**UNITEDSTATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-K**

 
| **x** | ** ** | **ANNUAL  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934.** |
|-------|------------|-------------------------------------------------------------------------------------------------------|

 

**For thefiscal year ended December 31, 2007.**

 
| **o** | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934.** |
|-------|------------|-----------------------------------------------------------------------------------------------------------|

 

**For the transitionperiod               to               .**

 

**Commission File Number**

 

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**IMAGEWARE SYSTEMS, INC.**

(Exact name of Registrant as Specified in its Charter)

 

| **Delaware**                                                    | ** ** | **33-0224167**                        |
|-----------------------------------------------------------------|------------|---------------------------------------|
| (State or Other  Jurisdiction of Incorporation or Organization) |       | (I.R.S. Employer  Identification No.) |
|                                                            |       |                                  |
| **10883  Thornmint Road, San Diego, California**                | ** ** | **92127**                             |
| (Address of  Principal Executive Offices)                       |       | (Zip Code)                            |

 

(Registrant’s telephone number, including area code):   **(858) 673-8600**

 

Securities registered pursuant to Section 12(b) of theExchange Act:

 

| **Title of Each Class**           | ** ** | **Name of Each Exchange  on Which Registered** |
|-----------------------------------|------------|------------------------------------------------|
| Common Stock, $0.01 par value     |       | American Stock Exchange                        |
| Warrants to Purchase Common Stock |       | American Stock Exchange                        |

 

Securities registered pursuant to Section 12(g) of the Act: **None**

 

Indicateby check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act.  Yes o     No x

 

Indicateby check mark if the registrant is not required to file reports pursuant to Section 13or Section 15(d) of the Exchange Act. Yes o     No x

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. Yes x     No o

 

Indicate by check mark if disclosure ofdelinquent filers pursuant to Item 405 of Regulation S-K is notcontained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment to this Form 10-K.  Yes x     No o

 

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, a non-accelerated filer or a smaller reportingcompany. See the definitions of “large accelerated filer,” “accelerated filer,”and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Checkone):

 
| Large accelerated filer o | Accelerated filer o | Non-accelerated  filer x  (Do not check if a  smaller reporting company) | Smaller reporting company o |
|--------------------------------|--------------------------|-------------------------------------------------------------------------------|----------------------------------|

 

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

 

The aggregate marketvalue of the voting and non-voting common equity held by non-affiliates of theregistrant, based on the closing sales price of the issuer’s Common Stock on June 30,2007, as reported on the American Stock Exchange was approximately$27,985,450.  Excluded from thiscomputation were 557,118 shares of Common Stock held by all current executive officersand directors and 1,539,901 shares held by each person who is known by theregistrant to own 5% or more of the outstanding Common Stock.  Share ownership information of certainpersons known by the issuer to own greater than 5% of the outstanding CommonStock for purposes of the preceding calculation is based solely on informationon Schedule 13G filed with the Commission and is as of June 30, 2006.Exclusion of shares held by any person or entity should not be construed toindicate that such person or entity possesses the power, directly orindirectly, to direct or cause the direction of the management or the policiesof the Registrant.

 

The number of shares ofthe registrant’s common stock outstanding as of April 4, 2008 was18,075,639.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

Portionsof the Registrant’s definitive proxy statement for the 2008 Annual Meeting ofStockholders to be filed with the Securities and Exchange Commission pursuantto Regulation 14A are incorporated by reference into Part III of this Form 10-Kto the extent stated herein.

 

 

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**IMAGEWARE SYSTEMS, INC.**

**2007 ANNUAL REPORT ON FORM 10-K**

**TABLE OF CONTENTS**

 
| PART I                                |                                                                                                                |   |
|--------------------------------------------|---------------------------------------------------------------------------------------------------------------------|--------|
|                                       |                                                                                                                |   |
| Item 1.                               | Business                                                                                                            |   |
|                                       |                                                                                                                |   |
| Item 1A.                              | Risk  Factors                                                                                                       |   |
|                                       |                                                                                                                |   |
| Item 1B.                              | Unresolved  Staff Comments                                                                                          |   |
|                                       |                                                                                                                |   |
| Item 2.                               | Properties                                                                                                          |   |
|                                       |                                                                                                                |   |
| Item 3.                               | Legal Proceedings                                                                                                   |   |
|                                       |                                                                                                                |   |
| Item 4.                               | Submission  of Matters to a Vote of Security Holders                                                                |   |
|                                       |                                                                                                                |   |
| PART II                               |                                                                                                                |   |
|                                       |                                                                                                                |   |
| Item 5.                               | Market for  Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases  of Equity Securities |   |
|                                       |                                                                                                                |   |
| Item 6.                               | Selected  Consolidated Financial Data                                                                               |   |
|                                       |                                                                                                                |   |
| Item 7.                               | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                         |   |
|                                       |                                                                                                                |   |
| Item 7A.                              | Quantitative  and Qualitative Disclosures About Market Risk                                                         |   |
|                                       |                                                                                                                |   |
| Item 8.                               | Consolidated  Financial Statements and Supplementary Data                                                           |   |
|                                       |                                                                                                                |   |
| Item 9.                               | Changes in  and Disagreements With Accountants on Accounting and Financial Disclosure                               |   |
|                                       |                                                                                                                |   |
| Item 9A.                              | Controls and  Procedures                                                                                            |   |
|                                       |                                                                                                                |   |
| Item 9B.                              | Other Information                                                                                                   |   |
|                                       |                                                                                                                |   |
| PART III                              |                                                                                                                |   |
|                                       |                                                                                                                |   |
| Item 10.                              | Directors,  Executive Officers and Corporate Governance                                                             |   |
|                                       |                                                                                                                |   |
| Item 11.                              | Executive  Compensation                                                                                             |   |
|                                       |                                                                                                                |   |
| Item 12.                              | Security  Ownership of Certain Beneficial Owners and Management and Related Stockholder  Matters                    |   |
|                                       |                                                                                                                |   |
| Item 13.                              | Certain  Relationships and Related Transactions                                                                     |   |
|                                       |                                                                                                                |   |
| Item 14.                              | Principal  Accountant Fees and Services                                                                             |   |
|                                       |                                                                                                                |   |
| PART IV                               |                                                                                                                |   |
|                                       |                                                                                                                |   |
| Item 15.                              | Exhibits and  Financial Statement Schedules                                                                         |   |
|                                       |                                                                                                                |   |
| Exhibit Index                         |                                                                                                                |
|                                       |                                                                                                                |   |
| Signatures                                 |                                                                                                                |
|                                       |                                                                                                                |   |
| Index to Consolidated Financial Statements |                                                                                                                |

 

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**Forward-Looking Statements**

 

Thestatements contained in this Annual Report of Form 10-K that are nothistorical are forward-looking statements within the meaning of Section 27Aof the Securities Act of 1933, as amended (the “Securities Act”), and Section 21Eof the Securities Exchange Act of 1934, as amended (the “Exchange Act”),including statements regarding our expectations, beliefs, intentions orstrategies regarding the future. Forward-looking statements include, withoutlimitation, statements regarding the extent and timing of future revenues andexpenses and customer demand, statements regarding deployment of our products,and statements regarding reliance on third parties. All forward-lookingstatements included in this report are based on information available to us asof the date hereof and we assume no obligation to update any forward-lookingstatements. Forward-looking statements involve known or unknown risks,uncertainties and other factors, which may cause our actual results,performance or achievements, or industry results to be materially differentfrom any future results, performance or achievements expressed or implied bysuch forward-looking statements. Factors that could cause or contribute to suchdifferences include but are not limited to: our need for additional capital,fluctuations in our operating results, continued new product introductions,market acceptance of our new product introductions, new product introductionsby competitors, technological changes in the digital imaging industry,uncertainties regarding intellectual property rights and the other factorsreferred to herein including, but not limited to, those items discussed under “RiskFactors” below.

 

**Trademarks**

 

Capturethe Image that Captures the Crook, C.R.I.M.E.S., FACE ID, ImageWare, SuspectID, and Vehicle ID, EPIBuilder, and EPISuite are registered trademarks ofthe Company. Biometric Engine, WinBadge Aviation, and IWS Biometric Engine aretrademarks of the Company.

 

Allother trademarks, service marks and/or trade names appearing in this documentare the property of their respective holders.

 

**PART I**

 

**Item 1.  Business.**

 

**OVERVIEW**

 

ImageWare Systems, Inc.is a leader in the emerging market for software-based identity managementsolutions, providing biometric, secure credential, law enforcement andenterprise authorization.  Our “flagship” product is the IWS BiometricEngine.  Scalable for small city business or worldwide deployment, ourbiometric engine is a multi-biometric platform that is hardware and algorithmindependent, enabling the enrollment and management of unlimited populationsizes.  Our identification products are used to manage and issue securecredentials, including national IDs, passports, driver licenses, smart cardsand access control credentials. Our law enforcement products provide law enforcementwith integrated mug shot, fingerprint LiveScan and investigative capabilities.We also provide comprehensive authentication security software, as well asreal-time voice recognition, multilingual speech translation and voiceanalytics technologies.  Biometric technology is now an integral part ofall markets we address, and all of our products are integrated into theBiometric Engine Platform.  Elements of the IWS Biometric Engine can beused as investigative tools for law enforcement utilizing multiple biometricsand forensic data elements, and to enhance security and authenticity of publicand private sector credentials.

 

Our biometric technologyis a core software component of an organization’s security infrastructure andincludes a multi-biometric identity management solution for enrolling,managing, identifying and verifying the identities of people by the physicalcharacteristics of the human body. We develop, sell and support variousidentity management capabilities within government (federal, state and local),law enforcement, commercial enterprises, and transportation and aviationmarkets for identification and verification purposes. Our IWS Biometric Engineis a biometric identity management platform for multi-biometric enrollment,management and authentication, managing population databases of virtuallyunlimited sizes. It is also offered as a Software Development Kit (SDK) basedsearch engine, enabling developers and system integrators to implement abiometric solution or integrate biometric capabilities into existingapplications without having to derive biometric functionality from pre-existingapplications.  The IWS Biometric Engine combined with our securecredential platform, IWS EPI Builder, provides a comprehensive, integratedbiometric and secure credential solution that can be leveraged for high-endapplications such as passports, driver licenses, national IDs, and other securedocuments. It can also be utilized within our law enforcement systems toincorporate any number of various multiple biometrics into one system.

 

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We recently added nextgeneration voice recognition, multilingual speech translation and voiceanalytics capabilities to our suite of biometric identity management solutions,enabling users to facilitate and improve communication across major languagegroups globally. The ImageWare Mediator products are offered standalone orintegrated with our Biometric Engine platform providing an advancedmultilingual communications capability. Government, intelligence, defense,public safety and border control customers are able to realize languagetranslation and voice recognition capabilities whereby an English-speaking usercan understand and be understood in numerous languages including Spanish,German, French, Korean, Arabic and Polish, among others. ImageWare Mediatorproducts support speech to speech translation, multilingual collaboration,conversational environments, which are represented for both voice and text andinclude biometric functionality for speaker identification and voice analytics.

 

Our law enforcementsolutions enable agencies to quickly capture, archive, search, retrieve, andshare digital images, fingerprints and criminal history records on astand-alone, networked, wireless or Web-based platform. We develop, sell andsupport a suite of modular software products used by law enforcement and publicsafety agencies to create and manage criminal history records and toinvestigate crime. Our IWS Law Enforcement solution consists of six softwaremodules: a Capture and Investigative module, which provides a criminal bookingsystem and related database; a Facial Recognition module, which uses biometricfacial recognition to identify suspects; a Suspect ID module, which facilitatesthe creation of full-color, photo-realistic suspect composites; a wirelessmodule, which provides access to centrally stored records over the Internet ina connected or wireless fashion; a PDA add-on module, which enables access tocentrally stored records while in the field on a handheld Pocket PC compatibledevice combined with central repository services which allows for inter-agencydata sharing on a local, regional, and/or national level; and a LiveScanmodule, which incorporates LiveScan capabilities into IWS Law Enforcementproviding integrated fingerprint and palm print biometric management for civiland law enforcement use.

 

Our Secure Credential IDsolutions empower customers to create secure and smart digital identificationdocuments with complete ID systems. We develop, sell and support software anddesign systems which utilize digital imaging in the production of photoidentification cards and credentials and identification systems. Our productsin this market consist of IWS EPI Suite, IWS EPI Builder (SDK), Identifier forWindows and ID Card Maker.  These products allow for the production ofdigital identification cards and related databases and records and can be usedby, among others, schools, airports, hospitals, corporations or governments. We have recently added the ability to incorporate multiple biometrics into theID systems we offer with the addition of our new IWS Biometric Engine to ourproduct line.

 

Our enterpriseauthentication software includes the IWS Desktop Security product which is acomprehensive authentication management infrastructure solution providing addedlayers of security to workstations, networks and systems through advancedencryption and authentication technologies. IWS Desktop Security is optimizedto enhance network security and usability, and uses multi-factor authenticationmethods to protect access, verify identity and help secure the computingenvironment without sacrificing ease-of-use features such as quick login.Additionally, IWS Desktop Security provides an easy integration with varioussmart card-based credentials including the Common Access Card (CAC), HomelandSecurity Presidential Directive 12 (HSPD-12) Personal Identity Verification(PIV) credential, and Transportation Worker Identification Credential (TWIC)with an organization’s access control process. IWS Desktop Security providesthe crucial end-point component of a Logical Access Control System (LACS), andwhen combined with a Physical Access Control System (PACS), organizationsbenefit from a complete door to desktop access control and security model.

 

### **CORPORATEHISTORY**

###  

ImageWareSystems, Inc., formerly known as ImageWare Software, Inc., wasincorporated in the State of California on February 6, 1987.  From the inception until 1995, we designed andsold software products for the photo entertainment industry.  In late 1994, we sold our photo entertainmentline of products, and utilized our core technologies to develop and sellproducts to law enforcement agencies.  In1994 our company was sold to a new ownership and we embarked upon the designand creation of digital imaging based software products for lawenforcement.  From 1995 to early 2000 ourbusiness consisted only of our law enforcement products.  We completed our initial public offering in April 2000.  At that time we recognized that our coreimaging technology and industry expertise positioned us to enter other andlarger markets, and we targeted the digital identification market fordiversification.  It was a fragmentedmarket which offered us the opportunity to establish market share through anacquisition program.  On August 22,2000, we acquired Imaging Technology Corporation (“ITC”), a privately helddeveloper of software and software systems for digital identificationdocuments.  On September 29, 2000,we purchased Goddard Technology Corporation (“Goddard”), a privately helddeveloper of software identification badging systems. On March 30, 2001,we purchased substantially all the assets of G & A Imaging Ltd.(“G & A”), a privately

 

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held developer ofsoftware and software systems for digital identification documents.  These three acquisitions, along with theinternal development of digital ID solutions for some of our law enforcementcustomers, firmly placed us in the market for digital ID software.  In 2001, ID software and systems became ourlargest product segment.  On December 19,2007, we added next generation voice recognition, multilingual speechtranslation and voice analytics capabilities to our suite of biometric identitymanagement solutions, enabling users to facilitate and improve communicationacross major language groups globally through our acquisition of Sol Logic, Inc.,a privately held developer of voice recognition technologies.

 

### **RECENTEVENTS**

###  

Significant developmentsaround national and homeland security, specifically identity management, aredirect results of the terrorist attacks of September 11, 2001,demonstrating the risks with insufficient credentialing and access controlsystems. Although the U.S. Government has taken strong initiatives to helpcombat terrorism and other identity related challenges, the industry is stillin flux with inadequate equipment and appropriate funding causing a delay indeployments. The growing rate of identity theft is also pervasive and becomingof great concern. These developments have impacted business.

 

The law enforcement andsecure credential markets, although seen as markets which would ultimatelybenefit from increased spending on security, were negatively impacted withinthe last five years by the tendency for the delay in purchasing decisions,awaiting guidance and funding from the government, and the use of availablefunding for payment of overtime expenditures incurred due to heightenedsecurity alerts. As we recognized these impacts, we continued to reduce costand consolidate our businesses while expanding our products to meet marketdemands. We have restructured our company to be more cost effective andefficient by consolidating resources and moving various operations.

 

As a result of ourstrategy to address international markets for large identity managementprojects, we sold our Singapore subsidiary in 2005 and closed our German salesoffice in 2006. We now address this market through local and U.S. basedstrategic partners and systems integrators with local sales and servicepresence, and manage international channel partners for our boxed ID Softwarefrom our U.S. offices.

 

These internationaloffices had historically emphasized the resale of third party merchandise(hardware and media) which generated lower gross margins than software andrequired significant fixed costs for sales, service and support. Although thesemeasures have resulted in lower top line revenue in the short term, managementbelieves that we will be able to replace the lost revenue with higher marginsoftware sales while continuing to enjoy the lower fixed costs.

 

In furtherance of ourstrategy to more efficiently address both domestic and international marketsfor large-scale identity management projects, we completed the sale of ourentire Professional Digital Photography (“PDI”) product line in the fourthquarter of 2006.  We sold this component because it had incurredsignificant operating losses and had lost significant market share.  Theassets sold consisted primarily of a suite of software and related inventoryincluding source, copyrights, trademarks, documentation and client base.

 

In the fourth quarter of2007, we acquired the assets of Sol Logic, Inc., a leading provider ofvoice recognition and multilingual translation technology. This acquisition wasin line with our strategic plan to expand our biometric product portfolio andenable us to enter new markets including military and defense.

 

**INDUSTRYBACKGROUND**

 

***Biometrics and Secure Credential Markets***

 

Webelieve the biometric identity management market will continue to grow as therole of biometrics becomes more widely adopted for enhancing security andcomplying with new government regulations such as HSPD-12. Our biometric andsecure credentialing solutions are meeting the demands for true multi-modalbiometric identity management systems, as well as providing scalability tosupport evolving functionality.

 

As a result of HSPD-12,government organizations are required to adopt new processes for verifying theidentity of employees and contractors as well as controlling access to securefacilities and information systems. In response to the strict requirements setforth by the Federal government, ImageWare enhanced its IWS Biometric Engineand secure credentialing product suite by adding card management and cardprinting modules which enable the offering of end-to-end support for PIV-I andPIV-II business processes, technical requirements, as well as the ability topartner with leading physical and logical access control vendors for logisticsand deployment considerations.

 

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Ourtechnology also has applications in markets related to secure credentials,identification and access control (physical and logical) in the public andprivate sectors.  Organizations concernedwith security can use our technology to create secure “smart” identificationcards that can be instantly checked against a database of facial images orother biometrics to prevent unauthorized access to secure areas. We believepotential customers in these markets include, among others, large corporations,border crossings (land, air and sea), airports, hospitals, universities and governmentagencies.

 

Identificationsystems have historically been sold based upon the cost-savings digital systemsoffer over traditional photo-based systems. We believe that the ability toeasily capture images and data in a digital database and to enable immediateand widespread access to that database for remote identification/verificationwill be a functionality that customers will require in the future and that suchfunctionality will be one of the primary drivers for future growth within thismarket. We are able to provide field-proven identification products with highquality reference accounts across the board in terms of size and complexity ofsystems and user requirements. When combined with our proven biometric and Webcapabilities, we believe we can provide a leading product offering into thebiometrically-enabled secure credential market.

 

***Law Enforcement and Public Safety Markets***

 

TheUnited States law enforcement and public safety markets are composed offederal, state and local law enforcement agencies.  Our target customers include local policedepartments, sheriffs’ departments and offices, primary state law enforcementagencies, prisons, special police agencies, county constable offices, andfederal agencies such as the FBI and the DEA. We are also targeting agencies in foreign countries for our biometricand law enforcement solutions.

 

Webelieve the September 11, 2001, terrorist attacks and subsequent creationof the Department of Homeland Security has accelerated the adoption of digitalidentification systems. Law enforcement customers are demanding end-to-endsolutions that incorporate robust features and functionalities such asbiometric and secure credentialing capabilities, as well as instant access tocentrally maintained records for real time verification of identity andprivileges.

 

TheU.S. federal government has promoted the development and use of nationwidecriminal history record databases called the Interstate Identification Index (“III”)and the National Crime Information Center (“NCIC”), each consisting of on-linenational and regional databases dedicated to serving criminal justice agencies.The Interstate Identification Index is maintained by the FBI and includespersons arrested for felonies or serious misdemeanors. The FBI has indicatedthat this index will accept photographs in the future. We anticipate that theinclusion of digital images in these databases will increase the value ofdigital booking systems and the demand for facial recognition applications.Since the September 11, 2001, terrorist attack on the U.S. there has beensignificant discussion at the federal and state levels of government regardingthe need for federal, state and local agencies to share information. Weanticipate that the movement toward sharing of information will accelerate theadoption of systems such as ImageWare’s by law enforcement agencies at alllevels.

 

**PRODUCTSAND SERVICES**

 

Our identity managementsolutions are primarily focused around biometrics, secure credentials andmultilingual translation providing complete, cross-functional and interoperablesystems. Our biometric and secure credentialing products provide complete andinteroperable solutions with features and functions required throughout theentire identity management life-cycle, enabling users the flexibility to makeuse of any desired options, such as identity proofing and enrollment, cardissuance, maintenance and access control. Our solutions offer a significantbenefit that one vendor’s solution is used throughout the various stages, fromestablishing an applicant’s verified identity, to issuance of smart card basedcredentials, to the usage and integration to physical and logical accesscontrol systems. Our multilingual translation products fulfills the need oftranslators, interpretation experts and linguists. These solutions addressglobal collaboration through the use if next generation multilingualcommunications that provide integrated multilingual and biometric contentservices and integrated capabilities.

 

These solutions improveglobal communication, the integrity and authenticity of access control tofacilities and information systems, as well as enhances security, increaseefficiency, reduce identity fraud, and protect personal privacy.

 

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Wecategorize our identity management products and services into three basicmarkets: (1) Biometrics, (2) Secure Credential, and (3) LawEnforcement and Public Safety. Our biometric product line consists of thefollowing:

 

***Biometrics***

 

**IWS BIOMETRICENGINE**

 

This is a biometricidentity management platform for multi-biometric enrollment, management andauthentication, managing population databases of unlimited sizes without regardto hardware or algorithm.  Searches can be1:1 (verification), 1:N (identification), X:N (investigative) and N:N (databaseintegrity). IWS Biometric Engine is technology and biometric agnostic, enablingthe use of biometric devices and algorithms from any vendor, and the support ofthe following biometric types: finger, face, iris, hand geometry, palm,signature, DNA, voice, 3D face and retina. IWS Biometric Engine is asecond-generation solution from ImageWare Systems that is based on field-provenImageWare technology solutions that have been used to manage millions ofbiometric records since 1997 and is ideal for a variety of applicationsincluding: criminal booking, background checks (civil and criminal), watchlist, visa/passport and border control (air, land and sea), physical andlogical access control, and other highly-secure identity managementenvironments.

 

IWSBiometric Engine is scalable, and biometric images and templates can beenrolled either live or offline.  Because it stores the enrolled images, a new algorithm can be quicklyconverted to support new or alternate algorithms and capture devices. TheBiometric Engine is built to be hardware “agnostic”, and currently supportsover 107 hardware capture devices and over 93 biometric algorithms.

 

In 2006, ImageWare launched an expanded suite ofapplication solutions based on the award-winning IWS Biometric Engine. The IWSBiometric Engine has previously been available as a Software Development Kit(SDK), as well as a platform for custom configurations to meet specificcustomer requirements. The added suite of products provide government, lawenforcement, border management and enterprise businesses, a wide variety ofapplication-specific solutions that address specific government mandates andtechnology standards. It also provides the ability to integrate into existinglegacy systems and expand based upon specific customer requirements. Thisenables users to integrate a complete solution or components as needed. The newapplication suite of products include complete packaged solutions for:

 

·                  HSPD-12Personal Identity Verification (PIV)

 

·                  Border Management

 

·                  ePassport & eVisa

 

·                  Applicant Identity Vetting

 

·                  Mobile Acquisition

 

·                  Disaster Management

 

·                  Physical Access Control

 

·                  Single-Sign-On and Logical AccessControl

 

**IWS PIV MANAGEMENT APPLICATION**

 

ImageWare provides a setof Enterprise Server products within our complete PIV solution, and thesesoftware products supply server-based features and functions, while the usecase for PIV requires client-based presentation of PIV data and workflow.  The IWS PIV Management Application suppliesthe web-based graphical user interface that presents the user or clientinterface to the various server functions. Furthermore, since the server-based applications perform specific functionsfor specific phases of the PIV life-cycle, these server-based applications needto be bound together with additional workflow processes.  Again, the IWS PIV Management Applicationmeets this need with software modules that interface and interconnect theserver-based applications.

