
            (391,599
            )
            
            
            (373,432
            )Non-controlling
      interest in net loss of subsidiary
            
            
            -
            
            
            
            -Net
      Loss from continuing operations before income taxes
            
            
            (391,599
            )
            
            
            (373,432
            )Income
      tax benefit
            
            
            80,600
            
            
            
            -Net
      Loss from continuing operations
            
            
            (310,999
            )
            
            
            (373,432
            )Net
      Loss from discontinued operations(including
      loss on disposal in 2007 of $7,949,039)
            
            
            -
            
            
            
            (10,056,641
            )Net
      Loss
            
            
            (310,999
            )
            
            
            (10,430,073
            )Deemed
      Dividend on Series D Redeemable Preferred Stock
            
            
            1,121,431
            
            
            
            -Net
      Loss Applicable to Common Shareholders
            
            $
            (1,432,430
            )
            
            $
            (10,430,073
            )Basic
      and Diluted Loss Per Common ShareFrom
      continuing operations
            
            $
            (0.07
            )
            
            $
            (0.02
            )From
      discontinued operations
            
            $
            -
            
            
            $
            (0.50
            )Net
      Loss per share - basic and diluted
            
            $
            (0.07
            )
            
            $
            (0.52
            )Weighted
      Average Number of Common Shares OutstandingBasic
      and diluted
            
            
            20,676,211
            
            
            
            20,105,342See
      notes to condensed consolidated financial statements.





4




TECHNEST
HOLDINGS, INC.


CONSOLIDATED
STATEMENT


OF
CHANGES IN STOCKHOLDERS' EQUITY


FOR
THE SIX MONTHS ENDED DECEMBER 31, 2008


(Unaudited)








Series
      A
            
            
            Series
      CConvertible
            
            
            ConvertibleCommon
      stock
            
            
            Preferred
      stock
            
            
            Preferred
      stockShares
            
            
            Amount
            
            
            Shares
            
            
            Amount
            
            
            Shares
            
            
            AmountBalance
      - June 30, 2008
            
            
            20,505,335
            
            
            $
            20,504
            
            
            
            64
            
            
            $
            -
            
            
            
            402,301
            
            
            $
            402Issuance
      and amortization of stock based compensation related to
      restricted stock grants
            
            
            170,876
            
            
            
            171
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Beneficial
      conversion feature on Series D redeemable, convertible preferred
      stock
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Accretion
      of Series D redeemable, convertible preferred stock to redemption
      value
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Accretion
      of dividend on Series D redeemable, convertible preferred
      stock
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Net
      loss
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -
            
            
            
            -Balance
      - December 31, 2008
            
            
            20,676,211
            
            
            $
            20,675
            
            
            
            64
            
            
            $
            -
            
            
            
            402,301
            
            
            $
            402




Additional
            
            
            
            
            
            TotalPaid-In
            
            
            Accumulated
            
            
            Stockholders'Capital
            
            
            Deficit
            
            
            EquityAmount
            
            
            Amount
            
            
            AmountBalance
      - June 30, 2008
            
            $
            37,792,582
            
            
            $
            (13,180,993
            )
            
            $
            24,632,495Issuance
      and amortization of stock based compensation related to restricted stock
      grants
            
            
            107,449
            
            
            
            -
            
            
            
            107,620Beneficial
      conversion feature on Series D redeemable, convertible preferred
      stock
            
            
            455,000
            
            
            
            -
            
            
            
            455,000Accretion
      of Series D redeemable, convertible preferred stock to redemption
      value
            
            
            (1,105,000
            )
            
            
            -
            
            
            
            (1,105,000
            )Accretion
      of dividend on Series D redeemable, convertible preferred
      stock
            
            
            (16,431
            )
            
            
            -
            
            
            
            (16,431
            )Net
      loss
            
            
            -
            
            
            
            (657,776
            )
            
            
            (657,776
            )Balance
      - December 31, 2008
            
            $
            37,233,600
            
            
            $
            (13,838,769
            )
            
            $
            23,415,908




See notes
to condensed consolidated financial statements.


5





TECHNEST
      HOLDINGS, INC.CONSOLIDATED
      STATEMENTS OF CASH FLOWSFOR
      THE SIX MONTHS ENDED DECEMBER 31, 2008 AND 2007
              (Unaudited)







2008
            
            
            2007Cash
      Flows From Operating Activities:Net
      loss
            
            $
            (657,776
            )
            
            $
            (11,338,938
            )Adjustment
      to reconcile net loss to net cash (used in) provided byoperating
      activities:Depreciation
      and amortization of property and equipment
            
            
            18,091
            
            
            
            21,821Amortization
      of intangible assets
            
            
            162,370
            
            
            
            162,370Non-cash
      interest expense
            
            
            -
            
            
            
            1,538,276Deferred
      income tax benefit
            
            
            (237,600
            )
            
            
            -Stock-based
      compensation to employees and directors
            
            
            107,620
            
            
            
            264,308Stock
      issued in connection with termination of stockholder
              and
      license agreement
            
            
            -
            
            
            
            1,380,000Loss
      on sale of equipment
            
            
            5,974
            
            
            
            -Loss
      on disposal of discontinued operations
            
            
            -
            
            
            
            7,949,039Changes
      in operating assets and liabilities:Accounts
      receivable
            
            
            328,781
            
            
            
            8,851,172Unbilled
      receivables
            
            
            23,888
            
            
            
            1,515,558Inventory
      and work in process
            
            
            (30,110
            )
            
            
            (2,525
            )Restricted
      cash
            
            
            18,630
            
            
            
            (235,000
            )Deposits,
      prepaid expenses and other current assets
            
            
            53,240
            
            
            
            87,044Accounts
      payable
            
            
            278,456
            
            
            
            (7,184,252
            )Unearned
      revenue
            
            
            -
            
            
            
            (255,816
            )Accrued
      expenses and other current liabilities
            
            
            (677,360
            )
            
            
            (2,001,181
            )Due
      to related parties
            
            
            -
            
            
            
            (290,036
            )Net
      Cash (Used In) Provided by Operating Activities
            
            
            (605,796
            )
            
            
            461,840




6





TECHNEST
      HOLDINGS, INC.CONSOLIDATED
      STATEMENTS OF CASH FLOWSFOR
      THE SIX MONTHS ENDED DECEMBER 31, 2008 AND 2007 (concluded)
              (Unaudited)






2008
            
            
            2007Cash
      Flows From Investing Activities:Proceeds
      from sale of equipment
            
            
            1,728
            
            
            
            -Purchase
      of property and equipment
            
            
            -
            
            
            
            (38,581
            )Proceeds
      from disposal of discontinued operations, net of transaction
      costs
            
            
            -
            
            
            
            10,567,615Acquisition
      of new definite-lived intangible assets
            
            
            (8,642
            )
            