 

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**IWS PIV MIDDLEWARE**

 

The IWS PIV Middlewareproduct, which is NIST certified and listed on the GSA approved product list,is a library of functions that connect a card reader & PIV card on thehardware side with a software application. The library implements the specifiedPIV Middleware API functions that support interoperability of PIV Cards.  This ImageWare software has been developed inconformance with the FIPS-201 specification, and the software has been certifiedby the NIST Personal Identification Verification Program (NPIVP) ValidationAuthority as being compliant.

 

**IWS BACKGROUND SERVER**

 

The IWS Background Server is a software applicationdesigned specifically for government and law enforcement organizations tosupport the first stage of biometric identity management functions such asidentity proofing and vetting. IWS Background Check Server automaticallyprocesses the submission of an applicant’s demographic and biographic data toinvestigative bureaus for background checks prior to issuing a credential.

 

**IWS DESKTOP SECURITY**

 

IWS Desktop Security is ahighly flexible, scalable and modular authentication management platform thatis optimized to enhance network security and usability. This architectureprovides an additional layer of security to workstations, networks and systemsthrough advanced encryption and authentication technologies. Biometrictechnologies (face, fingerprint, iris, voice or signature), can be seamlesslycoupled with TPM chips to further enhance corporate security. USB tokens, smartcards and RFID technologies can also be readily integrated.****Additionalfeatures include:

 

·                                       Support formultiple authentication tools including Public Key Infrastructure (PK1) withina uniformed  platform and privilegeManagement Infrastructure (PMI) technology to provide more advanced accesscontrol services and assure authentication and data integrity.

 

·                                       Integration withIWS Biometric Engine for searching and match capabilities (1:1, 1:N and X:N)

 

·                                       Integration withIWS EPI Builder for the production and management of secure Credentials

 

·                                       Support for bothBioAPI and BAPI standards

 

·                                        Supports asingle sign-on feature that securely manages Internet Explorer and Windowsapplication ID and password information.

 

·                                       Supports fileand folder encryption features.

 

·                                       Supports variousoperating systems, including Microsoft Windows 2000, Windows XP, and AndWindows Server 2003.

 

**IWSBIOMETRIC QUALITY ASSESSMENT & ENHANCEMENT** (IWSBiometric IQA&E)

 

The IWS BiometricIQA&E is a biometric image enhancement and assessment solution that assistsgovernment organizations with the ability to evaluate and enrich millions ofbiometric images automatically, saving time and costs associated with biometricenrollment while maintaining image and database integrity.

 

The IWS Biometric IQA&E improves the accuracy andeffectiveness of biometric template enrollments. The software may be usedstandalone or in conjunction with the IWS Biometric Engine. IWS BiometricIQA&E provides automated image quality assessment with respect to relevantimage quality standards from organizations such as International Civil AviationOrganization (ICAO) National Institute of Standards and Technology (NIST),International Organization for Standards (ISO) and American Association ofMotor Vehicle Association (AAMVA). IWS Biometric IQA&E also enablesorganizations to conduct multi-dimensional facial recognition which furtherenhances accuracy for numerous applications including driver licenses,passports and watch lists.

 

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IWS Biometric IQA&E automatically providesreal-time biometric image quality analysis and feedback to improve the overalleffectiveness of biometric images thus increasing the biometric verificationperformance, and maintaining database and image data integrity. IWS BiometricIQA&E provides a complete platform that includes an image enhancementlibrary for biometric types including face, finger and iris.

 

**IWSMEDIATOR**

 

The IWS Mediator solutionis a suite of products that provide next generation integrated voicerecognition, multilingual speech translation, voice analysis and biometriccapabilities for government, defense, public safety, border control, andcorporate enterprises. These products enable users to facilitate and improvecommunication across major language groups globally, while accurately interpretting to and from a foreign language including special terminology and nuances.In addition, the Mediator utilizes a core middleware component, Unity, toprovide users with the ease to collaborate and identify throughout diverse anddisparate mediums, as well as enable autonomous use through mobiletechnologies.  It supportsspeech-to-speech translation, multilingual collaboration, conversationalenvironments (both voice and text) and include biometric functionality forspeaker identification and voice analysis**. **Because it is scalable, andhardware and software agnostic,  usershave the freedom to select from best-of-breed applications to ensure efficientintegration, and work with various environments to provide focused andmission-critical capabilities.

 

**IWSCOLLABID**

 

The IWS CollabID productis self-contained, multilingual translation, collaborative and multimodalbiometrics solution providing a means for users to communicate with subjects intheir own language while allowing for subject verification and identificationthrough the use of multimodal biometrics including face, iris, fingerprint, aswell as support for the Common Access Card (CAC) and Personal IdentityVerification (PIV) credentials. IWS CollabID performs in various environmentsand addresses mission-critical operations such as two-speech, speech-to-speech(rules and statistical), voice analysis, as well as multilingual chat,distributed speech for MeshNet and document exploitation.

 

Furthermore, CollabIDcombines ImageWare’s advanced technologies in the areas of integratedmultilingual translation, voice analysis and biometric content services andcapabilities. These integrated capabilities offer immediate increase in globalcommunication while strengthening tactical missions. It also addresses theunique requirements for successful gisting, the art of conveying intent ormeaning, which requires sophistication of language databases and the efficiencybetween the integrated technology and trainer. Additional features include:

 

·      Abilityto provide critical content indicators, alerts and warnings for users andcommand distribution

 

·      Abilityto upload all collected content and download updates and additional informationto existing databases as required when connected

 

·      Supportfor multiple formats for stored and reported content

 

·      Assurancethat all content is collected and stored locally

 

***Secure Credential***

 

OurIdentification and Secure Credential Products consist of the followingproducts:

 

**IWS CARDMANAGEMENT**

 

The IWS Card ManagementSystem (CMS) is a comprehensive solution to support and manage the issuance ofsmart cards complete with the following capabilities:

 

·              Biometricenrollment and identity proofing with Smart Card encoding of biometrics

 

·              Flexiblemodels of central or distributed issuance of credentials

 

·              Customizable cardlife-cycle workflow managed by the CMS

 

Integrationof the CMS data with other enterprise solutions, such as physical accesscontrol and logical access control (i.e. Single-Sign-On – SSO)

 

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**IWS EPISUITE**

 

Thisis an ID software solution for producing, issuing, and managing securecredentials and personal identification cards. Users can efficiently managelarge amounts of data, images and card designs, as well as track and issuemultiple cards per person; automatically populate multiple cards, eliminatingredundant data entry, IWS EPI Suite was designed to integrate with ourcustomers’ existing security and computing infrastructure. We believe that thiscompatibility may be an appealing feature to corporations, government agencies,transportation departments, school boards, and other public institutions.

 

**IWS EPI BUILDER**

 

This is a softwaredeveloper’s kit and a leading secure credential component of identitymanagement and security solutions, providing all aspects of ID functionalityfrom image and biometric capture to the enrollment, issuance and management ofsecure documents. It contains components which developers or systemsintegrators can use to support and produce secure credentials includingnational IDs, passports, International Civil Aviation Office (ICAO)-complianttravel documents, smart cards and driver licenses. IWS EPI Builder enablesorganizations to develop custom identification solutions or incorporatesophisticated identification capabilities into existing applications includingthe ability to capture images, biometric and demographic data; enable biometricidentification and verification (1:1 and 1:X) as well as support numerous biometrichardware and software venders. It also enables users to add electronicidentification functionality for other applications, including access control,tracking of time and attendance, point of sale transactions, human resourcesystems, school photography systems, asset management, inventory control,warehouse management, facilities management and card production systems.

 

**IDENTIFIERFOR WINDOWS**

 

Thisfamily of products combines the ability to capture photographic imagesdigitally with the ability to create a database and to print identificationcards. Identifier for Windows offers a powerful, versatile, and user-friendlyapplication which can be used by schools, hospitals, corporations andgovernments.

 

**IWS PRINTFARM**

 

Whileit is the last stage of PIV Card Issuance, the PIV smart card printing processis by no means the least important stage. Production printing of tens of thousands of PIV cards requires asignificant investment and a well-engineered system.  The IWS EPI PrintFarm software offers a cost-effectiveyet high-performance method for high-volume card printing.

 

**IWS PIV ENCODER**

 

PIVsmart cards must be programmed with specific mandatory data, digital signaturesand programs in order to maintain the interoperability as well as the securityfeatures specified for the cards. The IWS PIV Encoder could be considered to becomplex device driver that properly programs the PIV smart cards.  The Encoder interacts with the CardManagement System for data payload elements. It interacts with the CertificateAuthority to encrypt or sign the PIV smart card data with trusted certificates.Finally, it acts as the application-level device driver to make the specificPIV smart card encoding system properly program the smart card, regardless ifthe system is a standalone encoding system or one integrated into a cardprinter.

 

***Law Enforcement and Public Safety***

 

Webelieve our integrated suite of software products significantly reduces theinefficiencies and expands the capabilities of traditional booking and mugshotsystems. Using our products, an agency can create a digital database ofthousands of criminal history records, each including one or more full-colorfacial images, finger and palm prints, text information and images of otherdistinctive physical features such as scars, marks and tattoos. This databasecan be quickly searched using text queries or by using our biometric facialrecognition or AFIS technology which can compare biometric characteristics ofan unknown suspect with those in the database.

 

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Our investigativesoftware products can also be used to create, edit and enhance digital imagesand to search databases of other agencies to which our customers have access.

 

OurIWS Law Enforcement solution consists of software modules, which may also bepurchased individually. The IWS Law Enforcement Capture and Investigativemodule make up our booking system and database. Our add-on modules includeLivescan, Facial Recognition, Suspect ID, a Wireless module, and a PDA add-onmodule.

 

**IWS LAW ENFORCEMENT**

 

IWS Law Enforcement is adigital booking, identification and investigative solution that enables usersto digitally capture, search, store and retrieve images and demographic dataincluding mug shots, scars, marks and tattoos (SMTs) and fingerprints. Lawenforcement can submit fingerprint data directly to the State AFIS, FBIcriminal repository, or other agencies as required. Additional features andfunctionality include real-time access to images and data, creation of digitalcomposite sketches, photo lineups, and production of identification cards andcredentials.  IWS Law Enforcement alsouses off-the-shelf hardware and is designed to comply with open industry standardsso that it can operate on an array of systems ranging from a stand-alonepersonal computer to a wide area network. To avoid duplication of entries, thesystem can be integrated easily with several other information storage andretrieval systems, such as a records management system or an automatedfingerprint identification system.

 

**CAPTURE**

 

Thissoftware module allows users to capture and store facial images as well asimages of distinguishing features such as scars, tattoos and other marks. Eachentry contains both images and text information in an easy-to-view format madeup of distinct fields. Current customers of this module range from agenciesthat capture a few thousand mugshots per year to those that capture hundreds ofthousands of mugshots each year.

 

**LIVESCAN**

 

Thissoftware module is FBI certified which complies with the FBI IntegratedAutomated Fingerprint Identification System (IAFIS) Image QualitySpecifications (IQS) while utilizing the latest FBI certified Livescan devicefrom most major vendors. Livescan allows users to capture single to ten printsand palm data, providing an integrated biometric management for civil and lawenforcement use. By adding Livescan capabilities, law enforcement organizationsfurther enhance the investigative process by providing additional identifiersto identify suspects involved in a crime. In addition, officers no longer need to travel to multiple bookingstations to capture fingerprints and mug shots. All booking information including images will be located at a centraldesignation and can be routed to the State AFIS or the FBI criminal historyrecord repository.

 

**INVESTIGATIVE**

 

Thissoftware module allows users to search the database created with IWS LawEnforcement. Officers can conduct text searches in many fields, including filenumber, name, alias, distinctive features, and other information such as gangmembership and criminal history. The Investigative module creates a catalogueof possible matches, allowing officers or witnesses to save time by lookingonly at mugshots that closely resemble the description of the suspect. Thismodule can also be used to create a line-up of similar facial images from whicha witness may identify the suspect.

 

**FACIALRECOGNITION**

 

Thissoftware module uses biometric facial recognition and retrieval technology tohelp authorities identify possible suspects. Images taken from surveillancevideos, digital sketches or photographs can be searched against a digitaldatabase of facial images to retrieve any desired number of faces with similarcharacteristics. This module can also be used at the time of booking toidentify persons using multiple aliases. Using biometrics-based technology, theapplication can search through thousands of facial images in a matter ofseconds, reducing the time it would otherwise take a witness to flip through apaper book of facial images that may or may not be similar to the descriptionof the suspect. The Facial Recognition module then creates a selection ofpossible matches ranked in order of similarity to the suspect, and a percentageconfidence level is attributed to each possible match. The applicationincorporates search engine technology which we license from various facialrecognition algorithm providers.

 

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**SUSPECTID**

 

Thissoftware module allows officers and witnesses to quickly create full-color,photo-realistic suspect composites. The digital composites are constructed fromlibraries of facial features based upon actual color photographs of suchfeatures. Suspect ID allows officers with minimal computer training andartistic talent to create a suspect composite by pointing and clicking with amouse. This module can be installed on a laptop computer and taken into thefield, allowing officers to conduct interviews and create composites beforewitnesses’ memories fade. For rapid identification, officers can distributecompleted composites within minutes via fax or e-mail.

 

**WIRELESS**

 

TheWireless module enables authorized personnel to access and search a county’sbooking records stored in IWS Law Enforcement through a standard Web browserfrom within the county’s intranet. This module allows remote access to the IWSLaw Enforcement database without requiring the user to be physically connectedto the customer’s network. This application requires only that the user haveaccess to the Internet and authorization to access the county’s intranet.

 

**PDA**

 

ThePDA module is a powerful investigative tool that allows officers to access IWSLaw Enforcement booking photos and related data in the field on a handheldPocket PC compatible device.

 

***Maintenance and Customer Support***

 

Aspart of our installation of a system, we offer to train our customers’employees as to the effective use of our products. We offer training bothon-site and at our facilities. We offer on-site hardware support to ourcustomers, generally within 24 hours of the customer request. Customerscan contract with us for technical support that enables them to use a toll-freenumber to speak with our technical support center for software support andgeneral assistance 24 hours a day, seven days a week. As many of ourgovernment customers operate around the clock and perceive our systems ascritical to their day-to-day operations, a very high percentage contract fortechnical support. Customer support services typically provide us with annualrevenue of 12% to 18% of the initial sales price of the hardware and softwarepurchased by our customers.  Maintenancerevenues typically account for approximately 21% to 25% of our total revenues.

 

***Software Customization and Fulfillment***

 

Wedirectly employ computer programmers and also retain independent programmers todevelop our software and perform quality control. We provide customers withsoftware that we specifically customize to operate on their existing computersystem. We work directly with purchasers of our system to ensure that thesystem they purchase will meet their unique needs. We configure and test thesystem either at our facilities or on-site and conduct any customizedprogramming necessary to connect the system with any legacy systems already inplace.  We can also provide customerswith a complete computer hardware system with our software already installedand configured. In either case, the customer is provided with a complete turnkeysolution which can be used immediately. When we provide our customers with acomplete solution including hardware, we use off-the-shelf computers, camerasand other components purchased from other companies such as IBM or HewlettPackard. Systems are assembled and configured either at our facilities or atthe customer’s location.

 

**OURSTRATEGY**

 

Ourstrategy is to provide open-architected identity management solutions includingmulti-biometric, multilingual translation, secure credential and law enforcementtechnologies that are stand alone, integrated and/or bundled with key partnersincluding channel relationships and large systems integrators such asHoneywell, Boeing, GE Security, CSC, Unisys, HP, IBM, Oracle, Motorola, amongothers. Key elements of our strategy for growth include the following:

 

***Fully Exploit the Biometrics, AccessControl and Identification Markets***

 

Theestablishment of the Department of Homeland Security coupled with the movementby governments around the world to authenticate the identity of their citizens,employees and contractors has accelerated the adoption of biometric 

 

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identification systemsthat can provide secure credentials and instant access to centrally maintainedrecords for real-time verification of identity and access (physical andlogical) privileges. Using our products, an organization can create securecredentials that correspond to records including images and biographic data ina digital database. A border guard or customs agent can stop an individual toquickly and accurately verify his identity against a database of authorizedpersons, and either allow or deny access as required. Our technology is alsostandards based and applied to facilitate activities such as federalidentification mandates while complying with personal identificationverification standards (HSPD-12), International Civil Aviation Organization(ICAO) standards, American Association of Motor Vehicle Administrators (AAMVA)driver licenses, voter registration, immigration control and welfare fraudidentification.

 

Withthe identity management market growing at a rapid pace, biometric identifiersare becoming recognized and accepted as integral components to theidentification process in the public and private sectors.  As biometric technologies (facialrecognition, fingerprint, iris, etc) are adopted, identification systems mustbe updated to enable their use in the field. We have built our solutions to enable the incorporation of one ormultiple biometrics, which can be associated with a record and stored both in adatabase and on a card for later retrieval and verification without regard tothe specific hardware employed.  Webelieve the increasing demand for biometric technology will drive demand forour solutions which enable their use by end users.  Our identity management products are built toaccommodate the use of biometrics and meet the demanding requirements acrossthe entire identity life cycle.

 

***Expand into the Multilingual Translation Market***

 

Theneed for multilingual translation, interpretation, global collaboration,identification and conversation-based systems are more urgent that ever before.The world community, including international organizations such as the UnitedNations and the European Union, are spread around the globe, requiring not onlya large number of linguists in general, but also a large number of linguistsfor each given language. Similarily, law enforcement agencies, while in supportof homeland security operations and information analysis, lack the necessarymanpower to support continuous language translation and monitoring of broadcastinformation sources which may provide insight, and other potentially criticaldata to support their tasks.

 

Giventhe unique environment in which these professionals work, accurateinterpretation to and from a foreign language, including special terminologyand nuances are critically important. Our Mediator suite of multilingualtranslation products provide users with the ease to collaborate and identifythroughout diverse and disparate mediums, as well as enable autonomous usethrough mobile technologies. We are utlizing our expertise in biometric andidentity management, and integrating these capabilities, providing a means forusers to communicate with subjects in their own language while allowing forsubject verification and identification through multimodal biometrics such asvoice, face, iris, fingerprint, as well as support for the Common Access Card(CAC) and Personal Identity Verification (PIV) credential.

 

***Fully Expand Law Enforcement and PublicSafety Markets***

 

Weintend to use our successful installations with customers such as the ArizonaDepartment of Public Safety, New South Wales Police, and the Los Angeles CountySheriff’s Department as reference accounts and to aggressively market IWS LawEnforcement as a superior technological solution. Our recent addition of theLivescan module and support for local AFIS to our IWS Law Enforcement willenhance its functionality and value to the law enforcement customer as well asincrease the potential revenue the Company can generate from a systemsale.  We primarily sell direct to thelaw enforcement community. Our sales strategy is to increase sales to new andexisting customers including renewing supporting maintenance agreements. Wehave also established relationships with large systems integrators such asMotorola to OEM our law enforcement solution utilizing their worldwide salesforce. We will focus our sales efforts in the near term to establish IWS LawEnforcement as the integrated mug shot and Livescan system adopted in as manycountries, states, large counties and municipalities as possible. Once we havea system installed in a region, we intend to then sell additional systems orretrieval seats to other agencies within the primary customer’s region and inneighboring regions. In addition, we plan to market our integratedinvestigative modules to the customer, including the Facial Recognition andWireless modules, Suspect ID, WitnessView, Wireless module, and PDA module. Ascustomer databases of digital mug shots grow, we expect that the perceivedvalue of our investigative modules, and corresponding revenues from sales ofthose modules, will also grow.

 

***Acquire Businesses That Enhance OurStrategic Position***

 

We mayacquire additional businesses that will complement our growth strategy andenhance our competitive position in our current markets and other markets thatutilize our core biometric identity management and multiligual translationtechnologies.

 

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***Expand into Related Applications within theLaw Enforcement and Public Safety Markets***

 

Ourproducts can provide solutions to law enforcement and public safety agenciesbeyond our core application of police booking systems and related investigativeproducts with minimal adaptation. The technology behind our IWS Law Enforcementproduct line can be used to create databases of missing children and to comparethe facial image of a lost child to the images in the database. Our system canbe used to help correctional facilities track and control inmates as well asfacilitate inmate release. Gun sellers could use our products to accessavailable criminal databases and help prevent the sale of guns to ineligiblepersons. Our technology can be used to monitor persons on parole or probationwithout requiring them to travel to their parole or probation officer. Weanticipate that a parolee or probationer will be able to have his photographtaken in a specially-designed kiosk which uses biometrics-based technology toidentify the person and inform his parole or probation officer of his location.

 

**SALESAND MARKETING**

 

Wemarket and sell our products through our direct sales force and through indirectdistribution channels, including systems integrators. We have sales and accountrepresentatives based domestically in Virginia, Maryland, Texas, Arizona,  and California. Geographically, as of March 1,2008, our sales and marketing force consists of 14 persons in the UnitedStates.

 

Wesell through a direct sales organization which is supported by the marketingorganization.  Our sales professionalsare supported by our technical experts who are available by telephone andconduct on-site customer presentations.

 

Thetypical sales cycle for IWS Biometric Engine and IWS Law Enforcement includes apre-sale process to define the potential customer’s needs and budget, anon-site demonstration and conversations between the potential customer andexisting customers. Government agencies are typically required to purchaselarge systems by including a list of requirements in a Request For Proposal,known as an “RFP,” and by allowing several companies to openly bid for theproject by responding to the RFP. If our response is selected, we enter intonegotiations for the contract and, if successful, ultimately receive a purchaseorder from the customer. This process can take anywhere from a few months toover a year.

 

OurBiometric and ID products are also sold to large integrators, direct via oursales force and to end users through distributors. Depending on the customer’srequirements, there may be instances that require an RFP. The sales cycle canvary from a few weeks to a year.

 

Inaddition to our direct sales force, we have developed relationships with anumber of systems integrators who contract with government agencies for theinstallation and integration of large computer and communication systems. Byacting as a subcontractor to these systems integrators, we are able to avoidthe time consuming and often-expensive task of submitting proposals togovernment agencies, and we also gain access to large clients.

 

Wealso work with companies that offer complementary products, where value iscreated through product integration. Through teaming arrangements we are ableto enhance our products and to expand our customer base through therelationships and contracts of our strategic partners.

 

Wepromote our products through trade journal advertisements, direct mail and attendanceat industry trade shows, including those sponsored by the BiometricConsortium, International Association for Biometrics, American Association ofMotor Vehicle Administrators, International Association forIdentification, American Society of Industrial Security and theInternational Association of Chiefs of Police. We also target other mediathrough public relations efforts, including non-industry publications, dailynewspapers, local and national news programs, and television programs relatedto law enforcement. Articles regarding our products have appeared in BusinessWeek, Los Angeles Times, Chicago Tribune, The Wall Street Journal and a numberof other publications.

 

Weplan to continue to market and sell our products internationally. Some of thechallenges and risks associated with international sales include the difficultyin protecting our intellectual property rights, difficulty in enforcingagreements through foreign legal systems and volatility and unpredictability inthe political and economic conditions of foreign countries. We believe we canwork to successfully overcome these challenges.

 

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**CUSTOMERS**

 

Wehave a wide variety of domestic and international customers. Most of our IWSLaw Enforcement customers are government agencies at the federal, state andlocal levels in the United States. Our products are also being used inAustralia, Canada, the United Arab Emirates, Kuwait, Mexico, Colombia, CostaRica, Venezuela, Singapore, Indonesia and the Philippines. The customer basefor our digital identification systems includes domestic and foreign governmentagencies, universities, airports, and private sector companies, many of whichare Fortune 500 or Fortune 1000 companies. In 2007, Unisys Corporationaccounted for approximately 18% of our revenues.  In 2006, Raytheon Company accounted forapproximately 21% of our revenues.  In2005 there was no single customer who accounted for more than 10% of ourrevenues.

 

**COMPETITION**

 

***The Law Enforcement and Public SafetyMarkets***

 

Due tothe fragmented nature of the law enforcement and public safety market and themodular nature of our product suite, we face different degrees of competitionwith respect to each IWS Law Enforcement module. We believe the principal basison which we compete with respect to all of our products are:

 

·              theunique ability to integrate our modular products into a complete biometric,Livescan, imaging and investigative system;

 

·              ourreputation as a reliable systems supplier;

 

·              theusability and functionality of our products; and

 

·              theresponsiveness, availability and reliability of our customer support.