            
            -Net
      Cash (Used In) Provided by Investing Activities
            
            
            (6,914
            )
            
            
            10,529,034Cash
      Flows From Financing Activities:Proceeds
      from issuance of Series D Redeemable, Convertible Preferred
      Stock
            
            
            650,000
            
            
            
            -Repayment
      of revolving line of credit, net
            
            
            -
            
            
            
            (4,562,808
            )Repayment
      of term loan
            
            
            -
            
            
            
            (2,166,667
            )Repayment
      of notes payable
            
            
            -
            
            
            
            (3,056,131
            )Net
      Cash Provided by (Used In) Financing Activities
            
            
            650,000
            
            
            
            (9,785,606
            )Net
      Increase In Cash
            
            
            37,290
            
            
            
            1,205,268Cash
      and Cash Equivalents - Beginning of Period
            
            
            76,761
            
            
            
            1,140,227Cash
      and Cash Equivalents - End of Period
            
            $
            114,051
            
            
            $
            2,345,495Supplemental
      Disclosures of Cash Flow Information:Cash
      paid during the periods for:Interest
            
            $
            -
            
            
            $
            1,329,411Taxes
            
            $
            -
            
            
            $
            -Non-cash
      Investing and Financing Activities:Beneficial
      conversion on Series D Redeemable, Convertible Preferred
    Stock
            
            $
            455,000
            
            
            $
            -Accretion
      of Series D Redeemable, Convertible Preferred Stock and deemed
      dividend
            
            $
            1,105,000
            
            
            $
            -Accrued
      dividend on Series D Redeemable, Convertible Preferred
    Stock
            
            $
            16,431
            
            
            $
            -See
      notes to condensed consolidated financial statements.




7




TECHNEST
HOLDINGS INC.


NOTES
TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


FOR
THE SIX MONTHS ENDED DECEMBER 31, 2008 AND 2007


(Unaudited)




1.  NATURE
OF OPERATIONS




Business





Technest
Holdings, Inc. (“Technest” or “the Company”) is engaged in the design, research
and development, integration, analysis, modeling, system networking, sales and
support of intelligent surveillance, three-dimensional facial recognition and
three-dimensional imaging devices and systems primarily in the security and
healthcare industries. Historically, the Company’s largest customers have been
the Department of Defense and the National Institute of Health.





Sale of EOIR Technologies,
Inc.





In May
2007, the Company’s Board of Directors approved a plan to divest the operations
of EOIR.  On September 10, 2007, Technest and its wholly owned
subsidiary, EOIR Technologies, Inc. (“EOIR”), entered into a Stock Purchase
Agreement with EOIR Holdings LLC (“LLC”), a Delaware limited liability company,
pursuant to which Technest agreed to sell EOIR to LLC (see Note
3).  LLC is an entity formed on August 9, 2007 by The White Oak Group,
Inc., an Atlanta, Georgia based private investment firm, for the purposes of
facilitating this transaction.  The White Oak Group, Inc. is focused
on investments in the aerospace and defense industry, with an emphasis on the
following sectors: Homeland security (detection and deterrence); avionics and
instrumentation; command and control; and communication networks and
services.





The sale
of EOIR to LLC was structured as a stock sale in which LLC acquired all of the
outstanding stock of EOIR in exchange for approximately $34 million in cash, $11
million of which was paid at closing and $23 million of which is payable upon
the successful re-award to EOIR of the contract with the U.S. Army's Night
Vision and Electronics Sensors Directorate (“NVESD”). This transaction closed on
December 31, 2007. On August 4, 2008, EOIR was one of three companies awarded
the U.S. Army's NVESD contract with a funding ceiling of $495 million. The
Contingent Purchase Price of $23 million was due as of August 21, 2008 in
accordance with the Stock Purchase Agreement.





On August
26, 2008, LLC notified Technest that, in their opinion, the conditions set forth
in the Stock Purchase Agreement triggering payment of the Contingent Purchase
Price had not been satisfied. LLC provided no explanation for its
contention.  Technest strongly believes that all conditions of the
Stock Purchase Agreement were met, and LLC’s position is without
merit.  Technest is aggressively pursuing payment of the Contingent
Purchase Price in accordance with the Stock Purchase
Agreement.  Accordingly on September 24, 2008, Technest notified LLC
that it has filed for final and binding arbitration of the matter in accordance
with the terms of the Stock Purchase Agreement. On February 4, 2009, the
duly selected arbitration panel from the American Arbitration Association (AAA)
notified the parties that the arbitration hearing was scheduled to commence on
June 22, 2009. Any reduction in the amount of the Contingent Purchase Price
as a result of arbitration or settlement would reduce the amount of the gain on
disposal of EOIR, net of tax.





In
accordance with Statement of Financial Accounting Standard (“SFAS”) No. 141,
“Business Combinations”, the Company recorded the $23 million of contingent
consideration in the quarter ended March 31, 2008.  At that time, the
Company determined that the outcome of the contingency was determinable beyond a
reasonable doubt based on having received notification of award of the NVESD
contract pending review by the Small Business
Administration.   The Company continues to believe the outcome of
the contingency is determinable beyond a reasonable doubt.  EOIR is
presented as a discontinued operation in the consolidated financial statements
in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of
Long-Lived Assets” (see Note 3).





8





2. 
BASIS OF PRESENTATION





Basis
of  Presentation





The consolidated financial statements
include the accounts of Technest and its wholly-owned subsidiary, Genex
Technologies, Inc. Also included in the consolidation are the results of
Technest’s 49% owned subsidiary Technest, Inc. (see Note
4).  Technest, Inc. conducts research and development in the field of
computer vision technology and Technest Holdings has the right of first refusal
to commercialize products resulting from this research and
development.  The Company’s Chief Executive Officer beneficially owns
23% of Technest, Inc. and a former employee of the Company and current
employee of Technest, Inc. owns an additional 23%.  The remaining 5%
interest  is held by an unrelated third party.  In accordance with
Financial Accounting Standards Board Interpretation No. 46R, Consolidation of
Variable Interest Entities (FIN 46R),   Technest, Inc. is
considered a variable interest entity (VIE) for which Technest Holdings, Inc. is
the primary beneficiary.  The equity of the non-controlling
shareholders in the capital  and retained earnings of Technest, Inc.
are shown separately on the liability side of the consolidated balance sheet,
between liabilities and stockholders' equity.  This non-controlling
interest is adjusted for the non-controlling shareholders' proportionate share
of Technest, Inc.’s net income and losses.  In the event that the
non-controlling interest’s portion of net losses exceeds the carrying value of
the non-controlling interest, the carrying amount will not be reduced below zero
and the Company will recognize all of the excess losses.  Upon the
return to profitable operations, net income attributable to the Company’s
interest would not be reduced for the non-controlling interest until the the
Company has fully recovered the losses that were attributable to, but not
recognized for, the non-controlling interest during the loss
period.  All significant inter-company balances and transactions have
been eliminated in consolidation.




On
December 31, 2007, the Company divested the operations of its subsidiary, EOIR
Technologies, Inc.  In accordance with SFAS No. 144, the assets,
liabilities and results of operations of this consolidated subsidiary have been
classified as a discontinued operation for all periods presented in the
accompanying consolidated financial statements (see Note 3).





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 six months ended December 31, 2008 are not necessarily
indicative of the result that may be expected for the year ending June 30, 2009.
The unaudited condensed consolidated financial statements should be read in
conjunction with the consolidated financial statements and footnotes included in
the Company's annual report on Form 10-KSB for the year ended June 30, 2008
filed with the Securities and Exchange Commission.




Recent Accounting
Pronouncements




The
Company adopted Statement of Financial Accounting Standards No. 157 (“SFAS
157”), Fair Value
Measurements, which provides a framework for measuring fair value under
generally accepted accounting principles. This Statement became effective for
the Company on July 1, 2008 and did not have a material impact on the
Company’s consolidated financial statements. The Company also adopted SFAS
No. 159, The Fair Value
Option for Financial Assets and Financial Liabilities, including an amendment of
FASB Statement No. 115. SFAS 159 allows an entity the irrevocable
option to elect fair value for the initial and subsequent measurement for
certain financial assets and liabilities on a contract-by-contract basis. The
Company did not elect fair value treatment for any financial assets or
liabilities upon adoption. SFAS 159 also became effective for the Company on
July 1, 2008 and did not have a material impact on the Company’s
consolidated financial statements.




9




In
accordance with SFAS 157, the Company groups its financial assets and financial
liabilities measured at fair value in three levels, based on the markets in
which the assets and liabilities are traded and the reliability of the
assumptions used to determine fair value:





Level 1— Quoted prices in active markets for identical assets or liabilities.
Level 1 assets and liabilities include debt and equity securities that are
traded in an active exchange market. Valuations are obtained from readily
available pricing sources for market transactions involving identical assets or
liabilities.





Level 2— Observable inputs
other than Level 1 prices, such as quoted prices for similar assets or
liabilities; quoted prices in markets that are not active; or other inputs that
are observable or can be corroborated by observable market data for
substantially the full term of the assets or liabilities. For example, Level 2
assets and liabilities may include debt securities with quoted prices that are
traded less frequently than exchange-traded instruments or mortgage loans held
for sale, for which the fair value is based on what the securitization market is
currently offering for mortgage loans with similar characteristics.





Level 3— Unobservable inputs
that are supported by little or no market activity and that are significant to
the fair value of the assets or liabilities. Level 3 assets and liabilities
include financial instruments whose value is determined using pricing models,
discounted cash flow methodologies, or similar techniques, as well as
instruments for which the determination of fair value requires significant
management judgment or estimation.





The
Company has no such assets or liabilities at July 1, 2008 and December 31,
2008.





Also, the
Company may be required, from time to time, to measure certain other financial
assets on a nonrecurring basis in accordance with GAAP. These adjustments to
fair value usually result from application of lower-of-cost-or-market accounting
or write-downs of individual assets. The Company had no such assets as of
December 31, 2008.





In
December 2007, the FASB issued Statement No. 160, “Noncontrolling Interests in
Consolidated Financial Statements, an amendment of Accounting Research Bulletin
(“ARB”) No. 51.”  This Statement amends ARB No. 51 to establish
accounting and reporting standards for the noncontrolling interest in a
subsidiary and for the deconsolidation of a subsidiary.  It clarifies
that a noncontrolling interest in a subsidiary is an ownership interest in the
consolidated entity that should be reported as equity in the consolidated
financial statements.  This Statement is effective for fiscal years
beginning on or after December 15, 2008 and is not expected to have a material
impact on the consolidated financial statements of the Company.





In June
2008, the FASB ratified EITF Issue No. 07-5, "Determining Whether an Instrument
(or an Embedded Feature) Is Indexed to an Entity's Own Stock" (EITF 07-5).
 EITF 07-5 provides that an entity should use a two step approach to
evaluate whether an equity-linked financial instrument (or embedded feature) is
indexed to its own stock, including evaluating the instrument's contingent
exercise and settlement provisions.   EITF 07-5 is effective for fiscal
years beginning after December 15, 2008.  The consensus must be applied to
outstanding instruments as of the beginning of the fiscal year in which the
consensus is adopted and should be treated as a cumulative-effect adjustment to
the opening balance of retained earnings. Early adoption is not permitted. The
Company is in the process of evaluating the impacts, if any, of adopting this
EITF.




3. 
DISCONTINUED OPERATIONS





For the
three and six months ended December 31, 2007, the operations of EOIR have been
reported in discontinued operations in the Statements of Operations in
accordance with SFAS No. 144, paragraph 42. Revenues and net loss from
discontinued operations were as follows:




10




3 Months
              Ended
              12/31/2007
            
            
            6 Months
              Ended 12/31/2007Revenues
      from discontinued operations
            
            $
            28,281,311
            
            
            $
            46,099,851Net
      loss from discontinued operations
            
            $
            (2,107,602
            )
            
            $
            (1,262,739
            )





Certain general and administrative and
interest expenses of the Company that are clearly associated with EOIR totaling
$4,075,022 in the six months ended December 31, 2007 have been included in the
net loss from discontinued operations.





4.
TECHNEST, INC.





On October 1, 2008, the Company
formed and acquired a 49% interest in Technest, Inc. in exchange for the
transfer of certain contracts and employees. Technest, Inc. conducts research
and development in the field of computer vision technology. Technest Holdings
has the right of first refusal to commercialize products resulting from this
research and development. The Company’s Chief Executive Officer beneficially
owns 23% of Technest, Inc. and a former employee of the Company and current
employee of Technest, Inc. owns an additional 23%.  The remaining 5%
interest is held by an unrelated third party. The Company has certain
rights of first refusal and repurchase rights at Fair Market Value, as defined
in certain restricted stock agreements, with respect to the shares of Technest,
Inc. that it does not own.  The Company allocates certain general and
administrative and overhead expenses to Technest, Inc. and in the three and six
months ended December 31, 2008, the Company allocated approximately $53,000 of
such expenses to Technest, Inc.




5. 
DEFINITE-LIVED INTANGIBLE ASSETS




Definite-lived
intangible assets consist of the following:




December
              2008
            
            Useful
      life
              (years)Patents
      - commercialized technology
            
            $
            440,000
            
            5Patents
      - other
            
            
            169,752
            
            15Customer
      relationships and contracts
            
            
            1,130,000
            
            5Accumulated
      amortization
            
            
            (1,258,369)Net
      definite-lived intangible asset
            
            $
            481,383




Amortization
expense was $162,370 for each of the six months ended December 31, 2008 and
2007.