 

Ourlaw enforcement product line faces competition from other companies such asDataWorks Plus and Cogent Systems, Inc. Internationally, there are often a number of local companies offeringsolutions in most countries. Many of our competitors’ products in this nicheoffer basic image capture and storage, but lack the functionality of integratedinvestigative products, including facial recognition and image editing andenhancement.

 

***Identification Markets***

 

Due tothe breadth of our software offering in the secure ID market space, we facediffering degrees of competition in certain market segments. The strength ofour competitive position is based upon:

 

·              ourstrong brand reputation with a customer base which includes small andmedium-sized businesses, Fortune 500 corporations and large governmentagencies;

 

·              theease of integrating our technology into other complex applications; and

 

·              theleveraged strength that comes from offering customers software tools, packagedsolutions and Web-based service applications that support a wide range ofhardware peripherals.

 

Oursoftware faces competition from Datacard Corporation, a privately heldmanufacturer of hardware, software and consumables for the ID market. There arealso a considerable number of smaller software competitors such as Number FiveSoftware Ltd., Loronix Information Systems, Inc. and Fox TechnologyPty Ltd. who compete in differing geographies, primarily in the packagedproduct segment.

 

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** **

***BiometricMarket***

 

Themarket to provide biometric systems to the identity management market isevolving and we face competition from a number of sources. We believe that thestrength of our competitive position is based on:

 

·                                          our unique ability to provide a systemwhich enables the enrollment, management and authentication of multiplebiometrics managing population databases of unlimited sizes;

 

·                                          searches canbe 1:1 (verification), 1:N (identification) and X:N (investigative); and N:N(database integrity)

 

·                                          the system istechnology and biometric agnostic, enabling the use of biometric devices andalgorithms from any vendor, and the support of the following biometric types:finger, face, iris, hand geometry, palm, DNA, signature, voice, and 3D face andretina;

 

Ourmulti-biometric product faces competition from L-1 Identity Solutions, Inc.,Ireland-based Daon, and French-based Sagem neither of which have offerings withthe scope and flexibility of our IWS Biometric Engine.

 

**INTELLECTUALPROPERTY**

 

Werely on trademark, patent, trade secret and copyright laws and confidentialityand license agreements to protect our intellectual property. We have severalunregistered and federally registered trademarks including the trademarkImageWare, as well as trademarks for which there are pending trademarkregistrations with the United States, Canadian and other International Patent &Trademark Offices.  We hold severalissued patents and have several other patent applications pending for elementsof our products.  We license and dependon intellectual property from third parties for our biometric products andmodules which utilizes third party biometric encoding and matchingtechnologies.

 

Weregard our software as proprietary and retain title to and ownership of the softwarewe develop.  We attempt to protect ourrights in the software primarily through trade secrets.  We have not published the source code of mostof our software products and require employees and other third-parties who haveaccess to the source code, other trade secret information, to signconfidentiality agreements acknowledging our ownership and the nature of thesematerials as our trade secrets.

 

Despitethese precautions, it may be possible for unauthorized parties to copy orreverse-engineer portions of our products. While our competitive position could be threatened by disclosure orreverse engineering of this proprietary information, we believe that copyrightand trademark protection are less important than other factors such as theknowledge, ability, and experience of our personnel, name recognition andongoing product development and support.

 

Oursoftware products are licensed to end users under a perpetual, nontransferable,nonexclusive license that stipulates which modules can be used and how manyconcurrent users may use them.  Theseforms of licenses are typically not signed by the licensee and may be moredifficult to enforce than signed agreements in some jurisdictions.

 

Althoughour products have never been the subject of an infringement claim, we cannotassure that third parties will not assert infringement claims against us in thefuture or that any such assertion will not require us to enter into royaltyarrangements or result in costly litigation.

 

**RESEARCHAND DEVELOPMENT**

 

Ourresearch and development team is made up of 26 programmers, engineers and otheremployees. We also contract with outside programmers for specific projects asneeded. We spent approximately $3.7 million, $3.7 million and $2.9 millionon research and development in 2007, 2006 and 2005, respectively. Wecontinually work to increase the speed, accuracy, and functionality of ourexisting products. We anticipate that our research and development efforts willcontinue to focus on new technology and products for the identity managementmarkets.

 

**EMPLOYEES**

 

As of March 1, 2008,we had a total of 72 full-time employees. Our employees are not covered by anycollective bargaining agreement, and we have never experienced a work stoppage.We believe that our relations with our employees are good.

 

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**Item 1A.  Risk Factors**

 

*Aninvestment in our common stock involves a high degree of risk. before investingin our common stock, you should consider carefully the specific risks detailedin this “Risk Factors” section and any applicable prospectus supplement,together with all of the other information contained in this prospectus and anyprospectus supplement. If any of these risks occur, our business, results ofoperations and financial condition could be harmed, the price of our commonstock could decline, and you may lose all or part of your investment.*

 

**RISKSRELATED TO OUR BUSINESS**

 

**RisksRelated to Our Business**

 

***We have incurred net losses inour six most recent fiscal years and AMEX has issued us a letter that itintends to remove our common stock from listing and registration on theexchange*****.**

 

The AMEX Company Guide(the “Company Guide”) provides that AMEX will normally consider suspendingdealings in, or removing from the list, securities of a company which sustainsnet losses in its five most recent fiscal years and has shareholders’ equity ofless than $6,000,000, unless the company has total market capitalization of atleast $50,000,000, or total assets and revenue of $50,000,000. We havesustained net losses during our six most recent fiscal years, and as of December 31,2007, our shareholders’ equity was approximately $3,527,000. In addition, we donot meet the alternative minimum market capitalization or total asset and revenuerequirements.

 

On December 14,2007, we received a letter from AMEX indicating that we do not comply with AMEX’scontinued listing standards due to our inability to maintain compliance withSections 1003(a)(ii), 1003(a)(iii) and 1003(a)(iv) of the CompanyGuide and that AMEX intends to remove our common stock from listing andregistration on AMEX by filing a delisting application with the Securities andExchange Commission (“SEC”).  The letterfrom AMEX states that we were not in compliance with (i) Section 1003(a)(ii) ofthe Company Guide because our shareholders’ equity was less than $4,000,000 andwe sustained losses from continuing operations and/or net losses in three outof our four most recent fiscal years, and (ii) Section 1003(a)(iii) ofthe Company Guide because our shareholders’ equity was less than $6,000,000 andwe sustained losses from continuing operations and/or net losses in our fivemost recent fiscal years.  We had alsobeen notified by AMEX that we were not in compliance with Section 1003(a)(iv) ofthe Company Guide in that we had sustained losses which are so substantial inrelation to our overall operations or our existing financial resources, or ourfinancial condition had become so impaired that it appeared questionable, inthe opinion of AMEX, as to whether we would be able to continue operationsand/or meet our obligations as they matured.

 

We filed an appeal ofAMEX’s determination and requested an oral hearing before an AMEX ListingQualifications Panel (a “Qualifications Panel”).  On March 10, 2008, we received a letterfrom AMEX granting our request.  Ourhearing with a Qualifications Panel is scheduled for April 16, 2008.  If the Qualifications Panel does not grantthe relief sought, our common stock will be delisted from AMEX following whichit is expected that our common stock would be quoted on the Over-the-CounterBulletin Board.  As a consequence of anysuch delisting, the public price of our common stock could be adversely affectedand a stockholder would likely find it more difficult to dispose of, or toobtain accurate quotations as to the prices of, our common stock.

 

***We have a history of significant recurring losses totalingapproximately $75.9 million, and these losses may continue in the future*****.**

 

As of December 31,2007, we had an accumulated deficit of $75.9 million, and these losses maycontinue in the future. We will need to raise capital to fund our continuingoperations, and financing may not be available to us on favorable terms or atall. In the event financing is not available in the time frame required, wewill be forced to sell certain of our assets or license our technologies toothers. We expect to continue to incur significant sales and marketing,research and development, and general and administrative expenses. As a result,we will need to generate significant revenues to achieve profitability and wemay never achieve profitability.

 

Our operating resultshave fluctuated in the past and are likely to fluctuate significantly in thefuture. We may experience fluctuations in our quarterly results of operationsas a result of:

 

·               varying demand for and market acceptance of ourtechnology and products;

 

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·               changes in our product or customer mix;

 

·               the gain or loss of one or more keycustomers or their key customers, or significant changes in the financialcondition of one or more of our key customers or their key customers;

 

·               our ability to introduce, certify and deliver newproducts and technologies on a timely basis;

 

·               the announcement or introduction of products and technologiesby our competitors;

 

·               competitive pressures on selling prices;

 

·               costs associated with acquisitions and the integrationof acquired companies, products and technologies;

 

·               our ability to successfully integrate acquiredcompanies, products and technologies, including the assets acquired from SolLogic;

 

·                  our accounting and legal expenses; and

 

·                  general economic conditions.

 

These factors, some ofwhich are not within our control, may cause the price of our stock to fluctuatesubstantially. To respond to these and other factors, we may need to makebusiness decisions that could result in failure to meet financial expectations.If our quarterly operating results fail to meet or exceed the expectations ofsecurities analysts or investors, our stock price could drop suddenly andsignificantly. Most of our expenses, such as employee compensation, inventoryand debt repayment obligations, are relatively fixed in the short term.Moreover, our expense levels are based, in part, on our expectations regardingfuture revenue levels. As a result, if our revenue for a particular period werebelow our expectations, we would not be able to proportionately reduce ouroperating expenses for that period. Any revenue shortfall would have adisproportionately negative effect on our operating results for the period.

 

***We received a “going concern” opinion from our independentregistered public accounting firm for the fiscal years ended December 31,2006  and 2007, which may negativelyimpact our business.***

 

We received a report fromStonefield Josephson, Inc., our independent registered public accountingfirm (“Stonefield Josephson”), regarding our consolidated financial statementsfor the fiscal year ended December 31, 2006 and 2007, which included anexplanatory paragraph stating that the consolidated financial statements wereprepared assuming we will continue as a going concern. The report also statedthat our substantial net losses and monetary liabilities have raisedsubstantial doubt about our ability to continue as a going concern.  The “goingconcern” opinion for the fiscal year ended December 31, 2007, may fail todispel any continuing doubts about our ability to continue as a going concern andcould adversely affect our ability to enter into collaborative relationshipswith business partners, to raise additional capital and to sell our products,and could have a material adverse effect on our business, financial conditionand results of operations.

 

***We currently have limited cash resources and we will requireadditional funding to finance our working capital requirements for at least thenext twelve months*****.**

 

We currently have limitedcash resources and we will require financing to fund our anticipated workingcapital requirements for at least the next twelve months. If we are not able togenerate positive cash flows from operations in the near future, we will berequired to seek additional funding through public or private equity or debtfinancing. There can be no assurance that additional financing will be availableon acceptable terms, or at all. If we are required to sell equity to raiseadditional funds, our existing stockholders may incur substantial dilution andany shares so issued may have rights, preferences and privileges superior tothe rights, preferences and privileges of our outstanding common stock. If weseek debt financing, the terms of the financing may require us to agree torestrictive covenants or impose other obligations that limit our ability togrow our business, acquire necessary assets or take other actions that weconsider necessary or desirable.  Also, we may be required to obtain fundsthrough arrangements with third parties that require us to relinquish rights tocertain of our technologies or products that we would seek to develop orcommercialize ourselves. In addition, our ability to raise additional capitalmay be dependent upon our common stock being listed on AMEX. We have notsatisfied the criteria for continued listing on AMEX in the past and we cannotguarantee that we will be able to satisfy the criteria for continued listing onAMEX in the future.

 

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***Our current ineligibility to use the Registration Statementon Form S-3 may affect our ability to finance our working capital requirementsfor the next twelve months*****.**

 

As a result of the factthat our Current Report on Form 8-K, filed with the SEC on December 21,2007, was filed after the deadline for its filing, we became ineligible throughDecember 2008 to register shares of our common stock on a Form S-3Registration Statement. Certain investors, for whom the ability to resell theirshares relatively soon after they acquire them is important, may only bewilling to participate in private financings by us if we can register their sharesusing a Form S-3 Registration Statement.  Therefore, ourineligibility to use Form S-3 could limit our ability to raise additionalcapital for at least the next 12 months or such longer period that we areineligible to use the Form S-3 Registration Statement.

 

***We depend upon a small number of large system sales rangingfrom $500,000 to in excess of $2,000,000, and we may fail to achieve one ormore large system sales in the future*****.**

 

Historically, we havederived a substantial portion of our revenues from a small number of sales oflarge, relatively expensive systems, typically ranging in price from $500,000to $2,000,000. If we fail to receive orders for these large systems in a givensales cycle on a consistent basis, our business could be significantly harmed.Further, our quarterly results are difficult to predict because we cannotpredict in which quarter, if any, large system sales will occur in a givenyear. As a result, we believe that quarter-to-quarter comparisons of ourresults of operations are not a good indication of our future performance. Insome future quarters, our operating results may be below the expectations ofsecurities analysts and investors, in which case the market price of our commonstock may decrease significantly.

 

***Our lengthy sales cycle may cause us to expend significantresources for as long as one year in anticipation of a sale to certaincustomers, yet we still may fail to complete the sale*****.**

 

When considering thepurchase of a large computerized identity management system, potentialcustomers of ours may take as long as one year to evaluate different systemsand obtain approval for the purchase. Under these circumstances, if we fail tocomplete a sale, we will have expended significant resources and received norevenue in return. Generally, customers consider a wide range of issues beforecommitting to purchase our products, including product benefits, ability tooperate with their current systems, product reliability and their own budgetaryconstraints. While potential customers are evaluating our products, we mayincur substantial selling costs and expend significant management resources inan effort to accomplish potential sales that may never occur.

 

***A significant number of our customers and potentialcustomers are government agencies that are subject to unique political andbudgetary constraints and have special contracting requirements which mayaffect our ability to obtain new and retain current government customers*****.**

 

A significant number ofour customers are government agencies. These agencies often do not set theirown budgets and therefore have little control over the amount of money they canspend from quarter-to-quarter or year-to-year. In addition, these agenciesexperience political pressure that may dictate the manner in which they spendmoney. Due to political and budgetary processes and other scheduling delaysthat may frequently occur relating to the contract or bidding process, somegovernment agency orders may be canceled or substantially delayed, and the receiptof revenues or payments from these agencies may be substantially delayed. Inaddition, future sales to government agencies will depend on our ability tomeet government contracting requirements, certain of which may be onerous orimpossible to meet, resulting in our inability to obtain a particular contract.Common requirements in government contracts include bonding requirements,provisions permitting the purchasing agency to modify or terminate at will thecontract without penalty, and provisions permitting the agency to performinvestigations or audits of our business practices, any of which may limit ourability to enter into new contracts or maintain our current contracts.

 

***We may fail to create new applications for our products andenter new markets, which may have an adverse effect on our operations,financial condition and prospects*****.**

 

We believe our futuresuccess depends in part on our ability to develop and market our technology forapplications other than booking systems for the law enforcement market. If wefail in these goals, our business strategy and ability to generate revenues andcash flow would be significantly impaired. We intend to expend significantresources to develop new technology, but the successful development of newtechnology cannot be predicted and we cannot guarantee we will succeed in thesegoals.

 

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***We occasionally rely on systems integrators to manage ourlarge projects, and if these companies do not perform adequately, we may losebusiness*****.**

 

We occasionally act as asubcontractor to systems integrators who manage large projects that incorporateour systems, particularly in foreign countries. We cannot control thesecompanies, and they may decide not to promote our products or may price theirservices in such a way as to make it unprofitable for us to continue ourrelationship with them. Further, they may fail to perform under agreements withtheir customers, in which case we might lose sales to these customers. If we loseour relationships with these companies, our business, financial condition andresults of operations may suffer.

 

***If the patents we own or license, or our other intellectualproperty rights, do not adequately protect our products and technologies, wemay lose market share to our competitors and our business, financial conditionand results of operations would be adversely affected*****.**

 

Our success dependssignificantly on our ability to protect our rights to the technologies used inour products. We rely on patent protection, trade secrets, as well as acombination of copyright and trademark laws and nondisclosure, confidentialityand other contractual arrangements to protect our technology. However, theselegal means afford only limited protection and may not adequately protect ourrights or permit us to gain or keep any competitive advantage. In addition, wecannot be assured that any of our current and future pending patentapplications will result in the issuance of a patent to us. The U.S. Patent andTrademark Office (“PTO”) may deny or require significant narrowing of claims inour pending patent applications, and patents issued as a result of the pendingpatent applications, if any, may not provide us with significant commercialprotection or be issued in a form that is advantageous to us. We could alsoincur substantial costs in proceedings before the PTO. These proceedings couldresult in adverse decisions as to the claims included in our patents.

 

Our issued and licensedpatents and those that may be issued or licensed in the future may bechallenged, invalidated or circumvented, which could limit our ability to stopcompetitors from marketing related products. Additionally, upon expiration ofour issued or licensed patents, we may lose some of our rights to excludeothers from making, using, selling or importing products using the technologybased on the expired patents. We also must rely on contractual rights with thethird parties that license technology to us to protect our rights in thetechnology licensed to us. Although we have taken steps to protect ourintellectual property and technology, there is no assurance that competitorswill not be able to design around our patents. We also rely on unpatentedproprietary technology. We cannot assure you that we can meaningfully protectall our rights in our unpatented proprietary technology or that others will notindependently develop substantially equivalent proprietary products orprocesses or otherwise gain access to our unpatented proprietary technology. Weseek to protect our know-how and other unpatented proprietary technology withconfidentiality agreements and intellectual property assignment agreements withour employees. However, such agreements may not provide meaningful protectionfor our proprietary information in the event of unauthorized use or disclosureor other breaches of the agreements or in the event that our competitorsdiscover or independently develop similar or identical designs or otherproprietary information. In addition, we rely on the use of registered andcommon law trademarks with respect to the brand names of some of our products.Our common law trademarks provide less protection than our registeredtrademarks. Loss of rights in our trademarks could adversely affect our business,financial condition and results of operations.

 

Furthermore, the laws offoreign countries may not protect our intellectual property rights to the sameextent as the laws of the United States. If we fail to apply for intellectualproperty protection or if we cannot adequately protect our intellectualproperty rights in these foreign countries, our competitors may be able tocompete more effectively against us, which could adversely affect ourcompetitive position, as well as our business, financial condition and resultsof operations.

 

***If third parties claim that we infringe their intellectualproperty rights, we may incur liabilities and costs and may have to redesign ordiscontinue selling certain products*****.**

 

Whether a productinfringes a patent involves complex legal and factual issues, the determinationof which is often uncertain. We face the risk of claims that we have infringedon third parties’ intellectual property rights. Searching for existingintellectual property rights may not reveal important intellectual property andour competitors may also have filed for patent protection, which is not as yeta matter of public knowledge, or claimed trademark rights that have not beenrevealed through our availability searches. Our efforts to identify and avoidinfringing on third parties’ intellectual property rights may not always besuccessful. Any claims of patent or other intellectual property infringement,even those without merit, could:

 

·               increase the cost of our products;

 

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·               be expensive and time consuming todefend;

 

·               result in us being required to paysignificant damages to third parties;

 

·               force us to cease making or selling productsthat incorporate the challenged intellectual property;

 

·               require us to redesign, reengineer orrebrand our products;

 

·               require us to enter into royalty orlicensing agreements in order to obtain the right to use a third party’sintellectual property, the terms of which may not be acceptable to us;

 

·               require us to indemnify third partiespursuant to contracts in which we have agreed to provide indemnification tosuch parties for intellectual property infringement claims;

 

·               divert the attention of our management;and

 

·               result in our customers or potentialcustomers deferring or limiting their purchase or use of the affected productsuntil the litigation is resolved.

 

In addition, new patentsobtained by our competitors could threaten a product’s continued life in themarket even after it has already been introduced.

 

***The failure to successfully integrate any business or assetacquisitions into our existing operations, or if we discover previouslyundisclosed liabilities, could negatively affect our business, financialcondition and results of operations*****.**

 

We completed theacquisition of certain assets of Sol Logic in December 2007, and we planto continue to review potential acquisition candidates. Our business and ourstrategy include building our business through acquisitions. However,acceptable acquisition candidates may not be available in the future or may notbe available on terms and conditions acceptable to us.

 

Successful acquisitionsdepend upon our ability to identify, negotiate, complete and integrate suitableacquisitions and to obtain any necessary financing. Even if we completeacquisitions, we may experience:

 

·               difficulties in integrating any acquiredcompanies, personnel and products into our existing business;

 

·               delays in realizing the benefits of theacquired company or products;

 

·               diversion of our management’s time andattention from other business concerns;

 

·               limited or no direct prior experience innew markets or countries we may enter;

 

·               higher costs of integration than weanticipated; and

 

·               difficulties in retaining key employeesof the acquired business who are necessary to manage these acquisitions.

 

In addition, anacquisition could materially impair our operating results by causing us toincur debt or requiring us to amortize acquisition expenses and acquiredassets. We may also discover deficiencies in internal controls, data adequacyand integrity, product quality, regulatory compliance and product liabilitiesthat we did not uncover prior to our acquisition of such businesses, whichcould result in us becoming subject to penalties or other liabilities. Anydifficulties in the integration of acquired businesses or unexpected penaltiesor liabilities in connection with such businesses could have a material adverseeffect on our business, financial condition and results of operations.

 

***We operate in foreign countries and are exposed to risks associatedwith foreign political, economic and legal environments and with foreigncurrency exchange rates*****.**

 

With our acquisition ofG&A Imaging Ltd. in 2001, we have significant foreign operations. As aresult, we are exposed to risks, including among others, risks associated withforeign political, economic and legal environments and with foreign 

 

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currency exchange rates.Our results may be adversely affected by, among other things, changes ingovernment policies with respect to laws and regulations, anti-inflationmeasures, currency conversions, remittance abroad and rates and methods oftaxation.

 

***We depend on key personnel, the loss of any of whom couldmaterially adversely affect future operations***.

 

Our success will dependto a significant extent upon the efforts and abilities of our executiveofficers and other key personnel. The loss of the services of one or more ofthese key employees and any negative market or industry perception arising fromthe loss of such services could have a material adverse effect on us and thetrading price of our common stock.  Our business will also be dependentupon our ability to attract and retain qualified personnel. Acquiring andkeeping these personnel could prove more difficult or cost substantially morethan estimated and we cannot be certain that we will be able to retain suchpersonnel or attract a high caliber of personnel in the future.

 

***Compliance with Section 404 of the Sarbanes-Oxley Actof 2002 may result in substantial costs to us and a diversion of managementattention and resources, and failure to maintain adequate internal controlsover financial reporting could result in our business being harmed and ourstock price declining***.

 

Section 404 of theSarbanes-Oxley Act of 2002 requires us to document and test the effectivenessof our internal controls over financial reporting in accordance with anestablished control framework and to report on our management’s conclusion asto the effectiveness of these internal controls over financial reportingbeginning with the fiscal year ending December 31, 2007.  Thissection also requires that our independent registered public accounting firmprovide an attestation report on our internal control over financial reportingbeginning with the fiscal year ending December 31, 2008. Our managementcompleted its evaluation of the effectiveness of our disclosure controls andprocedures as of December 31, 2007 and concluded that our internal controlsover financial reporting were effective as of that date.

 

The standards that mustbe met for management to continue to assess the internal control over financialreporting are complex and will require significant documentation, testing andpossible remediation to meet the detailed standards.  In addition, theattestation process that must be performed by our independent registered publicaccounting firm is new and complex. We may encounter problems or delays incompleting the activities necessary to continue to make assessments of ourinternal control over financial reporting, completing the implementation of anyrequested improvements, or receiving an unqualified attestation of ourassessment by our independent registered public accountants.  Ensuringthat we have adequate internal financial and accounting controls and proceduresin place is a costly and time-consuming effort that needs to be evaluatedfrequently, so compliance with these new rules could require us to incursubstantial costs and may require a significant amount of time and attention ofmanagement, which could seriously harm our business, financial condition andresults of operations. If we are unable to continue to our internal controlover financial reporting as effective, or if our independent registered publicaccounting firm is unable to provide an unqualified attestation report on ourassessment, investors may lose confidence in us and our stock price may benegatively impacted.

 

***We face competition from companies with greater financial,technical, sales, marketing and other resources, and, if we are unable tocompete effectively with these competitors, our market share may decline andour business could be harmed***.