6.
SERIES D REDEEMABLE, CONVERTIBLE PREFERRED STOCK





On October 1, 2008, the Company’s Board of Directors approved the
designation 3,000 shares of Series D Redeemable, Convertible Preferred Stock
(“Series D Preferred”).  The Series D Preferred has a total face value
of $3,000,000, a stated value of $1,000 per share and is convertible at any time
at $0.20 per share.  The Series D Preferred is redeemable by the
Company at a price equal to the stated value plus dividends upon receipt of the
Contingent Purchase Price (see Note 1).  Since the redemption of the
Series D Preferred is not solely within the control of the Company, it does not
meet the requirements for classification as equity.  As a result, the
Series D Preferred is classified in the mezzanine section of the balance
sheet.




11




Dividends
are accrued on the Series D Preferred quarterly at a rate of 5% per year and the
Series D Preferred ranks pari passu with the holders of the Series A and Series
C Preferred Stock (see Note 7).  Holders of the Series D Preferred
have the right to one vote for each share of common stock into which the Series
D Preferred could then convert.





On
October 31, 2008, the Company sold 1,300 shares of its Series D Preferred to
Southridge Partners, LP (“Southridge”), for a purchase price of $650,000 ($500
per share). $600,000 of these proceeds was used in connection with the Deer
Creek Settlement (see Note 13) and the remainder proceeds are for working
capital purposes.




The
Company has determined that as of the date of issuance there was a beneficial
conversion feature in the aggregate amount of $455,000 for the six months ended
December 31, 2008.  Since the Series D Preferred is redeemable upon
collection of the Contingent Purchase Price, the Company accreted the Series D
Preferred to its redemption value of $1,300,000 immediately upon
issuance.  This resulted in a deemed dividend in the amount of
$1,105,000.  The carrying value in future periods will be adjusted by
additional dividends earned and expected to be paid upon
redemption.  Total dividends accrued on the Series D Preferred amount
to $16,431 at December 31, 2008.




At
December 31, 2008, the Company had 1,300 shares of Series D Preferred issued and
outstanding.  The Series D Preferred has a liquidation preference of
$1,316,431 at December 31, 2008.




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 4,735.3
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 C and Series D Preferred Stock.




At
December 31, 2008 there were 64.325 shares of Series A Preferred Stock issued
and outstanding.




12




Series C Convertible
Preferred Stock




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 currently $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 Series D Preferred
Stock.





Technest
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 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 December 31, 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.  On February 7, 2007, the required registration
statement became effective and, as a result, the Company does not expect to
incur any additional liquidated damages.





At
December 31, 2008, the Company had 402,301 shares of Series C Preferred Stock
issued and outstanding.




Common Stock
Issuances




During
the six months ended December 31, 2008, the Company issued the following amounts
of common stock:





●
            63,125
      shares of its Common Stock with a fair value of $28,911 to two
      non-employee directors of the company as compensation for service on the
      Company’s board of directors for the period January 1, 2008 to June 30,
      2008.





●
            32,751
      shares of its Common Stock with a fair value of $15,000 to three
      non-employee directors of the company as compensation for service on the
      Company’s board of directors for the period April 1, 2008 to June 30,
      2008.





●
            75,000
      shares of its Common Stock with a fair value of $48,438 to two employees
      of the Company pursuant to achieving milestones set out in employment
      agreements.




The
Company has established the following reserves for the future issuance of common
stock as follows:




Reserve
      for the exercise of warrants
            
            
            649,286Reserve
      for conversion of Series A Convertible Preferred Stock
            
            
            306,047Reserve
      for conversion of Series C Convertible Preferred Stock
            
            
            402,301Reserve
      for conversion of Series D Redeemable, Convertible Preferred
      Stock
            
            
            9,811,245Total
      common stock reserves
            
            
            11,168,879





13




8. 
OPTIONS, WARRANTS AND STOCK-BASED COMPENSATION




Options





In June
2001, the Company established the 2001 Stock Option Plan ("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
2001 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 December 31,
2008 and 2007 and there are currently no options outstanding under the
Plan.





Warrants





Summary
information with respect to warrants granted is as follows:




Number
      of
              Shares
            
            
            Weighted
      Average
              Exercise
      PriceBalance,
      July 1, 2008
            
            
            649,286
            
            
            $
            5.00Issued
            
            
            -
            
            
            
            -Expired
            
            
            -
            
            
            
            -Balance,
      December 31, 2008
            
            
            649,286
            
            
            $
            5.00




The
following table summarizes the Company's warrants outstanding at December 31,
2008:





Exercise
      price
            
            
            Number
            
            Expiration
      Date$
            6.50
            
            
            
            374,286
            
            02/14/2010$
            5.85
            
            
            
            75,000
            
            08/03/2013$
            1.89
            
            
            
            200,000
            
            07/17/2011649,286Weighted
      average remaining life
            1.7
      years





As of
December 31, 2008 all warrants are exercisable.




14





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 (see Note 10), (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.




Total
stock-based compensation related to shares that vested in the six months ended
December 31, 2008 and 2007 was $107,620 and $264,308,
respectively.





As of
December 31, 2008, the Company has 272,345 shares available for future grant
under the Plan.




9. 
NET (LOSS) INCOME PER SHARE




Securities
that could potentially dilute basic earnings per share ("EPS") and that were not
included in the computation of diluted EPS because to do so would have been
anti-dilutive for the three and six months ended December, 2008 consists of the
following:




Shares
      Potentially Issuable2008
            
            
            2007Series
      A Convertible Preferred Stock
            
            
            306,047
            
            
            
            306,047Series
      C Convertible Preferred Stock
            
            
            402,294
            
            
            
            632,185Series
      D Redeemable, Convertible Preferred Stock
            
            
            6,582,155
            
            
            
            -Warrants
            
            
            649,286
            
            
            
            649,286Total
            
            
            7,939,782
            
            
            
            1,587,518





15




10.
COMMITMENTS AND CONTINGENCIES




Facility
Rental




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 $15,131, increasing annually
by 3%.  Rent expense for continuing operations in the three months
ended December 31, 2008 and 2007 was $55,550 and $44,071,
respectively.




Employment Agreements with
Gino M. Pereira and  Nitin V. Kotak





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




11. 
INCOME TAXES




The
benefit from federal and state income taxes related to continuing operations for
the six months ended December 31, 2008 was $237,600.