 

We face competition fromother established companies. A number of our competitors have longer operatinghistories, larger customer bases, significantly greater financial,technological, sales, marketing and other resources than we do.  As aresult, our competitors may be able to respond more quickly than we can to newor changing opportunities, technologies, standards or client requirements, morequickly develop new products or devote greater resources to the promotion andsale of their products and services than we can.  Likewise, their greatercapabilities in these areas may enable them to better withstand periodicdownturns in the identity management solutions industry and compete moreeffectively on the basis of price and production.  In addition, newcompanies may enter the markets in which we compete, further increasingcompetition in the identity management solutions industry.

 

We believe that ourability to compete successfully depends on a number of factors, including thetype and quality of our products and the strength of our brand names, as wellas many factors beyond our control. We may not be able to compete successfullyagainst current or future competitors, and increased competition may result inprice reductions, reduced profit margins, loss of market share and an inabilityto generate cash flows that are sufficient to maintain or expand the developmentand marketing of new products, any of which would adversely impact our resultsof operations and financial condition.

 

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**RisksRelated to Our Securities**

 

***The holders of our preferred stock have certain rights andprivileges that are senior to our common stock, and we may issue additionalshares of preferred stock without stockholder approval that could have amaterial adverse effect on the market value of the common stock*****.**

 

Our Board of Directors (“Board”)has the authority to issue a total of up to 4,000,000 shares of preferred stockand to fix the rights, preferences, privileges, and restrictions, includingvoting rights, of the preferred stock, which typically are senior to the rightsof the common stockholders, without any further vote or action by the commonstockholders. The rights of our common stockholders will be subject to, and maybe adversely affected by, the rights of the holders of the preferred stock thathave been issued, or might be issued in the future. Preferred stock also couldhave the effect of making it more difficult for a third party to acquire amajority of our outstanding voting stock. This could delay, defer, or prevent achange in control. Furthermore, holders of preferred stock may have otherrights, including economic rights, senior to the common stock. As a result,their existence and issuance could have a material adverse effect on the marketvalue of the common stock. We have in the past issued and may from time to timein the future issue, preferred stock for financing or other purposes withrights, preferences, or privileges senior to the common stock. As of December 31,2007, we had three series of preferred stock outstanding, Series Bpreferred stock, Series C 8% convertible preferred stock and Series D8% convertible preferred stock.

 

The provisions of our Series BPreferred Stock prohibit the payment of dividends on the common stock unlessthe dividends on those preferred shares are first paid. In addition, upon aliquidation, dissolution or sale of our business, the holders of the Series BPreferred Stock will be entitled to receive, in preference to any distributionto the holders of common stock, initial distributions of $2.50 per share, plusall accrued but unpaid dividends.  Pursuant to the terms of our Series BPreferred Stock we are obligated to pay cumulative cash dividends on shares of Series BPreferred Stock from legally available funds at the annual rate of $0.2125 pershare, payable in two semi-annual installments of $0.10625 each, whichcumulative dividends must be paid prior to payment of any dividend on ourcommon stock. As of December 31, 2007, we had cumulative undeclareddividends on the Series B Preferred Stock of approximately $9,000.

 

The Series CPreferred Stock has a liquidation preference equal to its stated value, plusany accrued and unpaid dividends thereon and any other fees or liquidateddamages owing thereon. The Series C Preferred Stock accrues cumulativedividends at the rate of 8.0% of the stated value per share per annum.  Atthe option of the Company, the dividend payment may be made in the form ofcash, after the payment of cash dividends to the holders of Series BPreferred Stock, or common stock issuable upon conversion of the Series CPreferred Stock.  Each share of Series C Preferred Stock isconvertible at any time at the option of the holder into a number of shares ofcommon stock equal to the stated value (initially $1,000 per share, subject toadjustment), plus any accrued and unpaid dividends, divided by the conversionprice (initially $1.50 per share, subject to adjustment). Subject to certainlimitations, the conversion price per share shall be adjusted in the event ofcertain subsequent stock dividends, splits, reclassifications, dilutiveissuances, rights offerings, and reclassifications.  Certain activitiesmay not be undertaken by the Company without the affirmative vote of a majorityof the holders of the outstanding shares of Series C Preferred Stock. Asof December 31, 2007, we had cumulative undeclared dividends on the Series CPreferred Stock of approximately $234,000.

 

The Series DPreferred Stock has a liquidation preference equal to its stated value, plusany accrued and unpaid dividends thereon and any other fees or liquidateddamages owing thereon. The Series D Preferred Stock accrues cumulativedividends at the rate of 8.0% of the stated value per share per annum.  Atthe option of the Company, the dividend payment may be made in the form ofcash, after the payment of cash dividends to the holders of Series B and Series CPreferred Stock, or common stock issuable upon conversion of the Series DPreferred Stock.  Each share of Series D Preferred Stock isconvertible at any time at the option of the holder into a number of shares ofcommon stock equal to the stated value (initially $1,000 per share, subject toadjustment), plus any accrued and unpaid dividends, divided by the conversionprice (initially $1.90 per share, subject to adjustment). Subject to certain limitations,the conversion price per share shall be adjusted in the event of certainsubsequent stock dividends, splits, reclassifications, dilutive issuances,rights offerings, and reclassifications.  Certain activities may not beundertaken by the Company without the affirmative vote of a majority of theholders of the outstanding shares of Series D Preferred Stock. As of December 31,2007, we had cumulative undeclared dividends on the Series D PreferredStock of approximately $98,000.

 

***Our stock price has been volatile, and your investment inour common stock could suffer a decline in value*****.**

 

There has beensignificant volatility in the market price and trading volume of equitysecurities, which is unrelated to the financial performance of the companies issuingthe securities. These broad market fluctuations may negatively affect the 

 

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market price of ourcommon stock. You may not be able to resell your shares at or above the priceyou pay for those shares due to fluctuations in the market price of our commonstock caused by changes in our operating performance or prospects and otherfactors.

 

Some specific factorsthat may have a significant effect on our common stock market price include:

 

·               actual or anticipated fluctuations in ouroperating results or future prospects;

 

·               our announcements or our competitors’announcements of new products;

 

·               the public’s reaction to our pressreleases, our other public announcements and our filings with the SEC;

 

·               strategic actions by us or ourcompetitors, such as acquisitions or restructurings;

 

·               new laws or regulations or newinterpretations of existing laws or regulations applicable to our business;

 

·               changes in accounting standards,policies, guidance, interpretations or principles;

 

·               changes in our growth rates or ourcompetitors’ growth rates;

 

·               developments regarding our patents orproprietary rights or those of our competitors;

 

·               our inability to raise additional capitalas needed;

 

·               substantial sales of common stockunderlying warrants and preferred stock;

 

·               concern as to the efficacy of ourproducts;

 

·               changes in financial markets or generaleconomic conditions;

 

·               sales of common stock by us or members ofour management team; and

 

·               changes in stock market analystrecommendations or earnings estimates regarding our common stock, othercomparable companies or our industry generally.

 

***Our future sales of our common stock could adversely affectits price and our future capital-raising activities could involve the issuanceof equity securities, which would dilute your investment and could result in adecline in the trading price of our common stock*****.**

 

We may sell securities inthe public or private equity markets if and when conditions are favorable, evenif we do not have an immediate need for additional capital at that time. Salesof substantial amounts of our common stock, or the perception that such salescould occur, could adversely affect the prevailing market price of our commonstock and our ability to raise capital. We may issue additional common stock infuture financing transactions or as incentive compensation for our executivemanagement and other key personnel, consultants and advisors. Issuing anyequity securities would be dilutive to the equity interests represented by ourthen-outstanding shares of common stock. The market price for our common stockcould decrease as the market takes into account the dilutive effect of any ofthese issuances. Furthermore, we may enter into financing transactions atprices that represent a substantial discount to the market price of our commonstock. A negative reaction by investors and securities analysts to anydiscounted sale of our equity securities could result in a decline in thetrading price of our common stock.

 

***If registration rights that we have previously granted areexercised, then the price of our common stock may be adversely affected*****.**

 

We have agreed toregister with the SEC certain shares of our common stock which we issued inunregistered offerings.  In the event these securities are registered withthe SEC, they may be freely sold in the open market provided the registrationstatement relating to such shares becomes effective and subject to tradingrestrictions to which our affiliates holding the shares may be subject fromtime to time. We expect that we also will 

 

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be required to registerany securities sold in future private financings. Additionally, the number ofshares of our common stock underlying issued and outstanding warrants andpreferred stock registered under prior registration statements, many of which arenow available for resale under Rule 144 of the Securities Act, issubstantial and sales of such underlying stock could cause significantdilution.  The sale of a significant amount of shares in the open market,or the perception that these sales may occur, could cause the trading price ofour common stock to decline or become highly volatile.

 

***Our corporate documents and Delaware law contain provisionsthat could discourage, delay or prevent a change in control of our company*****.**

 

Provisions in ourcertificate of incorporation and bylaws may discourage, delay or prevent amerger or acquisition involving us that our stockholders may considerfavorable. For example, our certificate of incorporation authorizes preferredstock, which carries special rights, including voting and dividend rights. Withthese rights, preferred stockholders could make it more difficult for a thirdparty to acquire us.

 

We are also subject tothe anti-takeover provisions of Section 203 of the Delaware GeneralCorporation Law. Under these provisions, if anyone becomes an “interestedstockholder,” we may not enter into a “business combination” with that personfor three years without special approval, which could discourage a third partyfrom making a takeover offer and could delay or prevent a change of control.For purposes of Section 203, “interested stockholder” means, generally,someone owning 15% or more of our outstanding voting stock or an affiliate ofours that owned 15% or more of our outstanding voting stock during the pastthree years, subject to certain exceptions as described in Section 203.

 

***We do not expect to pay cash dividends on our common stockfor the foreseeable future*****.**

 

We have never paid cashdividends on our common stock and do not anticipate that any cash dividends willbe paid on the common stock for the foreseeable future. The payment of any cashdividend by us will be at the discretion of our board of directors and willdepend on, among other things, our earnings, capital, regulatory requirementsand financial condition. Furthermore, the terms of our Series B PreferredStock, Series C Preferred Stock and Series D Preferred Stock directlylimit our ability to pay cash dividends on our common stock.

 

***Securities analysts may not continue to cover our commonstock or may issue negative reports, and this may have a negative impact on ourcommon stock’s market price*****.**

 

There is no guaranteethat securities analysts will continue to cover our common stock. If securitiesanalysts do not cover our common stock, the lack of research coverage mayadversely affect our common stock’s market price. The trading market for ourcommon stock relies in part on the research and reports that industry orfinancial analysts publish about our business or us. If one or more of theanalysts who cover us downgrades our stock, our stock price may declinerapidly. If one or more of these analysts ceases coverage of our common stock,we could lose visibility in the market, which in turn could cause our stockprice to decline. In addition, rules mandated by the Sarbanes-Oxley Act of2002, and a global settlement reached between the SEC, other regulatoryanalysts and a number of investment banks in April 2003, may lead to anumber of fundamental changes in how analysts are reviewed and compensated. Inparticular, many investment banking firms will now be required to contract withindependent financial analysts for their stock research. It may be difficultfor companies with smaller market capitalizations, such as our company, toattract independent financial analysts that will cover our common stock, whichcould have a negative effect on our market price.

 

***The large number of holders and lack of concentration ofownership of our common stock may make it difficult for us to reach a quorum orobtain an affirmative vote of our stockholders at future stockholder meetings*****.**

 

Our stock is held in alarge number of individual accounts. As a result, it may be difficult for us toreach a quorum or obtain an affirmative vote of a majority of our stockholderswhere either of those thresholds are measured based on the total number ofshares of our common stock outstanding. Difficulty in obtaining a stockholdervote could impact our ability to complete any financing or strategictransaction requiring stockholder approval or effect basic corporate governancechanges, such as an increase in the authorized number of shares of ourpreferred stock and our common stock.

 

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**Item1B. Unresolved Staff Comments**

 

Notapplicable.

 

**Item 2. Properties.**

 

Ourcorporate headquarters are located in San Diego, California where we occupyapproximately 16,000 square feet of office space and approximately 1,000 squarefeet of warehouse space. Our lease for this facility continues through September 2008at a cost of approximately $20,500 per month. We occupy 10,000 square feet in Gatineau, Province of Quebec. Thesepremises are leased until May 2009, at a cost of approximately $16,800 permonth. We occupy 3,470 square feet of office space in Portland, Oregon at acost of approximately $7,300 per month. Our lease for this facility continues through October 2009.

 

**Item 3. Legal Proceedings.**

 

We are periodically engagedin litigation in the ordinary course of business and do not believe that any ofsuch litigation is material to our ongoing operations.

 

**Item 4. Submission of Matters to a Vote of Security Holders.**

 

Not applicable.

 

**PART II**

 

**ITEM 5.Market for Common Equity and Related Stockholder Matters.**

 

*MarketInformation.*

 

OurCommon Stock trades under the symbol “IW” on the American Stock Exchange.

 

Thefollowing table sets forth the high and low sales prices per share for ourCommon Stock as reported by the American Stock Exchange for each quarter in2007 and 2006:

 
| **2007 Fiscal Quarters** | ** ** | **High** | ** ** | **Low** | ** ** |
|------------------------------------|------------|----------|------------|---------|------------|
| First Quarter                      |       | $        | 2.810      |    | $          | 1.450 |   |
| Second Quarter                     |       | $        | 2.740      |    | $          | 1.450 |   |
| Third Quarter                      |       | $        | 2.180      |    | $          | 1.400 |   |
| Fourth Quarter                     |       | $        | 2.000      |    | $          | 1.400 |   |

 
| **2006 Fiscal Quarters** | ** ** | **High** | ** ** | **Low** | ** ** |
|------------------------------------|------------|----------|------------|---------|------------|
| First Quarter                      |       | $        | 2.540      |    | $          | 1.350 |   |
| Second Quarter                     |       | $        | 2.560      |    | $          | 1.580 |   |
| Third Quarter                      |       | $        | 2.300      |    | $          | 1.110 |   |
| Fourth Quarter                     |       | $        | 2.250      |    | $          | 1.200 |   |

 

Thereis no public trading market for our preferred stock.

 

*Holders.*

 

As of March 25,2008, there were approximately 1,600 holders of record of our Common Stock.

 

*Dividends.*

 

Wehave never declared or paid dividends on our Common Stock and do not anticipatepaying any cash dividends on our shares of Common Stock in the foreseeablefuture. We are obligated to pay cumulative cash dividends on shares of Series BPreferred Stock from legally available funds at the annual rate of $0.2125 pershare, payable in two semi-annual installments of $0.10625 each, whichcumulative dividends must be paid prior to payment of any dividend on ourCommon 

 

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Stock.  The holders of our Series C PreferredStock are entitled to receive cumulative dividends, at the option of theCompany, payable (i) in common stock upon conversion of the Series CPreferred Stock, or (ii) in cash after the payment of cash dividends tothe holders of our Series B Preferred Stock at the rate of 8% per annum(as a percentage of stated value per share). The holders of our Series D Preferred Stock are entitled to receivecumulative dividends, at the option of the Company, payable (i) in commonstock upon conversion of the Series D Preferred Stock, or (ii) incash after the payment of cash dividends to the holders of our Series BPreferred Stock at the rate of 8% per annum (as a percentage of stated valueper share).

 

As of December 31,2007, the Company had cumulative undeclared dividends of approximately $9,000relating to our Series B Preferred Stock, approximately $234,000 relatingto our Series C Preferred Stock, and approximately 98,000 relating to our Series DPreferred Stock.

 

*Repurchases.*

 

We didnot repurchase any shares of our common stock during fiscal 2007.

 

**Item 6.Selected Consolidated Financial Data**

 

Thefollowing selected financial data should be read in conjunction with ourConsolidated Financial Statements and the related notes and “Management’sDiscussion and Analysis of Financial Condition and Results of Operations”appearing elsewhere in this Form 10-K. The selected consolidated statementof operations data presented below for each of the years ended December 31,2007, 2006, and 2005, and the consolidated balance sheet data at December 31,2007 and 2006 are derived from our Consolidated Financial Statements that havebeen included elsewhere in this Form 10-K. The selected consolidatedstatement of operations data for the years ended December 31, 2004 and2003 and consolidated balance sheet data at December 31, 2005, 2004, and2003 are derived from audited consolidated financial statements not included inthis Form 10-K. The historical results of operations are not necessarilyindicative of future results.

 

27

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** **

**STATEMENT OF OPERATIONS DATA:**

 
| ** **                                           | ** ** | **Year ended December 31,** | ** ** |
|------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                           | ** ** | **2007**                                   | ** ** | **2006** | ** ** | **2005(1)** | ** ** | **2004(1)** | ** ** | **2003(1)** | ** ** |
| ** **                                           | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues                                             |       | $                                          | 8,488,577  |   | $ | 10,189,566 |   | $ | 9,174,173 |   | $ | 9,176,865 |   | $ | 14,147,971 |   |
| Cost of revenues                                     |       | $                                          | 2,546,432  |   | $ | 3,329,039 |   | $ | 4,041,862 |   | $ | 3,106,256 |   | $ | 6,745,616 |   |
| Gross profit                                         |       | $                                          | 5,942,145  |   | $ | 6,860,527 |   | $ | 5,132,311 |   | $ | 6,070,609 |   | $ | 7,402,355 |   |
| Operating  expenses                                  |       | $                                          | 10,439,538 |   | $ | 11,933,609 |   | $ | 12,048,767 |   | $ | 9,824,470 |   | $ | 11,114,469 |   |
| Interest  (income) expense, net                      |       | $                                          | 215,155    |   | $ | 564,524 |   | $ | (53,288 | ) | $ | 5,172,193 |   | $ | 6,960,140 |   |
| Other (income)  expense, net                         |       | $                                          | 22,221     |   | $ | (119,330 | ) | $ | (166,390 | ) | $ | (187,640 | ) | $ | (207,046 | ) |
| Loss from  continuing operations before income taxes |       | $                                          | (4,734,769 | ) | $ | (5,518,276 | ) | $ | (6,696,778 | ) | $ | (8,738,414 | ) | $ | (10,465,208 | ) |
| Income tax  expense                                  |       | $                                          | —     |   | $ | — |   | $ | — |   | $ | — |   | $ | 61,735 |   |
| Loss from  continuing operations                     |       | $                                          | (4,734,769 | ) | $ | (5,518,276 | ) | $ | (6,696,778 | ) | $ | (8,738,414 | ) | $ | (10,526,943 | ) |
| Discontinued  operations                             |       | $                                          | 50,000     |   | $ | (407,939 | ) | $ | (1,658,926 | ) | $ | (900,185 | ) | $ | (208,850 | ) |
| Net loss                                             |       | $                                          | (4,684,769 | ) | $ | (5,926,215 | ) | $ | (8,355,704 | ) | $ | (9,638,599 | ) | $ | (10,735,793 | ) |
|                                                 |       |                                       |       |   |   |   |   |   |   |   |   |
| Basic loss per  share:                               |       |                                       |       |   |   |   |   |   |   |   |   |
| Net loss -  continuing operations                    |       | $                                          | (0.31      | ) | $ | (0.41 | ) | $ | (0.53 | ) | $ | (0.75 | ) | $ | (1.78 | ) |
| Net loss -  discontinued operations                  |       | $                                          | —     |   | $ | (0.03 | ) | $ | (0.13 | ) | $ | (0.08 | ) | $ | (0.04 | ) |
| Net loss –  preferred dividends                 |       | $                                          | (0.08      | ) | $ | — |   | $ | — |   | $ | — |   | $ | — |   |
| Net loss                                             |       | $                                          | (0.39      | ) | $ | (0.44 | ) | $ | (0.66 | ) | $ | (0.83 | ) | $ | (1.81 | ) |
| Weighted-average  shares (basic and diluted)         |       | 15,070,308                                 |       | 13,592,841 |   | 12,731,304 |   | 11,739,819 |   | 5,953,801 |   |

 

**BALANCE SHEET DATA:**

 
| Cash                             |   | $ | 1,044,242 |   | $ | 938,553   |   | $ | 741,184   |   | $ | 2,911,765  |   | $ | 578,093    |   |
|----------------------------------|--------|---|-----------|--------|---|-----------|--------|---|-----------|--------|---|------------|--------|---|------------|--------|
| Accounts  receivable, net        |   | $ | 424,739   |   | $ | 1,721,892 |   | $ | 1,340,154 |   | $ | 1,797,120  |   | $ | 1,449,968  |   |
| Inventories, net                 |   | $ | 130,342   |   | $ | 57,990    |   | $ | 207,833   |   | $ | 1,096,796  |   | $ | 804,526    |   |
| Other current  assets            |   | $ | 440,459   |   | $ | 137,609   |   | $ | 218,549   |   | $ | 247,548    |   | $ | 204,065    |   |
| Property and  equipment, net     |   | $ | 287,989   |   | $ | 351,700   |   | $ | 423,887   |   | $ | 510,270    |   | $ | 634,966    |   |
| Other and  pension assets        |   | $ | 718,214   |   | $ | 784,459   |   | $ | 738,238   |   | $ | 733,796    |   | $ | 726,414    |   |
| Intangibles, net                 |   | $ | 2,436,576 |   | $ | 141,294   |   | $ | 218,400   |   | $ | 764,125    |   | $ | 1,120,675  |   |
| Goodwill                         |   | $ | 4,452,042 |   | $ | 3,415,647 |   | $ | 3,415,647 |   | $ | 5,297,627  |   | $ | 5,297,627  |   |
| Total assets                     |   | $ | 9,934,603 |   | $ | 7,549,144 |   | $ | 7,303,892 |   | $ | 13,359,047 |   | $ | 10,816,334 |   |
| Total current  liabilities       |   | $ | 5,268,953 |   | $ | 5,212,961 |   | $ | 2,808,760 |   | $ | 4,281,140  |   | $ | 3,311,964  |   |
| Long-term  liabilities           |   | $ | 1,138,911 |   | $ | 1,016,293 |   | $ | 1,129,530 |   | $ | 811,688    |   | $ | 4,192,605  |   |
| Total  liabilities               |   | $ | 6,407,864 |   | $ | 6,229,254 |   | $ | 3,938,290 |   | $ | 5,092,828  |   | $ | 7,504,569  |   |
| Total  shareholders’ equity |   | $ | 3,526,739 |   | $ | 1,319,890 |   | $ | 3,365,602 |   | $ | 8,266,219  |   | $ | 3,311,765  |   |

 

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(1) Results ofoperations as presented have been restated to exclude the results of operationsof our Digital Photography and Digital Imaging Asia Pacific components due tothese components being classified as discontinued operations due to their salein November 2006 and March 2005, respectively.

 

***Item 7.   Management’s Discussionand Analysis of Financial Condition and Results of Operations.***

 

**FORWARD-LOOKINGSTATEMENTS**

 

The following discussion should be read in conjunction with ourconsolidated financial statements included elsewhere in this report.  This discussion contains forward-lookingstatements that involve risks and uncertainties.  Our actual results could differ materiallyfrom those anticipated in these forward-looking statements as a result ofvarious factors including those set forth under “Risk Factors” in Item 1Aabove.  Due to such fluctuations, historical results andpercentage relationships are not necessarily indicative of the operatingresults for any future period.

 

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** **

**OVERVIEW**

** **

ImageWare Systems, Inc.is a leader in the emerging market for software-based identity managementsolutions, providing biometric, secure credential and law enforcementtechnologies.  Our “flagship” product isthe IWS Biometric EngineTM.  Scalable forsmall city business or worldwide deployment, our biometric engine is amulti-biometric platform that is hardware and algorithm independent, enablingthe enrollment and management of unlimited population sizes.  Our identification products are used tomanage and issue secure credentials including national IDs, passports, driverlicenses, smart cards and access control credentials. Our law enforcementproducts provide law enforcement with integrated mug shot, fingerprint Livescanand investigative capabilities.  Thebiometric technology is now an integral part of all markets we address, and allof our products are integrated into the Biometric Engine Platform. Elements of the biometric engine can be used as investigative tools to lawenforcement potentially utilizing multiple biometrics and forensic dataelements, and to enhance security and authenticity of public and private sectorcredentials.