The
Company's deferred tax assets consist primarily of the tax effects of its net
operating loss carry forwards.  As of December 31, 2008, the Company
had a valuation allowance of $2,369,000.  The Company has recorded a
valuation allowance against deferred tax assets as management has determined
certain net operating loss carryforwards will not be available due to Internal
Revenue Code Section 382 ownership changes.  In the six months ended
December 31, 2008, there was no change in the valuation
allowance.   As of December 31, 2008, the Company has net
operating loss carryforwards not subject to IRC Section 382 limitations of
$3,333,000 which begin to expire in 2024.





There was
no provision for federal or state income taxes for the six months ended December
31, 2007 due to the Company's operating losses and a full valuation reserve on
deferred tax assets.  As of December 31, 2007, the Company had
provided a full valuation reserve against the deferred tax assets 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.
 EMPLOYEE BENEFIT PLANS




Technest
has adopted a 401(k) plan for the benefit of employees. Essentially all Technest
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 contributes 6%, excluding bonuses on an annual basis, to those who have
been employed by Technest for more than one year and remain employed on the last
day of the fiscal year.




Contributions
and other costs of this plan in the three months ended December 31, 2008 and
2007 were $21,746 and $22,231, respectively.





13.  LITIGATION





H&H





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 of the causes of action make
allegations against Technest Holdings, Inc., Michael Sheppard and Maura Marx,
former officers of Technest.




16




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.





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 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. On July 31, 2008,
the court denied the motion to dismiss for lack of subject matter jurisdiction.
On September 5, 2008, in accordance with the judge’s order of July 31, 2008,
Technest, Mr. Sheppard and Ms. Marx filed a motion for summary judgment to
dismiss all claims against them. We intend to defend our position
vigorously and cannot make any assurances about the litigation’s
outcome.





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 Holdings, Inc., seeking unspecified monetary damages. 
Deer Creek alleged 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.  The trial for this claim
took place on April 8, 2008. On August 12, 2008, a decision was rendered against
Technest.  As of September 22, 2008, the parties have agreed to settle
the judgment in lieu of further appeals in the amount of
$600,000.  The settlement amount was paid in October 2008 upon receipt
of the proceeds from the Series D Preferred issuance (see Note 6).





The
White Oak Group





On August
26, 2008, EOIR Holdings LLC (“LLC”) notified Technest that, in their opinion,
the conditions set forth in the Stock Purchase Agreement triggering payment of
the Contingent Purchase Price have not been satisfied. LLC provided no
explanation for its contention.  Technest strongly believes that all
conditions of the Stock Purchase Agreement were met, and LLC’s position is
without merit.  Technest is aggressively pursuing payment of the
Contingent Purchase Price in accordance with the Stock Purchase
Agreement.  Accordingly on September 24, 2008, Technest notified LLC
that it has filed for final and binding arbitration of the matter in accordance
with the terms of the Stock Purchase Agreement. On February 4, 2009, the
duly selected arbitration panel from the American Arbitration Association (AAA)
notified the parties that the arbitration hearing was scheduled to commence on
June 22, 2009. Technest is seeking payment of approximately $22 million
from LLC representing the contingent portion of the purchase price to be paid by
LLC upon the successful re-award to EOIR of the contract with the NVESD less an
amount due to LLC for a final working capital adjustment, which is included in
accrued expenses and other current liabilities on the Consolidated Balance
Sheets.  LLC is an entity formed for the purpose of facilitating the
acquisition of EOIR by The White Oak Group, Inc., an Atlanta based private
equity firm.




17




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 December 31, 2008 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




As a result of the sale of
EOIR, the remaining business of Technest is the design, research and
development, integration, sales and support of three-dimensional imaging devices
and systems primarily in the healthcare industries and intelligent surveillance
devices and systems, and three-dimensional facial recognition in the security
industries. Historically, the Company’s largest customers have been the National
Institutes of Health and the Department of Defense.




Our
products leverage several core technology platforms, including:




·
            3D
      Imaging Technology Platforms:-3D
      capture using patented Rainbow 3D technology-3D
      processing, data manipulation, and advanced modeling-3D
      display in volumetric space




·
            Intelligent
      Surveillance Technology Platforms:-360-degree video
      acquisition using mirror, lens, and array
configurations-2D
      video detection, tracking, recognition and enhancement
      software




·
            3D
      Facial Recognition Technology Platforms:-3D facial image
      acquisition and recognition algorithms and
  software




·
            General
      Technology Platforms:-High-speed
      imaging processing hardware and embedded
  algorithms




18


Medical Devices
Division
 
 3D
Digitizer Systems provide turnkey three-dimensional (3D) imaging
solutions.


The
EARCAD(Ear
Impression) system has been customized for applications in the custom hearing
aid and ear mold markets. The EARCAD system automates the process of converting
a physical ear impression into a 3D model for streamlined production and quality
control. Initial applications are for manufacturers looking to streamline their
operations and enables audiology practices to improve turnaround times and
accuracy. Approximately 2.5 million hearing aids were sold in the United States
in 2007 and the retail market world wide was over $6 billion. Market penetration
still has considerable potential growth as 17.6% of the US population, or 56
million people, are over the age of 60 with increasing life expectancy. EARCAD
will provide audiologists and manufacturers with a total value added solution
from its range of impression and non impression scanners and associated
software. In particular the non impression scanner is well suited to the new
“behind the ear” fit models which are approaching 50% of all hearing aids sold.
The first of these systems was sold in April 2008 to a major international
hearing aid manufacturer following a successful debut at the annual American
Audiology conference.




The
AFOCAD is being developed as a Rapid Design and Fabrication Product/ Service
Platform for Custom-Fabricated, Patient Specific, Ankle-Foot Orthoses
(AFOs) in collaboration with Northeastern University and Spaulding
Rehabilitation hospital in Boston, Massachusetts. The current market size for
AFO’s is approximately $1 billion. Many stroke and diabetic patients will
require an AFO as a result of their condition. The AFOCAD system is projected to
be available before the end of the current calendar year.




The
Dental DigitizerTMis being developed for
applications in the dental industry. The system automates the process of
creating 3D models from dental molds and impressions in a rapid and accurate
process. This system offers significant benefits in cost, quality, and
turnaround times for dental labs, dentists, and orthodontists in the creation of
dental crowns, bridges, aligners, braces, and other dental solutions. In
addition the Company is developing a hand held intra oral scanner for taking
digital impressions.





Defense
and Security Division - 3D-ID





Our major
products, developed and in development, include our OmniEyeTM Wellcam, OmniEyeTM
Cerberus, Smart Optical Sensor (SOS), Smart SuiteTM, OmniEye Viewer, Small
Tactical Ubiquitous Detection System (STUDS), 3D SketchArtist, and 3D
FaceCam.





OmniEyeTM
Wellcam is an ultra light, portable 360 degree field of view camera which can be
used in field applications, such as detection of underground weapon caches and
search and rescue beneath building rubble, due to its durability. OmniEyeTM
Cerberus is a re-configurable multi-sensor system that is designed for long
distance infrared and visible light detection. OmniEyeTM Cerberus delivers this
flexibility while still maintaining seamless panoramic coverage up to 360
degrees. During the three months ended December 31, 2008, the company delivered
21 Wellcams to the DoD pursuant to it’s IDIQ contract.





SOS high
speed image processing platform powers our Smart SuiteTM algorithms, enhancing
both new and existing sensor systems with capabilities including: reliable
target detection, motion tracking, and object classification and recognition.
Smart SuiteTM algorithms are a portfolio of advanced video analysis and
augmentation modules. The SOS is a powerful system that allows multiple cameras
to be deployed easily in a distributed, scaleable network that provides
autonomous surveillance.





OmniEye
Viewer is a software platform for a wide range of security and surveillance
camera products. A flexible user interface allows the user to remotely control
OmniEye remote sensors and choose the best view desired for their specific
application.  User's can choose from 360-degree "fish-eye" and/or panoramic
views, multi-sensor stitched views, or perspective Pan-Tilt-Zoom views to move
left-right, up-down to "see as a person would see".  Trip wires and regions
of interest can also be set to customize alarm scenarios to the
application.




19


STUDS are
state-of-the-art, miniature, disposable, low-cost motion-tracking, positioning
and imaging unattended ground sensors that permit long-range surveillance at
high resolution. The system also includes rapidly deployable wireless networking
and GPS mapping for integration with legacy sensors, among other
advantages.


3D
SketchArtist is a three-dimensional composite sketch tool that uses our patented
three-dimensional morphing technology. The tool allows you to transform ordinary
two-dimensional sketches into rapidly evolving mock-ups that can be modified via
facial features, poses, expressions, and lighting in seconds. In August 2008,
the 3D SketchArtist was successfully introduced at the annual International
Association of Identification (IAI) show.  The Company has received an
order for 25 copies for use by the Los Angeles Police Department.




3D
FaceCam changes the way we capture photographs. The 3D FaceCam uses three
sensors to create precise, complete 3D face images at light speed. By capturing
the very highly detailed geometric and texture information on a face, the 3D
FaceCam overcomes a photo’s traditional limitations of pose, lighting, and
expression. Capture speed is less than half a second, enabling rapid processing
of large numbers of people. 3D FaceCam is also highly accurate, making 3D
FaceCam ideal for facial recognition. In April 2008, the Company delivered
its first outdoor facial recognition system to the US Army for
evaluation.




Technest
Business Strategy





Our goal
is to establish the Company as a leading innovator in the 3-D imaging products
and solutions arena. The broad strategies that we have in place to achieve this
goal are outlined below:




·
            Focus
      on commercialization of pipeline
products;





·
            Utilize
      relationships with current and new industry partners to bring technology
      to market;





·
            Develop
      recurring revenue models where
possible;





·
            Continue
      to explore the cutting edge of 3-D and 360° imaging through continued
      research and development;





·
            Continue
      to develop a robust intellectual property portfolio;
  and





·
            Seek
      strategic opportunities.




RESULTS
OF OPERATIONS





Recent
Developments




Small
Business Status





On
June 26, 2008, the Small Business Administration (“SBA”) concluded a formal size
determination on Technest. The SBA found that although Technest met the
definition of a small business, the composition of its stock ownership
disqualified the Company from participating in the Small Business Innovation
Research (“SBIR”) program. As of that date, the Company was permitted to
complete SBIR contracts awarded previously but was precluded from applying for
new SBIR contracts.  Excluding revenues from EOIR, this has been the
major source of revenue, although not of profit, for Technest. On July 28, 2008,
the Board of Directors of Technest voted to authorize the transfer
of certain government contracts and employees and license certain
assets to a newly formed company, Technest, Inc., in which Technest retains a
49% interest and meets the ownership eligibility for SBIRs. Technest will retain
the right of first refusal on all commercial applications that are developed by
this company.  This transaction occurred on October 1, 2008 and the
novation of contracts commenced on October 1, 2008.  Management
believes that this does not detract from the stated goal of Technest to develop
revenues from commercialization of its intellectual property
portfolio.





20




Three and Six months ended
December 31, 2008 compared with the Three and Six months ended December 31,
2007




Revenues




Technest
had $767,959 in revenues from continuing operations during the three months
ended December 31, 2008 compared with $761,800 during the three months ended
December 31, 2007. During the three months ended December 31, 2008 the Company
delivered 21 WellCams pursuant to our IDIQ contract with the Department of
Defense. At December 31, 2008, the Company’s backlog of funded contracts was
approximately $1.8 million.





Technest
had $1,215,163 in revenues from continuing operations during the six months
ended December 31, 2008 compared with $1,323,573 during the six months ended
December 31, 2007. These revenues were largely generated by Small Business
Innovative Research grants (SBIR’s) in the field of 3-dimensional imaging. We
use the revenue from these grants to develop future potential products for our
business. By their nature these revenues are not consistent from quarter to
quarter.





Gross
profit




The gross
profit for the three months ended December 31, 2008 was $366,600 or 48% of
revenues. The gross profit for the three months ended December 31, 2007 was
$241,484 or 32% of revenues. The gross profit margin for the three months ended
December 2007 was higher due to better profit margins on firm fixed priced
contracts.





The gross
profit from continuing operations for the six months ended December 31, 2008 was
$539,264 or 44% of revenues. The gross profit for the six months ended December
31, 2007 was $594,339 or 45% of revenues. Technest expects to expand its revenue
base to include commercial product revenues and, accordingly, gross profit on
future revenues may differ.





Selling,
general and administrative expenses




Selling,
general and administrative expenses for the three months ended December 31, 2008
and 2007 were $633,885 and $530,481, respectively.  These expenses
consisted primarily of payroll related expenses and professional
fees.





Certain
general and administrative expenses of the Company in 2007 that are clearly
associated with EOIR have been included in the net loss from discontinued
operations.  Such amounts totaled $1,810,075, including certain
severance payments triggered by the sale of EOIR, in the three months ended
December 31, 2007.





Selling,
general and administrative expenses for the six months ended December 31, 2008
and 2007 were $1,157,068 and $2,547,952.  The 2008 amount relates
primarily to payroll related expenses and professional fees.  The 2007
amount includes payroll related expenses, professional fees, a $207,491 non-cash
amortization of stock-based compensation to directors and officers and a
$1,380,000 expense related to the fair value of stock issued in connection with
the termination of certain sections of a stockholder agreement dated March 13,
2007 and of a licensing agreement dated March 13, 2007.





Certain
general and administrative expenses of the Company in 2007 that are clearly
associated with EOIR totaling approximately $4,075,022 in the six months ended
December 31, 2007  have been included in the net loss from
discontinued operations





21





Research
and development





In the three months and six months
ended December, 31, 2008 the Company incurred $38,691 and $111,935,
respectively, in development expenses associated with its EARCAD, 3D scanner and
SketchArtist products.