 

**CRITICALACCOUNTING ESTIMATES**

 

Thediscussion and analysis of our consolidated financial condition and results ofoperations are based on our consolidated financial statements, which have beenprepared in accordance with accounting principals generally accepted in theUnited States of America, or U.S. GAAP. The preparation of these consolidated financialstatements in accordance with U.S. GAAP requires us to utilize accountingpolicies and make certain estimates and assumptions that affect the reportedamounts of assets and liabilities, the disclosure of contingencies as of thedate of the consolidated financial statements and the reported amounts ofrevenue and expenses during a fiscal period. The SEC considers an accountingpolicy to be critical if it is important to a company’s financial condition andresults of operations, and if it requires significant judgment and estimates onthe part of management in its application. Although we believe that ourjudgments and estimates are appropriate and correct, actual resultsmay differ from those estimates.

 

Thefollowing are our critical accounting policies because we believe they are bothimportant to the portrayal of our financial condition and results of operationsand require critical management judgments and estimates about matters that areuncertain. If actual results or events differ materially from thosecontemplated by us in making these estimates, our reported financial conditionand results of operations for future periods could be materially affected.  For a detailed discussion on the applicationof these and other accounting policies, see Note 1 in the Notes to theConsolidated Financial Statements in Item 8 of this Annual Report on Form 10-K,beginning on page F-7.

 

***Revenue Recognition***

 

Ourrevenue recognition policy is significant because our revenue is a keycomponent of our consolidated results of operations. We recognize revenue fromthe following major revenue sources:

 

·                  Long-term fixed-price contracts involving significantcustomization

 

·                  Fixed-price contracts involving minimal customization

 

·                  Software licensing

 

·                  Sales of computer hardware and identification media

 

·                  Postcontract customer support (PCS)

 

TheCompany’s revenue recognition policies are consistent with U. S. GAAP includingStatements of Position 97-2 “Software Revenue Recognition” and 98-9 “Modificationof SOP 97-2, Software Revenue Recognition With Respect to Certain Transactions”,Securities and Exchange Commission Staff Accounting Bulletin 104 , EmergingIssues Task Force Issue 00-21 “Revenue Arrangements with Multiple Deliverables”,and Emerging Issues Task Force Issue 03-05 “Applicability of AICPA Statement ofPosition 97-2 to Non-Software Deliverables in an Arrangement ContainingMore-Than-Incidental Software”. Accordingly, the Company recognizes revenuewhen all of the following criteria are met: persuasive evidence of anarrangement exists, delivery has occurred or services have been rendered, thefee is fixed or determinable, and collectibility is reasonably assured.

 

29

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Werecognize revenue and profit as work progresses on long-term, fixed-pricecontracts involving significant amount of hardware and software customizationusing the percentage of completion method based on costs incurred to datecompared to total estimated costs at completion. Revenue from contracts forwhich we cannot reliably estimate total costs or there are not significantamounts of customization are recognized upon completion. Determining when acontract should be accounted for using the percentage of completion methodinvolves judgment. Critical items that are considered in this process are thedegree of customization and related labor hours necessary to complete therequired work as well as ongoing estimates of the future labor hours needed tocomplete the contract. We also generate non-recurring revenue from thelicensing of our software. Software license revenue is recognized upon theexecution of a license agreement, upon deliverance, fees are fixed anddeterminable, collectibility is probable and when all other significantobligations have been fulfilled. We also generate revenue from the sale ofcomputer hardware and identification media. Revenue for these items isrecognized upon delivery of these products to the customer. Our revenue fromperiodic maintenance agreements is generally recognized ratably over therespective maintenance periods provided no significant obligations remain andcollectibility of the related receivable is probable.

 

For adetailed discussion on the application of these and other accounting policies,see Note 1 in the Notes to the Consolidated Financial Statements in Item 8of this Annual Report on Form 10-K, beginning on page F-7.

 

***Allowance for Doubtful Accounts***

 

Weprovide an allowance for our accounts receivable for estimated losses that mayresult from our customers’ inability to pay. We determine the amount of allowance by analyzing historical losses,customer concentrations, customer creditworthiness, current economic trends,the age of the accounts receivable balances, and changes in our customerpayment terms when evaluating the adequacy of the allowance for doubtfulaccounts. Our accounts receivables balance was $425,000, net of allowance fordoubtful accounts of $0 for the year ended December 31, 2007.

 

***Valuation of Goodwill, Other Intangible and Long-Lived Assets***

 

Weassess impairment of goodwill and identifiable intangible assets wheneverevents or changes in circumstances indicate that the carrying value may not berecoverable. Factors we consider important which could trigger an impairmentreview include the following:

 

·                                          Significant underperformance relative tohistorical or expected future operating results;

 

·                                          Significant changes in the manner of ouruse of the acquired assets or the strategy of our overall business;

 

·                                          Significant negative industry or economictrends;

 

Whenwe determine that the carrying value of goodwill and other intangible assetsmay not be recoverable based upon the existence of one or more of the aboveindicators of impairment, we measure any impairment based upon fair valuemethodologies. Goodwill and other net intangible assets amounted toapproximately $6,889,000 for the year ended December 31, 2007.  During the twelve months ended December 31,2007, we completed the acquisition of substantially all the assets of Sol Logic, Inc.  We recorded goodwill from this acquisition ofapproximately $1,036,000 after the allocation of purchase price as determinedby an unaffiliated, professional third-party valuation firm employing fairvalue methodologies.

 

In2002, Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwilland Other Intangible Assets” became effective, and as a result we ceased toamortize goodwill. In lieu of amortization, we performed an initial impairmentreview of our goodwill in June, 2002 and will perform an annual impairmentreview thereafter in the fourth quarter of our fiscal year.  Completion of our initial impairment testindicated there was no goodwill impairment. We also performed our annual impairment review as of December 31,2005, based upon our 2006 operating plan This annual impairment review indicated there was goodwill impairment inour Digital Photography segment as of December 31, 2005, and accordingly,we recorded an impairment loss in the 2005 Consolidated Statement ofOperations.  Both of these tests wereconducted by determining and comparing the fair value of our reporting units,as defined in SFAS 142, to the reporting unit’s carrying value as of that date.

 

Withthe sale of our Digital Photography component in 2006, we reassessed thecomposition of our operating segments and determined that we no longer operatein separate, distinct market segments but rather operate in one market segment,such segment being identity management. The Company’s determination was based on fundamental changes in the Company’sbusiness structure due to the consolidation of operations, restructuring of theCompany’s operations and 

 

30

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management team, and theintegration of what where previously distinct, mutually exclusive technologies.  This has resulted in changes in the manner bywhich the Company’s chief decision maker assesses performance and makesdecisions concerning resource allocation. As a result of our operation in one market segment, such segment beingidentity management, our 2006 and 2007 goodwill impairment review consisted ofthe comparison of the fair value of our identity management segment asdetermined by the quoted market prices of our common stock to the carryingamount of the segment. As the fair value exceeded the carrying value by asubstantial margin, we determined that our goodwill was not impaired.

 

Thereare many management assumptions and estimates underlying the determination ofan impairment loss, and estimates using different, but reasonable, assumptionscould produce significantly different results. Significant assumptions includeestimates of future levels of revenues and operating expenses. Therefore, thetiming and recognition of impairment losses by us in the future, if any, may behighly dependent upon our estimates and assumptions.  There can be no assurance that goodwillimpairment will not occur in the future.

 

Weaccount for long-lived assets in accordance with the provisions of SFAS No. 144,“Accounting for the Impairment or Disposal of Long-Lived Assets.”  This statement requires that long-livedassets and certain identifiable intangible assets be reviewed for impairmentwhenever events or changes in circumstances indicate that the carrying amountof an asset may not be recoverable.  Recoverabilityof assets to be held and used is measured by a comparison of the carryingamount of an asset to future net undiscounted cash flows expected to begenerated by the asset.  If such assetsare considered to be impaired, the impairment to be recognized is measured bythe amount which the carrying amount of the assets exceeds the fair value ofthe assets.  Fair value is determinedbased on discounted cash flows or appraised values, depending upon the nature ofthe asset.  Assets to be disposed of arereported at the lower of the carrying amount of fair value less costs tosell.  During the twelve months ended December 31,2007 we completed the acquisition of substantially all the assets of Sol Logic, Inc.  Pursuant to this acquisition, we recorded approximately$2,311,000 in identifiable intangible assets. The assets acquired were a covenant not to compete valued atapproximately $200,000, customer base valued at approximately $93,000 anddeveloped technology valued at approximately $2,018,000.  The allocation of the purchase price wasbased on fair value methodologies employed by an independent valuation firm.

 

Werecorded no impairment losses for long-lived or intangible assets during thetwelve months ended December 31, 2007 and 2006. In 2005, we recorded animpairment charge of approximately $253,000 related to our intangible asset forcertain trademark and tradenames carried in our Identification segment.  This loss reflects the amount by which thecarrying value of this asset exceeded its estimated fair value determined bythe assets’ future discounted cash flows. The impairment loss is recorded as a component of “Operating expenses”in the Statement of Operations for 2005. There are many management assumptions and estimates underlying the determinationof an impairment loss, and estimates using different, but reasonable,assumptions could produce significantly different results. Significantassumptions include estimates of future levels of revenues and operatingexpenses. Therefore, the timing and recognition of impairment losses by us inthe future, if any, may be highly dependent upon our estimates andassumptions.  There can be no assurancethat intangible asset impairment will not occur in the future.

 

***Stock-Based Compensation***

 

Uponadoption of SFAS 123R on January 1, 2006, we began estimating the value ofemployee stock options on the date of grant using the Black-Scholes model.Prior to the adoption of SFAS 123R, the value of each employee stock option wasestimated on the date of grant using the Black-Scholes model for the purpose ofthe pro forma financial disclosure in accordance with SFAS 123. Thedetermination of fair value of stock-based payment awards on the date of grantusing an option-pricing model is affected by our stock price as well asassumptions regarding a number of highly complex and subjective variables.These variables include, but are not limited to the expected stock pricevolatility over the term of the awards and the actual and projected employeestock option exercise behaviors. The expected term of options granted isderived from historical data on employee exercises and post-vesting employmenttermination behavior. We calculated our expected volatility assumption requiredin the Black-Scholes model based on the historical volatility of our stock. Asof January 1, 2006 we have adopted the modified prospective transitionmethod and its effect is included in our consolidated financial statements forthe twelve months ended December 31, 2006. We will update these assumptions on at least an annual basis and on aninterim basis if significant changes to the assumptions are warranted.

 

31

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**Year Ended December 31, 2007Compared to Year Ended December 31, 2006 and Year Ended December 31,2006 Compared to Year Ended December 31, 2005**

 

The following management’sdiscussion and analysis or plan of operation is based primarily upon ourIdentity Management segment.  Results aspresented do not contain the results of our Digital Photography component norour wholly-owned subsidiary, Digital Imaging Asia Pacific, due to thesecomponents being classified as discontinued operations due to the sale of DigitalPhotography in November 2006 and Digital Imaging Asia Pacific in the firstfiscal quarter of 2005.

 

***Revenues***

 

***ProductRevenues***

 
| ** **                               | ** ** | **TWELVE MONTHS ENDED** | ** ** |
|------------------------------------------|------------|-----------------------------------|------------|
| ** **                               | ** ** | **DECEMBER 31,**             | ** ** |
| ** **                               | ** ** | **2007**                          | ** ** | **Change** | ** ** | **2006** | ** ** | **Change** | ** ** | **2005** | ** ** |
|                                     |       |                              |       |   |   |   |   |   |   |   |   |
| **Product  revenues:**                   | ** ** | ** **                        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Software and  Royalties                  |       | $                                 | 4,966,860  |   | -16 | % | $ | 5,889,262 |   | 46 | % | $ | 4,036,856 |   |
| Percentage of  total net product revenue |       | 88                                | %          | 11 | % | 77 | % | 20 | % | 57 | % |
| Hardware and  consumables                |       | $                                 | 349,741    |   | -74 | % | $ | 1,347,452 |   | -36 | % | $ | 2,108,411 |   |
| Percentage of  total net product revenue |       | 6                                 | %          | -12 | % | 18 | % | -12 | % | 30 | % |
| Services                                 |       | $                                 | 335,573    |   | -9 | % | $ | 368,884 |   | -25 | % | $ | 488,852 |   |
| Percentage of  total net product revenue |       | 6                                 | %          | 1 | % | 5 | % | -2 | % | 7 | % |
| Patent Licensing                         |       | $                                 | —     |   | 0 | % | $ | — |   | -100 | % | $ | 500,000 |   |
| Percentage of  total net product revenue |       | 0                                 | %          | 0 | % | 0 | % | -7 | % | 7 | % |
| Total net  product revenues              |       | $                                 | 5,652,174  |   | -26 | % | $ | 7,605,598 |   | 7 | % | $ | 7,134,119 |   |

 

Identity managementsoftware and royalty revenues decreased 16% or approximately $922,000 duringthe twelve months ended December 31, 2007 as compared to the correspondingperiod in 2006.  Sales of our BiometricEngine and EPI identity management products decreased 11% or approximately$557,000 in 2007 from 2006.  This decreaseis reflective of lower sales of these products into project oriented solutions.  Also contributing to this decrease were lowerroyalties generated from our IWS Desktop Security product.   Sales of software and royalties related toour law enforcement products decreased 42% or $365,000 in 2007 from 2006 dueprimarily to decreased sales of our Crime Capture System to state and local lawenforcement agencies.

 

The increase in ourIdentity management software and royalties of 46% in 2006 from 2005 isreflective of increased  sales of ourBiometric Engine and EPI identity management products into project orientedsolutions. Also contributing to this increase were royalties generated from ourIWS Desktop Security product.  Theincrease in project-oriented revenues was offset by a decrease in sales ofboxed product through our distribution channel.

 

Hardware and consumableproduct sales decreased approximately 74% or $998,000 during twelve monthsended December 31, 2007 as compared to the corresponding period in2006.  Sales of hardware decreasedapproximately 60% or $279,000 from 2006 levels and reflect both a decrease inproject oriented work and in the hardware composition of orders received andcompleted by the Company.  Sales ofconsumables decreased approximately 82% or $719,000 and are reflective of lowerproject sales and recurring orders from our Law Enforcement customers.  Hardware and consumable sales for the twelvemonths ended December 31, 2006 contain approximately $203,000 related toour German sales office which was closed in order to reduce operating costs.

 

Hardware and consumableproduct sales decreased approximately 36% or $761,000 during twelve monthsended December 31, 2006 as compared to the corresponding period in 2005and reflects the repositioning of our international sales office in Germany inorder to lower fixed costs and pursue significant Identification projectsutilizing the Company’s software technologies as our primarydifferentiator.  This office hadhistorically emphasized the resale of third-party merchandise (hardware andconsumables) which generated lower gross margins than software (as a percentageof revenue) and required significant fixed costs for sales, service andsupport.  In furtherance of thisstrategy, in December 2005, we decided to reorganize our German salesoffice by closing our existing facility in order to reduce operating expenses.The effect on hardware and consumables revenues from the closure of this officewas a reduction of such revenues of approximately $732,000 in 2006 as comparedto 2005.

 

32

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Services revenues arecomprised primarily of software integration services, system installationservices and customer training.  Suchrevenues decreased 9% or approximately $33,000 during the twelve months ended December 31,2007 as compared to the corresponding period of 2006 due primarily to adecrease in project work.

 

Such revenues decreasedduring the twelve months ended December 31, 2006 as compared to thecorresponding period of 2005 due primarily to the composition of our customer’sorders and a decrease in our installation of hardware products.

 

We expect servicerevenues to increase in 2008 through our implementation of large-scale high-endinstallations.

 

We generated revenues of$500,000 from sublicensing our Image Editing System patent within the computervideo, web conferencing and cellular phone fields of use during the twelvemonths ended December 31, 2005. There were no such revenues earned in the comparable periods of 2007 or2006.

 

We believe that the period-to-period fluctuations ofidentity management software revenue in project-oriented solutions is largelydue to the timing of government procurement with respect to the variousprograms we are pursuing.  Based onmanagement’s current visibility into the timing of potential governmentprocurements, we believe that we will see a significant increase in governmentprocurement and implementations with respect to identity management initiativesduring  2008 and continuing into 2009.

 

We feel that we are well positioned for participationin one or more large-scale domestic or international projects which will enableour company to achieve significant product revenue growth.  In the past eighteen months we havecontinuously retooled our identity management suite of products to meetchanging government specifications and to enable customization for largeproject applications.  Additionally, wereoriented our sales organization to direct our resources and efforts towardestablishing partnerships with large systems integrators as we believe theseintegrators will be the ultimate choice for awards of large-scale secureidentification solutions.

 

Our backlog of productorders as of December 31, 2007, was approximately $867,000.  At December 31, 2007, we also hadmaintenance and support backlog of approximately $883,000 under existingmaintenance agreements.  Product revenueis typically recognized within a three to six month period depending upon therequired degree of customization, if any. Historically, we have experienced a very minimal risk of ordercancellation and do not anticipate order cancellations in excess of 5%.  Our revenue from maintenance agreements isgenerally recognized ratably over the respective maintenance periods providedno significant obligations remain and collectibility of the related receivableis probable.

 

***MaintenanceRevenues***

 
| ** **            | ** ** | **TWELVE MONTHS ENDED** | ** ** |
|-----------------------|------------|-----------------------------------|------------|
| ** **            | ** ** | **DECEMBER 31,**             | ** ** |
| ** **            | ** ** | **2007**                          | ** ** | **Change** | ** ** | **2006** | ** ** | **Change** | ** ** | **2005** | ** ** |
|                  |       |                              |       |   |   |   |   |   |   |   |   |
| Maintenance  revenues |       | $                                 | 2,836,403  |   | 10 | % | $ | 2,583,968 |   | 27 | % | $ | 2,040,054 |   |
|                       |            |                                   |            |  |  |  |  |  |  |  |  |  |  |  |

 

Maintenance revenuesincreased 10% for the twelve months ended December 31, 2007 as compared tothe corresponding period in 2006 and reflects the expansion of our installedbase resulting from the completion of significant project-oriented work duringthe year ended December 31, 2007 in conjunction with our retention ofexisting maintenance customers. Likewise, our increase in maintenance revenues for the twelve monthsended December 31, 2006 as compared to the corresponding period in 2005reflects the expansion of our installed base during 2006 combined with ourretention of existing maintenance customers.

 

We anticipate continuedgrowth of our installed base through the retention of existing customerscombined with the completion of project-oriented work; however we cannotpredict the timing of this anticipated growth.

 

33

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***Costof Product Revenues***

 
| ** **                                                  | ** ** | **TWELVE MONTHS ENDED** | ** ** |
|-------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                  | ** ** | **DECEMBER 31,**             | ** ** |
| ** **                                                  | ** ** | **2007**                          | ** ** | **Change** | ** ** | **2006** | ** ** | **Change** | ** ** | **2005** | ** ** |
| **Cost of  Product Revenues:**                              | ** ** | ** **                        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Software and  Royalties                                     |       | $                                 | 1,007,754  |   | -18 | % | $ | 1,225,300 |   | 32 | % | $ | 931,293 |   |
| Percentage of  software and royalty net product revenue     |       | 20                                | %          | -1 | % | 21 | % | -2 | % | 23 | % |
| Hardware and  consumables                                   |       | $                                 | 295,435    |   | -70 | % | $ | 983,167 |   | -50 | % | $ | 1,965,269 |   |
| Percentage of  hardware and consumables net product revenue |       | 84                                | %          | 11 | % | 73 | % | -20 | % | 93 | % |
| Services                                                    |       | $                                 | 76,984     |   | 933 | % | $ | 7,454 |   | -63 | % | $ | 20,197 |   |
| Percentage of  services net product revenue                 |       | 23                                | %          | 21 | % | 2 | % | -2 | % | 4 | % |
| Patent Licensing                                            |       | $                                 | —     |   | 0 | % | $ | — |   | 0 | % | $ | — |   |
| Percentage of  patent licensing net product revenue         |       | 0                                 | %          | 0 | % | 0 | % | 0 | % | 0 | % |
| Total net  product revenues                                 |       | $                                 | 1,380,173  |   | -38 | % | $ | 2,215,921 |   | -24 | % | $ | 2,916,759 |   |
| Percentage of  total net product revenues                   |       | 24                                | %          | -5 | % | 29 | % | -12 | % | 41 | % |

 

The dollar decrease inour costs of software and royalty product revenue of approximately 18% or$218,000 for the twelve months ended December 31, 2007 as compared to thecorresponding period of 2006 is reflective of lower software and royaltyrevenues being generated from project-oriented work in the 2007 year.  Identity management software and royaltyrevenues decreased 16% during the twelve months ended December 31, 2007 ascompared to the corresponding period in 2006.

 

The dollar increase inour costs of software and royalty product revenue of approximately 32% or$294,000 for the twelve months ended December 31, 2006 as compared to thecorresponding period of 2005 is reflective of increased software and royaltyrevenues being generated from project-oriented work which includes costs forthird-party software licenses and contract programming fees for softwarecustomization.  Such costs decreased as apercentage of software and royalty product revenues by approximately 2% duringthe twelve months ended December 31, 2006 as compared to the correspondingperiod of 2005 due to higher software and royalty product revenues in the 2006year.

 

Costs of product revenuesof our hardware and consumables revenues decreased approximately 70% or$688,000 for the twelve months ended December 31, 2007 as compared to thecorresponding period of 2006 due to lower sales of hardware andconsumables.  Sales of hardware decreasedapproximately $279,000 and sales of consumables decreased approximately $719,000for the twelve months ended December 31, 2007 as compared to thecorresponding period in 2006.  Theserevenue decreases resulted in lower cost of sales of approximately $157,000related to hardware and lower cost of sales of approximately $531,000 relatedconsumables.

 

Costs of product revenuesof our hardware and consumables revenues decreased approximately 50% or$982,000 for the twelve months ended December 31, 2006 as compared to thecorresponding period of 2005 due to lower sales of hardware andconsumables.  This decrease in hardwareand consumables product revenues is reflective of our decision in late 2005 toclose our German sales office.  Thisoffice had historically emphasized the resale of third-party merchandise(hardware and consumables) which generated lower gross margins than software(as a percentage of revenue) and required significant fixed costs for sales,service and support  The 2005 year alsocontains approximately $251,000 in inventory write-down costs associated withthe closure of our German sales office.

 

Costs of products alsocan vary as a percentage of product revenue from period to period dependingupon product mix and the third party software license content, hardwarecontent, and print media consumable content included in systems installedduring a given period.

 

34

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***MaintenanceCost of Revenues***

 
| ** **                                | ** ** | **TWELVE MONTHS ENDED** | ** ** |
|-------------------------------------------|------------|-----------------------------------|------------|
| ** **                                | ** ** | **DECEMBER 31,**             | ** ** |
| ** **                                | ** ** | **2007**                          | ** ** | **Change** | ** ** | **2006** | ** ** | **Change** | ** ** | **2005** | ** ** |
| ** **                                | ** ** | ** **                        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total  maintenance cost of revenues       |       | $                                 | 1,166,259  |   | 5 | % | $ | 1,113,118 |   | -1 | % | $ | 1,125,103 |   |
| Percentage of  total maintenance revenues |       | 41                                | %          | -2 | % | 43 | % | -12 | % | 55 | % |
|                                           |            |                                   |            |  |  |  |  |  |  |  |  |  |  |  |

 

Cost of maintenancerevenues increased approximately 5%, or $53,000 during the twelve months ended December 31,2007 as compared to the corresponding period of 2006 due primarily to highercosts incurred to service our expanding installed base.  Cost of maintenance revenues as a percentageof maintenance revenues decreased 2% during the twelve months ended December 31,2007 as compared to the corresponding period in 2006 due to higher maintenancerevenues available to absorb fixed costs.

 

Cost of maintenancerevenues as a percentage of maintenance revenues decreased approximately 12%during the twelve months ended December 31, 2006 as compared to thecorresponding period of 2005 due primarily to higher maintenance revenues toabsorb fixed maintenance costs.  Thedollar decrease during the twelve months ended December 31, 2006 ascompared to the corresponding period in 2005 is reflective of a higherpercentage of our maintenance revenues being generated from maintenancecoverage on software only solutions which typically have lower maintenancecosts than solutions comprised of both software and hardware components.