Amortization
of intangible assets




Amortization
of intangible assets for the three months and six months ended December 31 was
$81,185 and $162,370, respectively, for both 2008 and
2007.  Amortization expense relates to the definite-lived intangible
assets acquired in conjunction with Genex Technologies.




Operating
loss





The
operating loss from continuing operations for the three months ended December
31, 2008 was $387,161 compared with $370,182 for the three months ended December
31, 2007.





The
operating loss from continuing operations for the six months ended December 31,
2008 was $892,109 compared with $2,115,983 for the six months ended December 31,
2007.




Discontinued
Operations





The net
loss from EOIR’s operations was $2,107,602 in the three months ended December
31, 2007 including costs of $1,810,075 incurred by Technest that are clearly
associated with the discontinued operation.





The net
loss from EOIR’s operations was $1,262,739 in the six months ended December 31,
2007 including costs of $4,075,022 incurred by Technest that are clearly
associated with the discontinued operation.





The loss
from discontinued operations for the three and six month periods ended December
31, 2007 includes a loss on disposal $7,949,039 on the sale of
EOIR.




Net
Loss applicable to common shareholders





The net
loss attributable to common shareholders for the three and six months ended
December 31, 2008 was $1,432,430 and $1,779,207. Included in both periods is a
non-cash deemed dividend of $1,121,431 related to the issuance of Series D
Redeemable, Convertible Preferred Stock.





The net
loss attributable to common shareholders for the three and six months ended
December 31, 2007 was $10,430,073 and $11,338,938, respectively.





Liquidity
and Capital Resources




Cash
and Working Capital





On
December 31, 2008, Technest had a positive working capital balance of
$19,293,773. Net cash used in operating activities for the three months ended
December 31, 2008 was $605,796, including a non recurring legal settlement of
$600,000.




22




Cash
Used in Investing Activities





In the
six months ended December 31, 2008, Technest used cash of $8,642 for the
acquisition of new definite lived intangible assets representing costs
associated with filing for new patents.  The Company also sold certain
of their equipment for proceeds of $1,728 resulting in a loss on the sale of
$5,974.





Cash
Used in Financing Activities





In
October 2008, the Company received proceeds of $650,000 related to the issuance
of their Series D Preferred Stock (See Note 6).





Sources
of Liquidity





During
the six months ended December 31, 2008, the Company satisfied its operating and
investing cash requirements primarily from cash reserves and proceeds received
upon the issuance of our Series D Redeemable, Convertible Preferred
Stock.





A further
$23 million is due to the Company from the sale of EOIR. On August 26, 2008, LLC
notified Technest that, in their opinion, the conditions set forth in the Stock
Purchase Agreement triggering payment of the Contingent Purchase Price had not
been satisfied. LLC provided no explanation for its
contention.  Technest strongly believes that all conditions of the
Stock Purchase Agreement were met, and LLC’s position is without
merit.  Technest is aggressively pursuing payment of the Contingent
Purchase Price in accordance with the Stock Purchase
Agreement.  Accordingly on September 24, 2008, Technest notified LLC
that it has filed for final and binding arbitration of the matter in accordance
with the terms of the Stock Purchase Agreement.  On February 4, 2009, the
duly selected arbitration panel from the American Arbitration Association (AAA)
notified the parties that the arbitration hearing was scheduled to commence on
June 22, 2009.





The
Company is also expanding its efforts in commercial sales and believes that
these activities will contribute positively in fiscal 2009. In addition, the
Company is aggressively cutting costs and the Company’s officers are deferring a
portion of their remuneration. 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 no 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
December 31, 2008, Technest had warrants outstanding for the purchase of 649,286
shares of common stock. However, due to the net share settlement provisions of
these warrants, Technest does not expect any material cash proceeds upon
exercise.





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 and Estimates




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.




Our
critical accounting policies and use of estimates are discussed in and should be
read in conjunction with the annual consolidated financial statements and notes
included in the latest Form 10KSB, as filed with the SEC, which includes audited
consolidated financial statements for our fiscal years ended June 30, 2008 and
2007.





23





Item
4T. 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 (i) is
recorded, processed, summarized and reported within the time periods specified
in Securities and Exchange Commission rules and forms, and (ii) is accumulated
and communicated to our management, including our principal executive officer
and principal financial officer, as appropriate, to allow timely decisions
regarding required disclosure.




Changes
in Internal Control Over Financial Reporting.




There was
no change in our internal control over financial reporting during the quarter
ended December 31, 2008 that has materially affected, or is reasonably likely to
materially affect, our internal control over financial reporting.






PART II. OTHER INFORMATION




ITEM
1. Legal Proceedings





H&H





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 of the causes of action 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.





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 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. On July 31, 2008,
the court denied the motion to dismiss for lack of subject matter jurisdiction.
On September 5, 2008, in accordance with the judge’s order of July 31, 2008,
Technest, Mr. Sheppard and Ms. Marx filed a motion for summary judgment to
dismiss all claims against them. We intend to defend our position
vigorously and cannot make any assurances about the litigation’s
outcome.




24




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 Holdings, Inc., seeking unspecified monetary damages. 
Deer Creek alleged 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.  The trial for this claim
took place on April 8, 2008. On August 12, 2008, a decision was rendered against
Technest.  As of September 22, 2008, the parties have agreed to settle
the judgment in lieu of further appeals in the amount of
$600,000.  The settlement amount was paid in October 2008 upon receipt
of the proceeds from the Series D Preferred Stock issuance.





The
White Oak Group





On August
26, 2008, EOIR Holdings LLC (“LLC”) notified Technest that, in their opinion,
the conditions set forth in the Stock Purchase Agreement triggering payment of
the Contingent Purchase Price have not been satisfied. LLC provided no
explanation for its contention.  Technest strongly believes that all
conditions of the Stock Purchase Agreement were met, and LLC’s position is
without merit.  Technest is aggressively pursuing payment of the
Contingent Purchase Price in accordance with the Stock Purchase
Agreement.  Accordingly on September 24, 2008, Technest notified LLC
that it has filed for final and binding arbitration of the matter in accordance
with the terms of the Stock Purchase Agreement. On February 4, 2009, the
duly selected arbitration panel from the American Arbitration Association (AAA)
notified the parties that the arbitration hearing was scheduled to commence on
June 22, 2009. Technest is seeking payment of approximately $22 million
from LLC representing the contingent portion of the purchase price to be paid by
LLC upon the successful re-award to EOIR of the contract with the NVESD less an
amount due to LLC for a final working capital adjustment.  LLC is an
entity formed for the purpose of facilitating the acquisition of EOIR by The
White Oak Group, Inc., an Atlanta based private equity firm.