 

***ProductGross Profit***

 
| ** **                                              | ** ** | **TWELVE MONTHS ENDED** | ** ** |
|---------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                              | ** ** | **DECEMBER 31,**             | ** ** |
| ** **                                              | ** ** | **2007**                          | ** ** | **Change** | ** ** | **2006** | ** ** | **Change** | ** ** | **2005** | ** ** |
| **Product  gross profit**                               | ** ** | ** **                        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Software and  royalties                                 |       | $                                 | 3,959,106  |   | -15 | % | $ | 4,663,962 |   | 50 | % | $ | 3,105,563 |   |
| Percentage of  software and royalty product revenue     |       | 80                                | %          | 1 | % | 79 | % | 2 | % | 77 | % |
| Hardware and  consumables                               |       | $                                 | 54,306     |   | -85 | % | $ | 364,285 |   | 154 | % | $ | 143,142 |   |
| Percentage of  hardware and consumables product revenue |       | 16                                | %          | -11 | % | 27 | % | 20 | % | 7 | % |
| Services                                                |       | $                                 | 258,589    |   | -28 | % | $ | 361,430 |   | -23 | % | $ | 468,655 |   |
| Percentage of  services product revenue                 |       | 77                                | %          | -21 | % | 98 | % | 2 | % | 96 | % |
| Patent Licensing                                        |       | $                                 | —     |   | 0 | % | $ | — |   | -100 | % | $ | 500,000 |   |
| Percentage of  Patent Licensing product revenue         |       | 0                                 | %          | 0 | % | 0 | % | -100 | % | 100 | % |
| Total product  gross profit                             |       | $                                 | 4,272,001  |   | -21 | % | $ | 5,389,677 |   | 28 | % | $ | 4,217,360 |   |
| Percentage of  total product revenues                   |       | 76                                | %          | 5 | % | 71 | % | 12 | % | 59 | % |

 

Total product grossprofit as a percentage of product revenues increased approximately 5% despite adollar decrease of approximately $1,118,000 during the twelve months ended December 31,2007 as compared to the corresponding period during 2005 due primarily to ahigher percentage of total revenues coming from the sales of software androyalties which typically have lower costs than solutions containingsignificant amounts of hardware and consumables.

 

Total product grossprofit as a percentage of product revenues increased approximately 12% or$1,173,000 during the twelve months ended December 31, 2006 as compared tothe corresponding period during 2005 due primarily to higher product sales anda higher percentage of total revenues coming from the sales of software androyalties which typically have lower costs than solutions containingsignificant amounts of hardware and consumables.

 

The dollar decrease ingross profit of software and royalties of approximately 15% or $705,000 for thetwelve months ended December 31, 2007 as compared to the correspondingperiod in 2006 is reflective of lower sales of software and royalties intoproject-oriented work of approximately $922,000 in the twelve month periodending December 31, 2007.

 

35

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The dollar increase ingross profit of software and royalties of approximately 50% or 1,558,000 forthe twelve months ended December 31, 2006 as compared to the correspondingperiod in 2005 is reflective of higher sales of software and royalties intoproject-oriented work of approximately $1,852,000 in the twelve month periodending December 31, 2006.

 

Hardware and consumablegross profit as a percentage of hardware and consumable product revenuedecreased approximately 11% or $310,000 for the twelve months ended December 31,2007 as compared to the corresponding period in 2006 due to lower sales ofhardware and consumables of approximately $998,000 in the twelve month periodending December 31, 2007.

 

Hardware and consumablegross profit as a percentage of hardware and consumable product revenueincreased approximately 20% or $221,000 for the twelve months ended December 31,2006 as compared to the corresponding period in 2005 despite lower sales due tothe 2005 year containing approximately $251,000 in inventory write-down costsassociated with the closure of our German sales office.

 

***MaintenanceGross Profit***

 
| ** **                                | ** ** | **TWELVE MONTHS ENDED** | ** ** |
|-------------------------------------------|------------|-----------------------------------|------------|
| ** **                                | ** ** | **DECEMBER 31,**             | ** ** |
| ** **                                | ** ** | **2007**                          | ** ** | **Change** | ** ** | **2006** | ** ** | **Change** | ** ** | **2005** | ** ** |
| **Maintenance  gross profit**             |       |                              |       |   |   |   |   |   |   |   |   |
| Total  maintenance gross profit           |       | $                                 | 1,670,144  |   | 14 | % | $ | 1,470,850 |   | 61 | % | $ | 914,951 |   |
| Percentage of  total maintenance revenues |       | 59                                | %          | 2 | % | 57 | % | 12 | % | 45 | % |
|                                           |            |                                   |            |  |  |  |  |  |  |  |  |  |  |  |

 

Total gross profitdollars related to maintenance revenues increased approximately $199,000 duringthe twelve months ended December 31, 2007 as compared to the correspondingperiod in 2006 due to higher maintenance revenues of approximately $252,000offset by higher maintenance costs of $53,000. Our increase in maintenance revenues reflects our expanding installedbase combined with our retention of existing maintenance contracts.  Our increase in maintenance costs of $53,000during the twelve months ended December 31, 2007 reflects increased laborcosts.

 

Total gross profitdollars related to maintenance revenues increased approximately $556,000 duringthe twelve months ended December 31, 2006 as compared to the correspondingperiod in 2005 due to higher maintenance revenues to absorb fixed maintenancecosts combined with the 2006 year containing a larger percentage of maintenancerevenues being generated from maintenance coverage on software only solutionswhich typically have lower maintenance costs than solutions containing bothsoftware and hardware.

 

***OperatingExpenses***

 
| ** **                         | ** ** | **TWELVE MONTHS ENDED** | ** ** |
|------------------------------------|------------|-----------------------------------|------------|
| ** **                         | ** ** | **DECEMBER 31,**             | ** ** |
| ** **                         | ** ** | **2007**                          | ** ** | **Change** | ** ** | **2006** | ** ** | **Change** | ** ** | **2005** | ** ** |
| ** **                         | ** ** | ** **                        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Operating  expenses:**           | ** ** | ** **                        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| General &  administrative |       | $                                 | 3,865,463  |   | -12 | % | $ | 4,411,864 |   | -11 | % | $ | 4,970,060 |   |
| Percentage of  total net revenue   |       | 46                                | %          | 3 | % | 43 | % | -11 | % | 54 | % |
| Sales and  marketing               |       | $                                 | 2,647,444  |   | -26 | % | $ | 3,565,341 |   | 7 | % | $ | 3,335,139 |   |
| Percentage of  total net revenue   |       | 31                                | %          | -4 | % | 35 | % | -1 | % | 36 | % |
| Research &  development   |       | $                                 | 3,669,099  |   | 0 | % | $ | 3,652,081 |   | 25 | % | $ | 2,922,049 |   |
| Percentage of  total net revenue   |       | 43                                | %          | 7 | % | 36 | % | 4 | % | 32 | % |
| Impairment  losses                 |       | —                            |       | 0 | % | — |   | -100 | % | $ | 253,000 |   |
| Percentage of  total net revenue   |       | 0                                 | %          | 0 | % | 0 | % | -3 | % | 3 | % |
| Depreciation and  amortization     |       | $                                 | 257,532    |   | -15 | % | $ | 304,323 |   | -46 | % | $ | 568,519 |   |
| Percentage of  total net revenue   |       | 3                                 | %          | 0 | % | 3 | % | -3 | % | 6 | % |

 

***Generaland Administrative Expenses***

 

General and administrativeexpenses are comprised primarily of salaries and other employee-related costsfor executive, financial, and other infrastructure personnel. General legal,accounting and consulting services, insurance, occupancy and communicationcosts are also included with general and administrative expenses.  Such expenses decreased 

 

36

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during the twelve monthsended December 31, 2007 as compared to the corresponding period in 2006 byapproximately $546,000.  Major componentsof this change are:

 

·                  Decrease in stock-based compensation expense ofapproximately $380,000 due the expiration of certain restricted stock grantscombined with lower expenses recorded pursuant to SFAS 123(R) due to theexpiration of vesting periods for certain prior year share-based paymentissuances.

 

·                  Decrease in consulting and professional fees expenseof approximately $192,000 due to the termination of various consultingagreements.

 

·                  Decrease in insurance expense, dues and subscriptions,and other miscellaneous expenses of approximately $127,000.

 

·                  Increase in salaries and related personnel costs ofapproximately $153,000 due to increases in headcount in program managementpersonnel.

 

The percentage increaseis reflective of lower total net revenues during the year ended December 31,2007, as compared to the corresponding period in 2006.

 

General andadministrative expenses decreased during the twelve months ended December 31,2006 as compared to the corresponding period in 2005 by approximately$558,000.   Major components of thischange are:

 

·                  Decrease in general and administrative expenses ofapproximately $735,000 due to the closure of our sales office in Germany.

 

·                  Decreases in expenses recorded for bad debt expense ofapproximately $400,000.

 

·                  Increase in stock based compensation expenses recordedpursuant to the implementation of SFAS 123(R) of approximately $347,000.

 

·                  Increases in higher professional fees and othergeneral administrative expenses of approximately $230,000.

 

We are continuing tofocus our efforts on achieving additional future operating efficiencies byreviewing and improving upon existing business processes and evaluating ourcost structure. We believe these efforts will allow us to continue to graduallydecrease our level of general and administrative expenses expressed as apercentage of total revenues.

 

***Salesand Marketing Expenses***

 

Sales and marketingexpenses consist primarily of the salaries, commissions, other incentivecompensation, employee benefits and travel expenses of our sales force.   Such expenses decreased in 2007 byapproximately $918,000.  Major componentsof this change are:

 

·                  Decrease in salaries and personnel costs ofapproximately $737,000 due to reductions in headcount.

 

·                  Decrease in advertising and trade show expenses ofapproximately $146,000.

 

·                  Decrease in stock-based compensation expense ofapproximately $104,000 due lower expenses recorded pursuant to SFAS 123(R) dueto the expiration of vesting periods for certain prior year share-based paymentissuances.

 

·                  Increase in sales consulting expense of approximately$69,000.

 

We anticipate that thelevel of expenses incurred for sales and marketing during the twelve monthsended December 31, 2008 will increase as we pursue large project solutionopportunities.

 

37

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***Researchand Development Expenses***

 

Research and developmentcosts consist primarily of salaries, employee benefits and outside contractorsfor new product development, product enhancements and custom integration work.Such expenses were approximately $3.7 million during the twelve months ended December 31, 2007 and 2006.  In 2007, such costs were incurred primarilyfor the accelerated development of an expanded suite of applications utilizingour ImageWare Biometric Engine, the development of our Personal IdentityVerification (PIV) solution, and continued development of our IWS desktopsecurity program.  We utilize contractprogramming services in conjunction with internal research and development resourcesto carry out our research and development.

 

Research and developmentcosts increased approximately 25% or $730,000 during the twelve months ended December 31,2006 as compared to the corresponding period of 2005 due to the accelerateddevelopment of our new Biometric Engine, the Web enablement of our CCS productline, development of our new Desktop Security program (released in the fourthquarter of 2005) utilizing internal research and development resources andcontract programming.

 

 Our level of expenditures in research anddevelopment reflects our belief that to maintain our competitive position inmarkets characterized by rapid rates of technological advancement, we mustcontinue to invest significant resources in new systems and software as well ascontinue to enhance existing products.

 

***ImpairmentLosses***

 

Impairment lossesrepresent the amount by which the carrying amount of long-lived assets exceedstheir fair value.  Fair value isdetermined based on the best information available in the circumstances,including present value techniques.  TheCompany did not record any impairment losses during the twelve months ended December 31,2007 and 2006.  During the twelve monthsended December 31, 2005, we recorded impairment losses of $1,245,000 forgoodwill carried in our former Digital Photography segment and $253,000 for ourtrademark and tradename asset carried in our former Identification segment.

 

***Depreciationand Amortization***

 

Depreciation andamortization decreased during the twelve months ended December 31, 2007 ascompared to the corresponding period in 2006 due primarily to fully depreciatedoffice and computer equipment.

 

Depreciation andamortization decreased during the twelve months ended December 31, 2006 ascompared to the corresponding period in 2005 due primarily to loweramortization of certain definite long-lived intangible assets due to asignificant portion of such assets being fully amortized at the end of ourfirst fiscal quarter of 2006.

 

***InterestExpense, Net***

 

For the year endedDecember 31, 2007, we recognized interest income of $48,000 and interestexpense of $263,000.  For the year ended December 31,2006, we recognized interest income of $28,000 and interest expense of$593,000.  For the year ended December 31,2005, we recognized interest income of $55,000 and interest expense of $2,000.

 

Interest expensefor the year ended December 31, 2007 contains 3 components approximating$248,000 related to our secured notes payable issued in March 2006 andpaid in full in March 2007: $19,000 of coupon interest, $213,000 in notediscount amortization, and $16,000 in deferred financing fee amortizationclassified as interest expense.

 

Interest expensefor the year ended December 31, 2006, contains 3 components approximating$578,000 related to our secured notes payable issued in March 2006:$89,000 of coupon interest, $408,000 in note discount amortization, and $81,000in deferred financing fee amortization classified as interest expense.

 

***Liquidityand Capital Resources***

 

As of December 31,2007, we had total current assets of $2,040,000 and total current liabilitiesof $5,269,000, or negative working capital of $3,229,000. At December 31,2007 and 2006, we had available cash of $1,044,000 and $939,000, respectively.

 

38

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Net cash used inoperating activities was $2,875,000 for the year ended December 31, 2007,as compared to $2,817,000 for the corresponding period in 2006. We used cash tofund net losses of $3,568,000, excluding non-cash expenses (depreciation,amortization, debt issuance costs, debt discount, stock-based compensation, andprovision for losses on accounts receivable, reductions in inventory valuationallowance, and write-down of investments in equity securities) of $1,117,000for the year ended December 31, 2007. We used cash to fund net losses of $3,990,000, excluding non-cashexpenses (depreciation, amortization, debt issuance costs, debt discount,stock-based compensation, and provision for losses on accounts receivable lessgains on sale of subsidiary) of $1,936,000 for the year ended December 31,2006.  For the year ended December 31,2007, we generated cash of $913,000 through reductions in current assets andused cash of $220,000 from decreases in current liabilities (excluding debt).For the year ended December 31, 2006, we used cash of $267,000 to fundincreases in current assets offset by increases in current liabilities of$1,440,000 (excluding debt).

 

Net cash used byinvesting activities was $522,000 for the year ended December 31,2007.  Net cash used by investingactivities was $133,000 for the year ended December 31, 2006. For the yearended December 31, 2007, we used cash to fund capital expenditures ofcomputer equipment and software, furniture and fixtures and leaseholdimprovements of approximately $86,000. The level of equipment purchasesresulted primarily from continued growth of the business and replacement ofolder equipment.  For the year ended December 31,2007, we used cash of $410,000 for our acquisition of Sol Logic, Inc. andused cash of $26,000 to fund increases in restricted cash securing ourperformance of certain software implementation contracts.  For the year ended December 31, 2006, weused cash to fund capital expenditures of computer equipment and software,furniture and fixtures and leasehold improvements of approximately $158,000.The level of equipment purchases resulted primarily from continued growth ofthe business and replacement of older equipment.  For the year ended December 31, 2006, wegenerated cash of $25,000 for the sale of our wholly-owned Digital Photographycomponent.

 

Net cash provided byfinancing activities was $3,560,000 for the year ended December 31, 2007.We generated cash of $2,621,000 from our issuance of common stock in a privateplacement and generated cash of $1,233,000 from our issuance of preferred stockin a private placement.  We alsogenerated cash of $1,121,000 from our issuance of common stock pursuant towarrant exercises.  In 2007, we used cashof $1,310,000 to repay notes payable and used cash of $51,000 for the paymentof dividends on our Series B Preferred Stock and incurred financingrelated expenses of $54,000.  Net cashprovided by financing activities was $3,224,000 for the year ended December 31,2006.  In 2006, we generated cash of$2,064,000 from our issuance of preferred stock in a private placement.  We also generated cash of $1,550,000 from ourissuance of senior secured notes payable offset by debt issuance costs of$98,000.  In 2006, we used cash of$240,000 to repay notes payable and used cash of $52,000 for the payment ofdividends on our Series B Preferred Stock.

 

***ContractualObligations and Commercial Commitments***

 

We conduct operations inleased facilities under operating leases expiring at various dates through2009.  In conjunction with ourperformance on various software installation and implementation contracts, weare contingently liable under two irrevocable letters of credit in an aggregateamount of $169,000. The letters of credit expire on April 30, 2008 in theamount of $37,000 and on December 26, 2008 in the amount of $132,000.  We also have various short-term notes payableand capital lease obligations due at various times during 2009. The followingtable sets forth a summary of our obligations under operating leases, capitalleases, notes payable and irrevocable letters of credit for the next fiveyears:

 
| ** **                                                           | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** | **2012** | ** ** | **Total** | ** ** |
|----------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|-----------|------------|
|                                                                 |       |     |       |     |       |     |       |     |       |     |       |      |       |
| Minimum annual  lease payments under operating leases                |       | $        | 492,000    |     | $          | 158,000  |       | $        | 0          |     | $          | 0         |       | $ | 0 |   | $ | 650,000 |   |
|                                                                 |       |     |       |     |       |     |       |     |       |     |       |      |       |
| Other commercial  commitments:                                       |       |     |       |     |       |     |       |     |       |     |       |      |       |
|                                                                 |       |     |       |     |       |     |       |     |       |     |       |      |       |
| Standby letters  of credit                                           |       | $        | 169,000    |     | $          | 0        |       | $        | 0          |     | $          | 0         |       | $ | 0 |   | $ | 169,000 |   |
|                                                                 |       |     |       |     |       |     |       |     |       |     |       |      |       |
| Total  contractual cash obligations and other commercial commitments |       | $        | 661,000    |     | $          | 158,000  |       | $        | 0          |     | $          | 0         |       | $ | 0 |   | $ | 819,000 |   |

 

39

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The report of the Company’sindependent accountants included with this Annual Report contains anexplanatory paragraph regarding our ability to continue as a goingconcern.  We are seeking additionalfinancing that we believe is necessary to fund our working capital requirementsfor at least the next twelve months in conjunction with the successfulimplementation of our business plan. Our business plan includes, among otherthings, the monitoring and controlling of operating expenses, collection ofsignificant trade and other accounts receivables, and controlling of capitalexpenditures.  If we are unable to secureadditional financing or successfully implement our business plan, we will berequired to seek funding from alternate sources and/or institute cost reductionmeasures.  We may seek to sell equity ordebt securities, secure a bank line of credit, or consider strategic alliances.  The sale of equity or equity-relatedsecurities could result in additional dilution to our shareholders.  There can be no assurance that additionalfinancing, in any form, will be available at all or, if available, will be onterms acceptable to us.  In addition, ourability to raise additional capital may be dependent upon our common stockbeing quoted on the American Stock Exchange. On December 14, 2007, we received a letter from AMEX indicatingthat we do not comply with AMEX’s continued listing standards. We filed anappeal of AMEX’s determination and requested an oral hearing before an AMEXListing Qualifications Panel (a “Qualifications Panel”).  On March 10, 2008, we received a letterfrom AMEX granting our request.  Ourhearing with a Qualifications Panel is scheduled for April 16, 2008.  If the Qualifications Panel does not grantthe relief sought, our common stock will be delisted from AMEX following whichit is expected that our common stock would be quoted on the Over-the-CounterBulletin Board.

 

Insufficient funds mayrequire us to delay, scale back or eliminate some or all of our activities, andif we are unable to obtain additional funding there is substantial doubt aboutour ability to continue as a going concern.

 

**Item 7A.Quantitative and Qualitative Disclosures about Market Risk**

 

***ForeignCurrency Exchange Risk***

 

Market risk is thepotential loss arising from adverse changes in market rates and prices, such asinterest rates and foreign currency exchange rates.  Changes in foreign currency exchange rateshave an impact on our results of operations. Our exposure to adverse movementsin foreign currency exchange rates is primarily related to our subsidiariesoperating expense, primarily in Canada and Germany, denominated in therespective local currency. We currently do not enter into forward exchangecontracts to hedge exposures denominated in foreign currencies and do not usederivative financial instruments for trading or speculative purposes. Theeffect of an immediate 10% change in foreign currency exchange rates should nothave a material effect on our future operating results or cash flows; however,a long term change in foreign currency rates would likely result in increasedtechnical support and engineering expenses. The vast majority of our sales aretransacted in U. S. dollars.

 

**Item 8.Consolidated Financial Statements and Supplementary Data.**

 

The index to ourConsolidated Financial Statements and the Report of Independent RegisteredPublic Accounting Firm appears in Part IV of this Form 10-K.

 

**Item 9.Changes in and Disagreements With Accountants on Accounting and FinancialDisclosure.**

 

Notapplicable

 

**Item 9A.Controls and Procedures.**

 

Managementis responsible for establishing and maintaining adequate internal control overfinancial reporting of the Company.

 

*Evaluationof disclosure controls and procedures*.  Our chief executiveofficer and our chief financial officer, after evaluating the effectiveness ofour disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e))as of December 31, 2007 (the “Evaluation Date”), have concluded that as ofsuch date, our disclosure controls and procedures were adequate and effectiveto ensure that information required to be disclosed in the reports that we fileunder the Securities and Exchange Act of 1934 is recorded, processed,summarized and reported within the time period specified in the Commission’s rules andforms.

 

The Company’s managementassessed the effectiveness of the Company’s internal control over financialreporting as of December 31, 2007 in accordance with the standards setforth by the Public Company Accounting Oversight Board (“PCAOB”).  In accordance with these standards,management assessed and tested, on a sample basis, the Company’s internalcontrol over financial reporting according to a comprehensive risk analysisusing the Internal Control – Integrated Framework issued by the Committee ofSponsoring Organizations of the Treadway Commission, (“COSO”).  It is management’s opinion that the testingmethodology of the internal control framework is appropriate and providesreasonable assurance as to the integrity and reliability of our internalcontrols over financial reporting. Based on the 

 

40

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results of its evaluation,the Company’s management has concluded that the Company’s internal control overfinancial reporting was effective as of December 31, 2007.  This annual report does not include anattestation report of the Company’s registered public accounting firm regardinginternal control over financial reporting. Management’s report was not subject to attestation by the Company’sregistered public accounting firm pursuant to the temporary rules of theSecurities and Exchange Commission that permit the Company to provide onlymanagement’s report in this annual report

 

*Changes in internal controls*. There has been no change in our internal controls over financialreporting during the quarter ended December 31, 2007, that has materiallyaffected, or is reasonably likely to materially affect our internal controlover financial reporting.

 

**Item 9B.Other Information.**

 

Not applicable.

 

**PART III**

 

**Item 10.****              Directors, Executive Officers and CorporateGovernance**

 

**(a)  ***Identification of Directors.*  Theinformation under the caption “Election of Directors,” appearing in the ProxyStatement to be filed for the 2008 Annual Meeting of Stockholders isincorporated herein by reference.

 

**(b)  ***Identification of Executive Officers.*  Theinformation under the caption “Certain Information with Respect to ExecutiveOfficers,” appearing in the Proxy Statement to be filed for the 2008 AnnualMeeting of Stockholders is incorporated herein by reference.

 

**(c)  ***Compliance with Section 16(a) of theExchange Act.*  The information under the caption “Compliancewith Federal Securities Laws,” appearing in the Proxy Statement to be filed forthe 2008 Annual Meeting of Stockholders is incorporated herein by reference.

 

**(d)  ***Code of Ethics.*  The Company hasadopted a *Code of Business Conduct and Ethics*policy that applies to our directors and employees (including the Company’sprincipal executive officer, principal financial officer, principal accountingofficer or     controller, or personsperforming similar functions).  TheCompany intends to promptly disclose (i) the nature of any amendment tothis code of ethics that applies to our principal executive officer, principalfinancial officer, principal accounting officer or controller, or personsperforming similar functions and (ii) the nature of any waiver, includingan implicit waiver, from a provision of this code of ethics that is granted toone of these specified individuals, the name of such person who is granted thewaiver and the date of the waiver on our website in the future.  A copy of our Code of Business Conduct andEthics can be obtained from our website at http://www.iwsinc.com.

 

**(e)  ***AuditCommittee.*** **The information under the caption “InformationRegarding the Board and its Committees,” appearing in the Proxy Statement to befiled for the 2008 Annual Meeting of Stockholders is incorporated herein byreference.

 

**Item 11.****              Executive Compensation**

 

The information under theheading “Executive Compensation and Other Information” appearing in the ProxyStatement to be filed for the 2008 Annual Meeting of Stockholders isincorporated herein by reference.

 

**Item 12.****              Security Ownership of Certain BeneficialOwners and Management and Related Stockholder Matters**

 

The information under theheading “Principal Stockholders” appearing in the Proxy Statement to be filedfor the 2008 Annual Meeting of Stockholders is incorporated herein byreference.

 

41

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**Item 13.****              Certain Relationships and RelatedTransactions**

 

The information under theheading “Certain Relationships and Related Transactions,” appearing in theProxy Statement to be filed for the 2008 Annual Meeting of Stockholders isincorporated herein by reference.

 

**Item 14.****              Principal Accountant Fees and Services**

 

The information under theheading “Principal Accountant Fees and Services,” appearing in the ProxyStatement to be filed for the 2008 Annual Meeting of Stockholders isincorporated herein by reference.

 

**PART IV**

 

**Item 15.*****             *Exhibits and Financial Statement Schedules**

 

**(a)  **1.Index to Consolidated Financial Statements

 

See Index to ConsolidatedFinancial Statements and financial statement schedules.

 

**(a)  **2.Index to Financial Statement Schedules

 

Referto Schedule II, Valuation and Qualifying Accounts, hereto.

 

Schedule II

Valuation and Qualifying Accounts and Reserves

(in thousands)

For the Fiscal Years Ended December 31, 2005,2006 and 2007

 
| ** **                               | ** ** | **Balance at** | ** ** | ** **    | ** ** | ** **     | ** ** | **Balance**      | ** ** |
|------------------------------------------|------------|---------------------|------------|---------------|------------|----------------|------------|------------------|------------|
| ** **                               | ** ** | **Beginning**       | ** ** | ** **    | ** ** | ** **     | ** ** | **at End**  | ** ** |
| ** **                               | ** ** | **of Year**    | ** ** | **Additions** | ** ** | **Deductions** | ** ** | **of Year** | ** ** |
|                                     |       |                |       |          |       |           |       |             |       |
| December 31,  2007:                 |       |                |       |          |       |           |       |             |       |
| Allowance for  doubtful accounts         |       | $                   | 483        |          | $          | 25             | (a)        | $                | 508        | (b) | $ | — |   |
| Reserve for  inventories                 |       | 52                  |       | —        |       | 36             | (d)        | $                | 16         |   |
| Deferred income  tax valuation allowance |       | 15,981              |       | 1,227         | (e)        | —         |       | $                | 17,208     |   |
|                                     |       |                |       |          |       |           |       |             |       |
| December 31,  2006:                 |       |                |       |          |       |           |       |             |       |
| Allowance for  doubtful accounts         |       | $                   | 478        |          | $          | 39             | (a)        | $                | 34         | (b) | $ | 483 |   |
| Reserve for  inventories                 |       | 300                 |       | 3             |       | 251            | (d)        | 52               |       |
| Deferred income  tax valuation allowance |       | 14,644              |       | 1,337         | (e)        | —         |       | 15,981           |       |
|                                     |       |                |       |          |       |           |       |             |       |
| December 31,  2005:                 |       |                |       |          |       |           |       |             |       |
| Allowance for  doubtful accounts         |       | $                   | 303        |          | $          | 450            | (a)        | $                | 275        | (b) | $ | 478 |   |
| Reserve for  inventories                 |       | 47                  |       | 281           | (c)        | 28             |       | 300              |       |
| Deferred income  tax valuation allowance |       | 11,882              |       | 2,762         | (e)        | —         |       | 14,644           |       |

 

----

| (a) | Represents increase in the  required allowance for doubtful accounts reserve based on the Company’s  evaluation of accounts receivable. |
|-----|----------------------------------------------------------------------------------------------------------------------------------------------|
| (b) | Represents amounts written  off as uncollectible.                                                                                            |
| (c) | Represents increase in the  required reserve based on the Company’s evaluation of obsolete inventory.                                   |
| (d) | Represents amounts written  off as obsolete inventory.                                                                                       |
| (e) | Represents net increases in  deferred income tax valuation allowance                                                                         |

 

42

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**(b)  **Exhibits

 

The following Exhibitsare filed as part of, or incorporated by reference into, this Report on Form 10-K:

 

**Item 16.****                                                 Exhibitsand Financial Statement Schedules**

 

**(a)  Exhibits**

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                        |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1                 |       | Stock Purchase  Agreement, dated March 1, 2005, between the Registrant and Argus  Solutions Ltd. (incorporated by reference to Exhibit 2.1 to the  Registrant’s Current Report on Form 8-K, filed March 9, 2005).                                                             |
| 2.2                 |       | Agreement and Plan of  Merger, dated October 27, 2005 (incorporated by reference to Annex A to  the Registrant’s Definitive Proxy Statement on Schedule 14A, filed  November 15, 2005).                                                                                                 |
| 3.1                 |       | Certificate of  Incorporation (incorporated by reference to Annex B to the Registrant’s  Definitive Proxy Statement on Schedule 14A, filed November 15, 2005).                                                                                                                               |
| 3.2                 |       | Bylaws (incorporated by  reference to Annex C to the Registrant’s Definitive Proxy Statement on  Schedule 14A, filed November 15, 2005).                                                                                                                                                     |
| 3.3                 |       | Certificate of  Designations of Preferences, Rights and Limitations of Series C 8%  Convertible Preferred Stock dated November 2, 2006, as amended  (incorporated by reference to Exhibit 3.1 to the Registrant’s Current  Report on Form 8-K, filed November 20, 2006). |
| 3.4                 |       | Certificate of  Designations of Preferences, Rights and Limitations of Series D 8%  Convertible Preferred Stock dated March 8, 2007 (incorporated by  reference to Exhibit 3.1 to the Registrant’s Current Report on  Form 8-K, filed March 15, 2007).                   |
| 4.1                 |       | Warrant to Purchase  Common Stock in favor of Imperial Bank, dated January 15, 1998  (incorporated by reference to Exhibit 10.42 to the Registrant’s  Registration Statement on Form SB-2 (No. 333-93131), filed  December 20, 1999, as amended).                        |
| 4.2                 |       | Registration Rights  Agreement, dated May 22, 2002, by and between the Registrant and Perseus  2000 L.L.C. (incorporated by reference to Exhibit 10.3 to the  Registrant’s Current Report on Form 8-K, filed May 24, 2002).                                                   |
| 4.3                 |       | Warrant to Purchase  Common Stock, dated June 13, 2003, issued by the Registrant to L.F.  Global Holdings, LLC (incorporated by reference to Exhibit 10.5 to the  Registrant’s Current Report on Form 8-K, filed June 20, 2003).                                              |
| 4.4                 |       | Form of Warrant  dated November 24, 2003 (incorporated by reference to Exhibit 99.2  to the Registrant’s Current Report on Form 8-K, filed February 9,  2004).                                                                                                           |
| 4.5                 |       | Form of  Registration Rights Agreement dated November 24, 2003 (incorporated by  reference to Exhibit 99.3 to the Registrant’s Current Report on  Form 8-K, filed February 9, 2004).                                                                                     |
| 4.6                 |       | Form of  Registration Rights Agreement dated March 13, 2003 (incorporated by  reference to Exhibit 10.2 to the Registrant’s Quarterly Report on  Form 10-QSB, filed May 15, 2003).                                                                                       |
| 4.7                 |       | Form of Warrant  dated January 29, 2004 (incorporated by reference to Exhibit 99.5  to the Registrant’s Current Report on Form 8-K, filed February 9,  2004).                                                                                                            |
| 4.8                 |       | Form of  Registration Rights Agreement dated January 29, 2004 (incorporated by  reference to Exhibit 99.8 to the Registrant’s Current Report on  Form 8-K, filed February 9, 2004).                                                                                      |
| 4.9                 |       | Form of Warrant  dated July 22, 2005 and dated July 28, 2005 (incorporated by  reference to Exhibit A to Exhibit 10.1 to the Registrant’s Current  Report on Form 8-K, filed July 26, 2005).                                                                   |
| 4.10                |       | Form of Warrant dated  March 17, 2006 (incorporated by reference to Exhibit 4.1 to the  Registrant’s Quarterly Report on Form 10-Q, filed May 22, 2006).                                                                                                                 |
| 4.11                |       | Registration Rights  Agreement, dated November 14, 2006 by and among the Registrant and  certain investors (incorporated by reference to Exhibit 10.2 to the  Registrant’s Current Report on Form 8-K, filed November 20, 2006).                                              |
| 4.12                |       | Form of Warrant to  Purchase Common Stock dated November 14, 2006 (incorporated by reference  to Exhibit 10.3 to the Registrant’s Current Report on Form 8-K,  filed November 20, 2006).                                                                                 |
| 4.13                |       | Registration Rights  Agreement, dated March 9, 2007, by and among the Registrant and certain  accredited investors (incorporated by reference to Exhibit 10.2 to the  Registrant’s Current Report on Form 8-K, filed March 15, 2007).                                         |
| 4.14                |       | Form of Warrant to  Purchase Common Stock dated March 9, 2007 (incorporated by reference to  Exhibit 10.3 to the Registrant’s Current Report on Form 8-K, filed  March 15, 2007).                                                                                        |

 

43

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| 4.15  |   | Registration Rights  Agreement, dated September 25, 2007, by and among the Registrant and  certain accredited investors (incorporated by reference to Exhibit 10.2  to the Registrant’s Current Report on Form 8-K, filed September 26,  2007).                                                                         |
|-------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 4.16  |   | Form of Warrant to  Purchase Common Stock dated September 25, 2007 (incorporated by  reference to Exhibit 10.3 to the Registrant’s Current Report on  Form 8-K, filed September 26, 2007).                                                                                                                         |
| 4.17  |   | Registration Rights  Agreement, dated December 19, 2007, by and among the Registrant, Sol  Logic, and Wink Jones, as the representative of Sol Logic (incorporated by  reference to Exhibit 4.1 to the Registrant’s Current Report on  Form 8-K, filed December 21, 2007).                                              |
| 4.18  |   | Amendment No. 1 to  Registration Rights Agreement, dated March 28, 2008, by and among the  Registrant, Sol Logic, and Wink Jones, as the representative of Sol Logic,  and Wink Jones, as the representative of Sol Logic (incorporated by reference  to Exhibit 4.1 to the Registrant’s Current Report on Form 8-K, filed April 1,  2008). |
| 10.1  |   | Employment Agreement,  dated September 27, 2005, between the Registrant and S. James Miller  (incorporated by reference to Exhibit 10.1 to the Registrant’s Current  Report on Form 8-K, filed September 30, 2005).                                                                                                     |
| 10.2  |   | Employment Agreement, dated  September 27, 2005, between the Registrant and Wayne G. Wetherell  (incorporated by reference to Exhibit 10.2 to the Registrant’s Current  Report on Form 8-K, filed September 30, 2005).                                                                                                  |
| 10.3  |   | Change of Control and  Severance Benefits Agreement, dated October 31, 2005, between Registrant  and Charles Aubuchon (incorporated by reference to Exhibit 10.1 to the  Registrant’s Current Report on Form 8-K, filed November 3, 2005).                                                                              |
| 10.4  |   | Offer of Employment  Letter Agreement, dated December 19, 2007, between the Registrant and  Frank Mitchell (incorporated by reference to Exhibit 10.2 to the  Registrant’s Current Report on Form 8-K, filed December 21, 2007).                                                                                        |
| 10.5  |   | Form of  Indemnification Agreement entered into by the Registrant with its directors  and executive officers (incorporated by reference to Exhibit 10.4 to the  Registrant’s Registration Statement on Form SB-2 (No. 333-93131),  filed December 20, 1999, as amended).                                           |
| 10.6  |   | 1994 Employee Stock  Option Plan (incorporated by reference to Exhibit 10.6 to the Registrant’s  Registration Statement on Form SB-2 (No. 333-93131), filed  December 20, 1999, as amended).                                                                                                                            |
| 10.7  |   | 1994 Nonqualified Stock  Option Plan (incorporated by reference to Exhibit 10.7 to the  Registrant’s Registration Statement on Form SB-2 (No. 333-93131),  filed December 20, 1999, as amended).                                                                                                                        |
| 10.8  |   | Amended and Restated  1999 Stock Plan Award (incorporated by reference to Appendix B of the  Registrant’s Definitive Proxy Statement on Schedule 14A, filed  November 21, 2007).                                                                                                                                                       |
| 10.9  |   | Form of Stock  Option Agreement (incorporated by reference to Exhibit 10.2 to the  Registrant’s Current Report on   Form 8-K, filed July 14, 2005).                                                                                                                                                                     |
| 10.10 |   | 2001 Equity Incentive  Plan (incorporated by reference to Exhibit 10.2 to the Registrant’s  Quarterly Report on   Form 10-QSB, filed November 14, 2001).                                                                                                                                                                     |
| 10.11 |   | Form of Restricted  Stock Bonus Agreement (incorporated by reference to Exhibit 99.3 to the  Registrant’s Registration Statement on Form S-8, filed November 27,  2001).                                                                                                                                                |
| 10.12 |   | Form of Stock  Option Agreement (incorporated by reference to Exhibit 99.2 to the  Registrant’s Registration Statement on Form S-8, filed November 27,  2001).                                                                                                                                                          |
| 10.13 |   | Note and Warrant  Purchase Agreement, dated May 22, 2002, by and between the Registrant  and Perseus (incorporated by reference to Exhibit 10.1 to the Registrant’s  Current Report on Form 8-K, filed May 24, 2002).                                                                                                   |
| 10.14 |   | Form of Securities  Purchase Agreement dated November 14, 2003 (incorporated by reference to  Exhibit 99.1 to the Registrant’s Current Report on Form 8-K, filed  February 9, 2004).                                                                                                                               |
| 10.15 |   | Form of Securities  Purchase Agreement dated January 29, 2004 (incorporated by reference to Exhibit 99.4  to the Registrant’s Current Report on Form 8-K, filed February 9,  2004).                                                                                                                                |   |
| 10.16 |   | Offer of Restricted  Stock in Exchange for Certain Stock Options Previously Granted — Offer Made  to James Miller (incorporated by reference to Exhibit 10.1 to the  Registrant’s Quarterly Report on Form 10-QSB, filed August 16,  2004).                                                                             |   |
| 10.17 |   | Offer of Restricted  Stock in Exchange for Certain Stock Options Previously Granted — Offer Made  to Wayne Wetherell, dated March 30, 2004 (incorporated by reference to Exhibit 10.3  to the Registrant’s Quarterly Report on Form 10-QSB, filed August 16,  2004).                                               |   |
| 10.18 |   | Form of Securities  Purchase Agreement dated July 22, 2005 and July 28, 2005 (incorporated  by reference to Exhibit 10.1 to the Registrant’s Current Report on Form 8-K,  filed July 26, 2005).                                                                                                               |   |
| 10.19 |   | Security Agreement,  dated March 17, 2006, executed by the Registrant in favor of Little Bear  Investments, LLC (incorporated by reference to Exhibit 10.1 to the  Registrant’s Current Report on Form 8-K, filed March 23, 2006).                                                                                      |   |
| 10.20 |   | Form of Secured  Promissory Note dated March 17, 2006 (incorporated by reference to Exhibit 10.1  to the                                                                                                                                                                                                                          |   |
|       |        |                                                                                                                                                                                                                                                                                                                                                  |  |  |

 

44

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|   |   | Registrant’s Quarterly Report on Form 10-Q,  filed May 22, 2006).                                                                                                                                                                                                                                   |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.21  |   | Securities Purchase Agreement, dated November 14,  2006 by and among the Registrant and certain accredited investors  (incorporated by reference to Exhibit 10.1 to the Registrant’s Current  Report on Form 8-K, filed November 20, 2006).                                               |
| 10.22  |   | Securities Purchase Agreement, dated March 9,  2007, by and among the Registrant and certain accredited investors  (incorporated by reference to Exhibit 10.1 to the Registrant Current  Report on Form 8-K, filed March 15, 2007).                                                            |
| 10.23  |   | Securities Purchase Agreement, dated September 25,  2007, by and among the Registrant and certain accredited investors  (incorporated by reference to Exhibit 10.1 to the Registrant’s Current  Report on Form 8-K, filed September 26, 2007).                                            |
| 10.24  |   | Asset Purchase Agreement and Plan of Reorganization,  among Sol Logic, Frank Mitchell, as shareholder of Sol Logic, and Wink Jones,  as the representative of Sol Logic (incorporated by reference to Exhibit 10.1  to the Registrant’s Current Report on Form 8-K, filed December 21,  2007). |
| 10.25  |   | Amendment No. 1 to Asset Purchase and Plan of Reorganization,  by and between the Registrant and Wink Jones, as the representative of Sol  Logic (incorporated by reference to Exhibit 10.1 to the Registrant’s Current  Report on Form 8-K, filed April 1, 2008).                                            |
| 10.26  |   | Product Line Purchase Agreement, dated November 30,  2006, by and between the Registrant and PhotoLynx, Inc. (incorporated by  reference to Exhibit 10.3 to the Registrant’s Current Report on Form 8-K,  filed December 26, 2006).                                                  |
| 10.27  |   | Standard Commercial Lease, dated September 26,  2003, by and between Thornmint I and the Registrant (incorporated by  reference to Exhibit 10.1 to the Registrant’s Quarterly Report on Form 10-QSB,  filed November 14, 2003).                                                           |
| 10.28  |   | Amendment to Office Lease, dated June 12, 2006,  by and between Thornmint I and the Registrant (incorporated by reference to Exhibit 10.1  to the Registrant’s Quarterly Report on Form 10-Q, filed August 14,  2006).                                                                    |
| 10.29  |   | Office Lease, dated September 7, 2006, by and  between Union Bank of California as Trustee for Quest Group Trust VII and the  Registrant (incorporated by reference to Exhibit 10.1 to the Registrant’s  Quarterly Report on Form 10-Q, filed November 20, 2006).                         |
| 10.30  |   | Office Space Lease between I.W. Systems Canada  Registrant and Dundeal Canada (GP) Inc. dated June 1, 2006 (incorporated  by reference to Exhibit 10.40 to the Registrant’s Annual Report on Form 10-K,  filed April 17, 2007).                                                           |
| 21.1   |   | Subsidiaries of the Registrant                                                                                                                                                                                                                                                                                     |
| 23.1   |   | Consent of Stonefield Josephson, Inc.,  Independent Registered Public Accounting Firm                                                                                                                                                                                                                         |
| 31.1   |   | Certification of the Principal Executive Officer  pursuant to Rule 13a-14(a) and 15d-14(a)                                                                                                                                                                                                               |
| 31.2   |   | Certification of the Principal Financial and  Accounting Officer pursuant to Rule 13a-14(a) and 15d-14(a)                                                                                                                                                                                                |
| 32.1   |   | Certification by the Principal Executive Officer and  Principal Financial and Accounting Officer pursuant to 18 U.S.C. 1350 as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                                                                                             |

 

45

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**SIGNATURES**

 

In accordance withSection 13 or 15(d) of the Exchange Act, the registrant caused thisreport to be signed on its behalf by the undersigned, thereunto dulyauthorized.

 
| ** **          | **IMAGEWARE SYSTEMS, INC.** |
|---------------------|----------------------------------|
|                |                             |   |
|                |                             |   |
| April 15, 2008 | By:                              | /s/ **S. JAMES MILLER, JR.** |
| ** **          | ** **                       | **S.  James Miller, Jr.** |
|                |                             | Chief Executive  Officer and   Chairman of the Board of Directors |

 

In accordance withthe Exchange Act, this report has been signed below by the following persons onbehalf of the registrant and in the capacities and on the dates indicated.

 
| **Signature**              | ** ** | **Title**                                                            | ** ** | **Date**             |
|----------------------------|------------|----------------------------------------------------------------------|------------|----------------------|
|                       |       |                                                                 |       |                 |
| /s/ S. JAMES  MILLER, JR.  |       | Chief Executive Officer  and Chairman of the Board of Directors      |       | April 15,  2008 |
| S. James  Miller, Jr. |       | *(Principal Executive Officer)*                                      | * *   | * *             |
|                       |       |                                                                 |       |                 |
| /s/ WAYNE G.  WETHERELL    |       | Senior Vice President  of Administration and Chief Financial Officer |       | April 15,  2008 |
| Wayne G.  Wetherell        |       | *(Principal Financial and  Accounting Officer)*                      | * *   | * *             |
|                       |       |                                                                 |       |                 |
| /s/ JOHN CALLAN            |       | Director                                                             |       | April 15,  2008 |
| John Callan                |       |                                                                 |       |                 |
|                       |       |                                                                 |       |                 |
| /s/ PATRICK J.  DOWNS      |       | Director                                                             |       | April 15,  2008 |
| Patrick J. Downs           |       |                                                                 |       |                 |
|                       |       |                                                                 |       |                 |
| /s/ JOHN L.  HOLLERAN      |       | Director                                                             |       | April 15,  2008 |
| John L. Holleran           |       |                                                                 |       |                 |
|                       |       |                                                                 |       |                 |
| /s/ DAVID LOESCH           |       | Director                                                             |       | April 15,  2008 |
| David Loesch               |       |                                                                 |       |                 |
|                       |       |                                                                 |       |                 |
| /s/ STEVE HAMM             |       | Director                                                             |       | April 15,  2008 |
| Steve Hamm                 |       |                                                                 |       |                 |
|                       |       |                                                                 |       |                 |
| /s/ DAVID CAREY            |       | Director                                                             |       | April 15,  2008 |
| David Carey                |       |                                                                 |       |                 |

 

46

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**IMAGEWARESYSTEMS, INC.**

 

**INDEX TO CONSOLIDATED FINANCIALSTATEMENTS**

 
| REPORT OF INDEPENDENT  REGISTERED PUBLIC ACCOUNTING FIRM |   |
|----------------------------------------------------------|--------|
|                                                     |   |
| CONSOLIDATED  FINANCIAL STATEMENTS:                      |   |
|                                                     |   |
| CONSOLIDATED  BALANCE SHEETS                             |   |
|                                                     |   |
| CONSOLIDATED  STATEMENTS OF OPERATIONS                   |   |
|                                                     |   |
| CONSOLIDATED  STATEMENTS OF CASH FLOW                    |   |
|                                                     |   |
| CONSOLIDATED  STATEMENTS OF COMPREHENSIVE LOSS           |   |
|                                                     |   |
| CONSOLIDATED  STATEMENTS OF SHAREHOLDERS’ EQUITY    |   |
|                                                     |   |
| NOTES TO CONSOLIDATED FINANCIAL STATEMENTS               |   |

 

47

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** **

** **

**REPORT of Independent RegisteredPublic Accounting Firm**

 

Board of Directors and Shareholders 

ImageWare Systems, Inc.

 

We have audited the accompanying consolidated balance sheets of ImageWare Systems,Inc. as of December 31, 2007 and 2006, and the related consolidated statementsof operations, comprehensive loss, shareholders’ equity, and cash flows foreach of the three years in the period ended December 31, 2007. Our audits alsoincluded the consolidated financial statement schedule listed in the Index atItem 15(a)(2) as of and for the years ended December 31, 2007, 2006 and 2005. These consolidated financial statements and schedule are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these financial statements and schedule based on our audits. 

 

We conducted our audits in accordance with the standards of the PublicCompany Accounting Oversight Board (United States). Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whetherthe financial statements are free of material misstatement.  We were notengaged to perform an audit of the Company’s internal control over financialreporting.  Our audit included consideration of internal control overfinancial reporting as a basis for designing audit procedures that areappropriate in the circumstances, but not for the purpose of expressing anopinion on the effectiveness of the Company’s internal control over financialreporting.  Accordingly, we express no such opinion.  An audit alsoincludes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements, assessing the accounting principlesused and significant estimates made by management, as well as evaluating theoverall financial statement presentation. We believe that our audits provide areasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to abovepresent fairly, in all material respects, the financial position of ImageWareSystems, Inc. as of December 31, 2007 and 2006, and the results of itsoperations and its cash flows for each of the three years in the period ended December31, 2007 in conformity with accounting principles generally accepted in theUnited States of America. Also, in our opinion, the related financial statementschedule, when considered in relation to the basic financial statements takenas a whole, presents fairly in all material respects the information set forththerein.

 

The accompanying consolidated financial statements have been preparedassuming the Company will continue as a going concern.  As discussed in Note 1 to the consolidatedfinancial statements, the Company has incurred substantial net losses sinceinception and has substantial monetary liabilities as of December 31,2007.  These matters, among others, raisea substantial doubt about the Company’s ability to continue as a going concern. Management’s plans concerning thesematters are described in Note 1.  Theseconsolidated financial statements do not include any adjustments relating tothe recoverability and classifications of recorded assets, or the amounts andclassification of liabilities that might be necessary in the event the Companycannot continue in existence.

 

/s/ Stonefield Josephson, Inc.