ITEM
1A. 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 “Note Regarding 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





Technest
has initiated arbitration proceedings for the payment of the $23,000,000
contingent purchase price under the Stock Purchase Agreement for the sale of
EOIR. If Technest is unsuccessful in the arbitration and the contingent purchase
price is not paid, Technest’s financial condition will be significantly
harmed.





On
September 24, 2008, we commenced arbitration proceedings against EOIR Holdings
LLC (“LLC”) in accordance with the Stock Purchase Agreement dated September 10,
2007. The arbitration hearing is scheduled to begin on June 22,
2009. We are seeking payment of approximately $22 million from Holdings,
which acquired our former subsidiary, E-OIR Technologies, Inc. (“EOIR”) on
December 31, 2007.  The $22 million payment represents the contingent
portion of the purchase price to be paid by LLC upon the successful re-award to
EOIR of the contract with the U.S. Army's Night Vision and Electronics Sensors
Directorate (“NVESD”). On August 4, 2008, EOIR was awarded the contract with the
U.S. Army’s NVESD. We believe the payment became due and payable on August 21,
2008.  If we are not successful in the arbitration and the contingent
purchase price is not paid, our financial condition will be significantly
harmed.




25




We have a limited operating history.
As a result, it may be difficult to evaluate our prospects for profitable
operations.




Technest
has a limited operating history on which a potential investor may base an
evaluation of us, our prospects and our ability to operate 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 December 31,
2008, our accumulated deficit was approximately $13.8 million. 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.





If Technest is not successful in its
businesses after the sale of EOIR, the anticipated benefits of the sale may not
be realized.




Historically,
EOIR had been the majority of Technest’s business operations.  After
the sale of EOIR, Technest operates independent of EOIR and EOIR’s
resources.  Achieving the anticipated benefits of the sale will
depend, in part, on the Company’s success in leveraging opportunities and
success in applying the proceeds of the sale. The challenges involved include
the following:




·
            shifting
      management’s primary focus to technologies in the fields of intelligent
      surveillance, three-dimensional facial recognition and three-dimensional
      imaging;




·
            establishing
      new sales and vendor partner relationships in these
  fields;




26




·
            demonstrating
      to customers that the sale will not result in adverse changes to the
      ability of the Company to address the needs of customers;
    and




·
            retaining
      key employees.





It is not
certain that Technest can be successful in a timely manner or at all or that any
of the anticipated benefits of the sale will be realized.  In
addition, Technest cannot assure you that there will not be substantial
unanticipated costs associated with the sale process, that the sale activities
will not result in a decrease in revenues in Technest’s other businesses and/or
a decrease in the value of Technest common stock, or that there will not be
other material adverse effects from the sale. If the benefits of the sale do not
meet the market expectations, the market price of Technest common stock may
decline.




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.




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.




27




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:




·
            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.




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.





Risks
Related to Contracting with the United States Government





Our
current revenues are derived from a small number of contracts within the U.S.
government set aside for small businesses.




We
currently derive substantially all of our revenue from Small Business Innovation
Research contracts with the U.S. Governmentsuch that the loss of
any one contract could materially reduce our revenues. As a result, our
financial condition and our stock price would be adversely
affected.





In order
to receive these Small Business Innovation Research contracts, we must satisfy
certain eligibility criteria established by the Small Business Administration.
If we do not satisfy these criteria, we would not be eligible for these
contracts and thus, our primary source of revenue would no longer be available
to us.  As a result, our financial condition would be adversely
affected.




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:




28




·
            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
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.




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.





Risks
Related To “Controlled Companies”





Technest’s
controlling stockholder has significant influence over the Company.





According
to the stock records of Technest, as of  January 27, 2009, Southridge
Partners LP, together with its affiliates, were the largest stockholders of
Technest, owning approximately 63% of Technest’s outstanding common stock as the
record holders of 12,903,872 shares.  Recently, Southridge appointed
three members to Technest’s board of directors (currently, there are a total of
six directors on Technest’s board of directors).  As a result, Southridge
possesses significant influence over our affairs.  Southridge’s stock
ownership and relationships with members of Technest’s board of directors may
have the effect of delaying or preventing a future change in control, impeding a
merger, consolidation, takeover or other business combination or discouraging a
potential acquirer from making a tender offer or otherwise attempting to obtain
control of Technest, which in turn could materially and adversely affect the
market price of Technest’s common stock.




29




A
very small number of investors hold a controlling interest in our stock. As a
result, the ability of minority shareholders to influence our affairs is
extremely limited.




A very
small number of investors collectively owned more than 63% of Technest’s
outstanding common stock on a primary basis.  As a result, those investors
have the ability to control all matters submitted to the stockholders of
Technest for approval (including the election and removal of
directors).  A significant change to the composition of our board
could lead to a change in management and our 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.




Moreover,
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 these investors or any other party retains a controlling
interest.




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.




We are
obligated to register shares held by Markland Technologies, Inc. or any of its
transferees as well as shares  held by other holders. 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 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.





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.




30




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.




31




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 2006 to January 2009, the trading price of
our common stock ranged from a low price of $0.05 per share to a high price of
$11.35 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
Relating to New Corporate Governance Standards




We
expect our administrative costs and expenses resulting from certain 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, it may be more difficult for us
to attract and retain 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.




32




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.




ITEM
6.  Exhibits




Exhibit
      No.
            Description
            Filed
      with this Quarterly Report
            Incorporated
      by referenceForm
            Filing
      Date
            Exhibit
      No.4.1
            Technest
      Series D 5% Convertible Preferred Stock Certificate of Designations filed
      with the Secretary of State of Nevada on October
    1, 2008.
            
            10-KSB
            October
      2, 2008
            4.1810.1
            Securities
      Purchase Agreement dated October 30, 2008 between Technest Holdings, Inc.
      and Southridge Partners, LP.
            
            8-K
            November
      5, 2008
            10.131.1
            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





33




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: February
      13, 2009
            By:
            /s/ Gino M.
PereiraGino
      M. Pereira

              Chief
      Executive Officer and PresidentDate: February
      13, 2009
            By:
            /s/ Nitin V.
      KotakNitin
      V. Kotak
              Chief
      Financial Officer








34




Exhibit
Index






Exhibit
      No.
            Description
            Filed
      with this Quarterly Report
            Incorporated
      by referenceForm
            Filing
      Date
            Exhibit
      No.4.1
            Technest
      Series D 5% Convertible Preferred Stock Certificate of Designations filed
      with the Secretary of State of Nevada on October
      1,  2008.
            
            10-KSB
            October
      2, 2008
            4.1810.1
            Securities
      Purchase Agreement dated October 30, 2008 between Technest Holdings, Inc.
      and Southridge Partners, LP.
            
            8-K
            November
      5, 2008
            10.131.1
            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