Los Angeles California 

April 14, 2008

 

48

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**IMAGEWARE SYSTEMS, INC.**

**CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                                                                                                                                                                                                                                                             | ** ** | **December 31,  2007** | ** **    | **December 31,  2006** | ** **    |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|---------------|-----------------------------|---------------|
| **ASSETS**                                                                                                                                                                                                                                                                                             | ** ** | ** **                  | ** **    | ** **                  | ** **    |
| ** **                                                                                                                                                                                                                                                                                             | ** ** | ** **                  | ** **    | ** **                  | ** **    |
| Current Assets:                                                                                                                                                                                                                                                                                        |       |                        |          |                        |          |
| Cash                                                                                                                                                                                                                                                                                                   |       | $                           | 1,044,242     |                        | $             | 938,553 |   |
| Accounts  receivable, net of allowance for doubtful accounts of $0 and $483,132 at  December 31, 2007 and 2006, respectively                                                                                                                                                                      |       | 424,739                     |          | 1,721,892                   |          |
| Inventories, net                                                                                                                                                                                                                                                                                       |       | 130,342                     |          | 57,990                      |          |
| Other current  assets                                                                                                                                                                                                                                                                                  |       | 440,459                     |          | 137,609                     |          |
| Total Current  Assets                                                                                                                                                                                                                                                                                  |       | 2,039,782                   |          | 2,856,044                   |          |
|                                                                                                                                                                                                                                                                                                   |       |                        |          |                        |          |
| Property and  equipment, net                                                                                                                                                                                                                                                                           |       | 287,989                     |          | 351,700                     |          |
| Other assets                                                                                                                                                                                                                                                                                           |       | 24,307                      |          | 175,952                     |          |
| Pension assets                                                                                                                                                                                                                                                                                         |       | 693,907                     |          | 608,507                     |          |
| Intangible  assets, net                                                                                                                                                                                                                                                                                |       | 2,436,576                   |          | 141,294                     |          |
| Goodwill                                                                                                                                                                                                                                                                                               |       | 4,452,042                   |          | 3,415,647                   |          |
| **Total  Assets**                                                                                                                                                                                                                                                                                      | ** ** | **9,934,603**               | ** **    | **$**                       | **7,549,144** | ** ** |
| ** **                                                                                                                                                                                                                                                                                             | ** ** | ** **                  | ** **    | ** **                  | ** **    |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                                                                                                                                                                                          |       |                        |          |                        |          |
|                                                                                                                                                                                                                                                                                                   |       |                        |          |                        |          |
| Current  Liabilities:                                                                                                                                                                                                                                                                                  |       |                        |          |                        |          |
| Accounts payable                                                                                                                                                                                                                                                                                       |       | $                           | 1,415,492     |                        | $             | 1,718,820 |   |
| Deferred revenue                                                                                                                                                                                                                                                                                       |       | 1,010,514                   |          | 1,258,045                   |          |
| Accrued expenses                                                                                                                                                                                                                                                                                       |       | 1,340,947                   |          | 1,138,718                   |          |
| Acquisition  related obligation                                                                                                                                                                                                                                                                        |       | 1,502,000                   |          | —                      |          |
| Notes payable to  third parties                                                                                                                                                                                                                                                                        |       | —                      |          | 1,097,378                   |          |
| Total Current  Liabilities                                                                                                                                                                                                                                                                             |       | 5,268,953                   |          | 5,212,961                   |          |
|                                                                                                                                                                                                                                                                                                   |       |                        |          |                        |          |
| Pension  obligation                                                                                                                                                                                                                                                                                    |       | 1,138,911                   |          | 1,016,293                   |          |
| Total  Liabilities                                                                                                                                                                                                                                                                                     |       | 6,407,864                   |          | 6,229,254                   |          |
|                                                                                                                                                                                                                                                                                                   |       |                        |          |                        |          |
| Commitments and  contingencies                                                                                                                                                                                                                                                                         |       | —                      |          | —                      |          |
|                                                                                                                                                                                                                                                                                                   |       |                        |          |                        |          |
| Shareholders’  equity                                                                                                                                                                                                                                                                             |       |                        |          |                        |          |
| Preferred stock,  authorized 4,000,000 shares:                                                                                                                                                                                                                                                         |       |                        |          |                        |          |
| Series B convertible  redeemable preferred stock, designated 750,000 shares, 389,400 shares issued,  and 239,400 shares outstanding at December 31, 2007 and 2006,  liquidation preference $598,500 at December 31, 2007 and  December 31, 2006                                    |       | 2,394                       |          | 2,394                       |          |
| Series C  convertible non-redeemable preferred stock, designated 3,500 shares, 2,500  shares issued, and 2,200 and 2,500 shares outstanding at December 31,  2007 and 2006, respectively, liquidation preference $2,200,000 and $2,500,000  at December 31, 2007 and 2006, respectively |       | 22                          |          | 25                          |          |
| Series D  convertible non-redeemable preferred stock, designated 2,000 shares, 1,500  shares issued, and 1,388 and 0 shares outstanding at December 31, 2007  and 2006, respectively, liquidation preference $1,388,000 and $0 at  December 31, 2007 and 2006, respectively             |       | 14                          |          | —                      |          |
| Common stock,  $.01 par value, 50,000,000 shares authorized, 17,797,826 and 13,700,849  shares issued at December 31, 2007 and 2006, respectively, 17,791,122  and 13,694,145 shares outstanding at December 31, 2007 and 2006,  respectively                                                |       | 176,729                     |          | 135,759                     |          |
|                                                                                                                                                                                                                                                                                                   |       |                        |          |                        |          |
| Additional paid  in capital                                                                                                                                                                                                                                                                            |       | 79,293,500                  |          | 71,553,329                  |          |
| Treasury stock,  at cost - 6,704 shares                                                                                                                                                                                                                                                                |       | (63,688                     | )             | (63,688                     | )             |
| Accumulated  other comprehensive income                                                                                                                                                                                                                                                                |       | 6,983                       |          | 24,773                      |          |
| Accumulated  deficit                                                                                                                                                                                                                                                                                   |       | (75,889,215                 | )             | (70,332,702                 | )             |
| Total  shareholders’ equity                                                                                                                                                                                                                                                                       |       | 3,526,739                   |          | 1,319,890                   |          |
|                                                                                                                                                                                                                                                                                                   |       |                        |          |                        |          |
| **Total  Liabilities and Shareholders’ Equity**                                                                                                                                                                                                                                                   | ** ** | **$**                       | **9,934,603** | ** **                  | **$**         | **7,549,144** | ** ** |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

49

----

 

**IMAGEWARE SYSTEMS, INC.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

 
| ** **                                                                                                                                                                                                                                                                                  | ** ** | **TWELVE MONTHS ENDED  December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                                                                                                                                                                                                                  | ** ** | **2007**                                             | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                                                                                                                                                                                                                                                  | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Revenues:**                                                                                                                                                                                                                                                                               |       |                                                 |       |   |   |   |   |
| Product                                                                                                                                                                                                                                                                                     |       | $                                                    | 5,652,174  |   | $ | 7,605,598 |   | $ | 7,134,119 |   |
| Maintenance                                                                                                                                                                                                                                                                                 |       | 2,836,403                                            |       | 2,583,968 |   | 2,040,054 |   |
|                                                                                                                                                                                                                                                                                        |       | 8,488,577                                            |       | 10,189,566 |   | 9,174,173 |   |
| **Cost of  revenues:**                                                                                                                                                                                                                                                                      |       |                                                 |       |   |   |   |   |
| Product                                                                                                                                                                                                                                                                                     |       | 1,380,173                                            |       | 2,215,921 |   | 2,916,759 |   |
| Maintenance                                                                                                                                                                                                                                                                                 |       | 1,166,259                                            |       | 1,113,118 |   | 1,125,103 |   |
|                                                                                                                                                                                                                                                                                        |       |                                                 |       |   |   |   |   |
| Gross profit                                                                                                                                                                                                                                                                                |       | 5,942,145                                            |       | 6,860,527 |   | 5,132,311 |   |
|                                                                                                                                                                                                                                                                                        |       |                                                 |       |   |   |   |   |
| **Operating  expenses:**                                                                                                                                                                                                                                                                    |       |                                                 |       |   |   |   |   |
| General &  administrative                                                                                                                                                                                                                                                          |       | 3,865,463                                            |       | 4,411,864 |   | 4,970,060 |   |
| Sales and  marketing                                                                                                                                                                                                                                                                        |       | 2,647,444                                            |       | 3,565,341 |   | 3,335,139 |   |
| Research &  development                                                                                                                                                                                                                                                            |       | 3,669,099                                            |       | 3,652,081 |   | 2,922,049 |   |
| Impairment  losses                                                                                                                                                                                                                                                                          |       | —                                               |       | — |   | 253,000 |   |
| Depreciation and  amortization                                                                                                                                                                                                                                                              |       | 257,532                                              |       | 304,323 |   | 568,519 |   |
|                                                                                                                                                                                                                                                                                        |       | 10,439,538                                           |       | 11,933,609 |   | 12,048,767 |   |
|                                                                                                                                                                                                                                                                                        |       |                                                 |       |   |   |   |   |
| Loss from  operations                                                                                                                                                                                                                                                                       |       | (4,497,393                                           | )          | (5,073,082 | ) | (6,916,456 | ) |
|                                                                                                                                                                                                                                                                                        |       |                                                 |       |   |   |   |   |
| Interest  (income) expense, net                                                                                                                                                                                                                                                             |       | 215,155                                              |       | 564,524 |   | (53,288 | ) |
|                                                                                                                                                                                                                                                                                        |       |                                                 |       |   |   |   |   |
| Other (income)  expense, net                                                                                                                                                                                                                                                                |       | 22,221                                               |       | (119,330 | ) | (166,390 | ) |
|                                                                                                                                                                                                                                                                                        |       |                                                 |       |   |   |   |   |
| Loss from  continuing operations before income taxes                                                                                                                                                                                                                                        |       | (4,734,769                                           | )          | (5,518,276 | ) | (6,696,778 | ) |
|                                                                                                                                                                                                                                                                                        |       |                                                 |       |   |   |   |   |
| Income tax  benefit (expense)                                                                                                                                                                                                                                                               |       | —                                               |       | — |   | — |   |
|                                                                                                                                                                                                                                                                                        |       |                                                 |       |   |   |   |   |
| Loss from  continuing operations                                                                                                                                                                                                                                                            |       | (4,734,769                                           | )          | (5,518,276 | ) | (6,696,778 | ) |
|                                                                                                                                                                                                                                                                                        |       |                                                 |       |   |   |   |   |
| Discontinued  operations:                                                                                                                                                                                                                                                                   |       |                                                 |       |   |   |   |   |
| Gain (loss) from  operations of discontinued Digital Photography and Digital Imaging Asia  Component (including gain on disposal of Digital Photography component of  $50,000 in 2007; $19,956 in 2006 and gain on disposal of Digital Imaging Asia  Pacific Component of $232,508 in 2005) |       | $                                                    | 50,000     |   | $ | (407,939 | ) | $ | (1,658,926 | ) |
| Income tax  benefit (expense)                                                                                                                                                                                                                                                               |       | —                                               |       | — |   | — |   |
| Gain (loss) on  discontinued operations                                                                                                                                                                                                                                                     |       | 50,000                                               |       | (407,939 | ) | (1,658,926 | ) |
|                                                                                                                                                                                                                                                                                        |       |                                                 |       |   |   |   |   |
| Net loss                                                                                                                                                                                                                                                                                    |       | (4,684,769                                           | )          | (5,926,215 | ) | (8,355,704 | ) |
| Preferred  dividends                                                                                                                                                                                                                                                                        |       | (1,171,258                                           | )          | (110,998 | ) | (52,997 | ) |
| Net loss  available to common shareholders                                                                                                                                                                                                                                                  |       | $                                                    | (5,856,027 | ) | $ | (6,037,213 | ) | $ | (8,408,701 | ) |
|                                                                                                                                                                                                                                                                                        |       |                                                 |       |   |   |   |   |
| Basic and  diluted loss per common share - see note 2                                                                                                                                                                                                                                       |       |                                                 |       |   |   |   |   |
| Continuing  operations                                                                                                                                                                                                                                                                      |       | $                                                    | (0.31      | ) | $ | (0.41 | ) | $ | (0.53 | ) |
| Discontinued  operations                                                                                                                                                                                                                                                                    |       | —                                               |       | (0.03 | ) | (0.13 | ) |
| Preferred  dividends                                                                                                                                                                                                                                                                        |       | (0.08                                                | )          | — |   | — |   |
| Basic and  diluted loss per common available to common shareholders                                                                                                                                                                                                                         |       | $                                                    | (0.39      | ) | $ | (0.44 | ) | $ | (0.66 | ) |
|                                                                                                                                                                                                                                                                                        |       |                                                 |       |   |   |   |   |
| Weighted-average  shares outstanding (basic and diluted)                                                                                                                                                                                                                                    |       | 15,070,308                                           |       | 13,592,841 |   | 12,731,304 |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

50

----

 

**IMAGEWARE SYSTEMS, INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

 
| ** **                                                                                                 | ** ** | **TWELVE MONTHS ENDED  December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                                                 | ** ** | **2007**                                             | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                                                       |       |                                                 |       |   |   |   |   |
| **Cash  flows from operating activities**                                                                  |       |                                                 |       |   |   |   |   |
| Net loss                                                                                                   |       | (4,684,769                                           | )          | $ | (5,926,215 | ) | $ | (8,355,704 | ) |
| Adjustments to  reconcile net loss to net cash used by operating activities Depreciation and  amortization |       | 257,532                                              |       | 307,118 |   | 599,950 |   |
| Amortization of  debt discount and debt issuance costs                                                     |       | 228,872                                              |       | 489,731 |   | — |   |
| Stock based  compensation                                                                                  |       | 556,384                                              |       | 1,117,596 |   | 310,597 |   |
| Gain on sale of  subsidiary                                                                                |       | —                                               |       | (19,956 | ) | (232,508 | ) |
| Inventory  write-down                                                                                      |       | —                                               |       | 3,000 |   | 280,768 |   |
| Provision on  losses on accounts receivable                                                                |       | 25,000                                               |       | 39,000 |   | 450,000 |   |
| Write-down of  certain long-lived assets                                                                   |       | —                                               |       | — |   | 1,570,128 |   |
| Write-down of  investment in equity securities                                                             |       | 84,956                                               |       | — |   | 146,525 |   |
| Restructuring  charges                                                                                     |       | —                                               |       | — |   | 204,000 |   |
| Reduction in  inventory obsolescence reserve                                                               |       | (35,618                                              | )          | — |   | — |   |
| Change in assets  and liabilities                                                                          |       |                                                 |       |   |   |   |   |
| Accounts  receivable                                                                                       |       | 1,221,771                                            |       | (420,738 | ) | (72,571 | ) |
| Inventories                                                                                                |       | (36,734                                              | )          | 141,799 |   | 365,853 |   |
| Other current  assets                                                                                      |       | (187,100                                             | )          | 97,190 |   | 10,943 |   |
| Pension assets                                                                                             |       | (85,400                                              | )          | (85,532 | ) | 62,409 |   |
| Other assets                                                                                               |       |                                                 |       | — |   | 18,105 |   |
| Accounts payable                                                                                           |       | (303,328                                             | )          | 1,028,360 |   | (529,661 | ) |
| Accrued expenses                                                                                           |       | 208,061                                              |       | 173,659 |   | (687,672 | ) |
| Deferred revenue                                                                                           |       | (247,532                                             | )          | 174,491 |   | 38,735 |   |
| Contract costs                                                                                             |       | —                                               |       | — |   | (424,299 | ) |
| Pension  obligation                                                                                        |       | 122,618                                              |       | 63,965 |   | 37,175 |   |
|                                                                                                       |       |                                                 |       |   |   |   |   |
| Total  adjustments                                                                                         |       | 1,809,482                                            |       | 3,109,683 |   | 2,148,477 |   |
|                                                                                                       |       |                                                 |       |   |   |   |   |
| Net cash used by  operating activities                                                                     |       | (2,875,287                                           | )          | (2,816,532 | ) | (6,207,227 | ) |
|                                                                                                       |       |                                                 |       |   |   |   |   |
| **Cash  flows from investing activities**                                                                  |       |                                                 |       |   |   |   |   |
| Purchase of  property and equipment                                                                        |       | (85,914                                              | )          | (157,825 | ) | (309,415 | ) |
| Restricted cash  and cash equivalents                                                                      |       | (26,000                                              | )          | — |   | — |   |
| Acquisition of  businesses, net of cash acquired                                                           |       | (409,761                                             | )          | — |   | — |   |
| Proceeds from  sales of subsidiary net of cash sold and direct transaction costs                           |       |                                                 |       | 25,000 |   | 1,208,630 |   |
|                                                                                                       |       |                                                 |       |   |   |   |   |
| Net cash  generated by (used in) investing activities                                                      |       | (521,675                                             | )          | (132,825 | ) | 899,215 |   |
|                                                                                                       |       |                                                 |       |   |   |   |   |
| **Cash  flows from financing activities**                                                                  |       |                                                 |       |   |   |   |   |
| Proceeds from  issuance of preferred stock, net of issuance costs                                          |       | 1,232,704                                            |       | 2,063,176 |   | — |   |
| Proceeds from  issuance of common stock, net of issuance costs                                             |       | 2,621,472                                            |       | — |   | 3,234,128 |   |
| Proceeds from  issuance of notes payable with warrants                                                     |       | —                                               |       | 1,550,000 |   | — |   |
| Other financing  issuance costs                                                                            |       | (54,258                                              | )          | (97,500 | ) | — |   |
| Repayment of  notes payable                                                                                |       | (1,310,000                                           | )          | (240,000 | ) | (18,491 | ) |
| Dividends paid                                                                                             |       | (50,872                                              | )          | (51,935 | ) | (52,997 | ) |
| Proceeds from  exercise of stock purchase warrants                                                         |       | 1,120,707                                            |       | — |   | 62,652 |   |
|                                                                                                       |       |                                                 |       |   |   |   |   |
| Net cash  provided by financing activities                                                                 |       | 3,559,753                                            |       | 3,223,741 |   | 3,225,292 |   |
| Effect of  exchange rate changes on cash                                                                   |       | (57,102                                              | )          | (77,015 | ) | (87,861 | ) |
| Net increase  (decrease) in cash                                                                           |       | 105,689                                              |       | 197,369 |   | (2,170,581 | ) |
|                                                                                                       |       |                                                 |       |   |   |   |   |
| Cash at  beginning of period                                                                               |       | 938,553                                              |       | 741,184 |   | 2,911,765 |   |
|                                                                                                       |       |                                                 |       |   |   |   |   |
| Cash at end of  period                                                                                     |       | $                                                    | 1,044,242  |   | $ | 938,553 |   | $ | 741,184 |   |
|                                                                                                       |       |                                                 |       |   |   |   |   |
| Supplemental disclosure  of cash flow information:                                                         |       |                                                 |       |   |   |   |   |
| Cash paid for  interest                                                                                    |       | $                                                    | 46,087     |   | $ | 62,402 |   | $ | — |   |
| Cash paid for  income taxes                                                                                |       | $                                                    | —     |   | $ | — |   | $ | — |   |
| Summary of  non-cash investing and financing activities:                                                   |       |                                                 |       |   |   |   |   |
| Beneficial  conversion feature of preferred stock                                                          |       | $                                                    | 814,000    |   | $ | 33,000 |   | — |   |
| Exchange of  common shares for marketable equity securities                                                |       | $                                                    | —     |   | $ | — |   | $ | 231,481 |   |
| Changes in  minimum pension liability                                                                      |       | $                                                    | (37,371    | ) | $ | (177,203 | ) | $ | 280,668 |   |
| Unrealized  holding losses on marketable securities                                                        |       | $                                                    | —     |   | $ | 39,311 |   | $ | — |   |
| Conversion of  preferred stock to common                                                                   |       | $                                                    | 4          |   | $ | 100 |   | $ | — |   |
| Warrants issued  with notes payable                                                                        |       | $                                                    | —     |   | $ | 621,103 |   | $ | — |   |
| Equipment  received in lieu of cash on accounts receivable                                                 |       | $                                                    | 50,382     |   | $ | — |   | $ | — |   |

 

The accompanying notes are an integral part of these consolidatedfinancial statements.

 

51

----

 

**IMAGEWARESYSTEMS, INC.**

**CONSOLIDATED STATEMENTS OFCOMPREHENSIVE LOSS**

 
| ** **                                                                | ** ** | **TWELVE MONTHS ENDED  DECEMBER 31,** | ** ** |
|---------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                | ** ** | **2007**                                             | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                                | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net loss                                                                  |       | $                                                    | (4,684,769 | ) | $ | (5,926,215 | ) | $ | (8,355,704 | ) |
| Other  comprehensive income (loss):                                       |       |                                                 |       |   |   |   |   |
| Unrealized  losses on available-for-sale securities arising during period |       | 39,311                                               |       | (39,311 | ) | — |   |
| Additional  minimum pension liability                                     |       | 37,371                                               |       | 177,203 |   | (280,668 | ) |
| Foreign currency  translation adjustment                                  |       | (94,472                                              | )          | (77,015 | ) | (87,861 | ) |
| Comprehensive  loss                                                       |       | $                                                    | (4,702,559 | ) | $ | (5,865,338 | ) | $ | (8,724,233 | ) |

 

The accompanyingnotes are an integral part of these consolidated financial statements.

 

52

----

 

**ImageWareSystems, Inc.**

**Consolidated Statements of Shareholders’ Equity(Deficit)**

**for theYears Ended December 31, 2005, 2006 and 2007**

 
| ** **                                                                     | ** ** | **Series B** | ** ** | ** **        | ** ** | ** **        | ** ** | ** **            | ** ** | ** **              | ** ** | ** **  | ** ** | ** **        | ** ** | ** **      | ** ** | ** **      | ** ** | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** |
|--------------------------------------------------------------------------------|------------|-------------------|------------|-------------------|------------|-------------------|------------|-----------------------|------------|-------------------------|------------|-------------|------------|-------------------|------------|-----------------|------------|-----------------|------------|------------|------------|-------------|------------|------------|------------|
| ** **                                                                     | ** ** | **Convertible,**  | ** ** | **Series C** | ** ** | **Series D** | ** ** | ** **            | ** ** | ** **              | ** ** | ** **  | ** ** | ** **        | ** ** | ** **      | ** ** | **Accumulated** | ** ** | ** ** | ** ** | ** **  | ** ** |
| ** **                                                                     | ** ** | **Redeemable**    | ** ** | **Convertible,**  | ** ** | **Convertible,**  | ** ** | ** **            | ** ** | ** **              | ** ** | ** **  | ** ** | ** **        | ** ** | **Additional**  | ** ** | **Other**       | ** ** | ** ** | ** ** | ** **  | ** ** |
| ** **                                                                     | ** ** | **Preferred**     | ** ** | **Preferred**     | ** ** | **Preferred**     | ** ** | **Common Stock** | ** ** | **Treasury Stock** | ** ** | **Paid-In** | ** ** | **Comprehensive** | ** ** | **Accumulated** | ** ** | ** **      | ** ** |
| ** **                                                                     | ** ** | **Shares**        | ** ** | **Amount**        | ** ** | **Shares**        | ** ** | **Amount**            | ** ** | **Shares**              | ** ** | **Amount**  | ** ** | **Shares**        | ** ** | **Amount**      | ** ** | **Shares**      | ** ** | **Amount** | ** ** | **Capital** | ** ** | **Loss**   | ** ** | **Deficit** | ** ** | **Total** | ** ** |
| Balance at  December 31, 2004                                             |       | 249,400           |       | 2,494             |       | —            |       | —                |       | —                  |       | —      |       | 11,969,089        |       | 118,442         |       | (6,704          | )          | (63,688    | )          | 63,789,396  |       | 332,425    |       | (55,912,850 | ) | 8,266,219 |   |
|                                                                           |       |              |       |              |       |              |       |                  |       |                    |       |        |       |              |       |            |       |            |       |       |       |        |       |       |       |   |   |   |   |
| Issuance of  common stock for cash, net of financing commissions               |       | —            |       | —            |       | —            |       | —                |       | —                  |       | —      |       | 1,397,287         |       | 13,973          |       | —          |       | —     |       | 3,220,155   |       | —     |       | — |   | 3,234,128 |   |
|                                                                           |       |              |       |              |       |              |       |                  |       |                    |       |        |       |              |       |            |       |            |       |       |       |        |       |       |       |   |   |   |   |
| Issuance of  common stock as consideration for investment in equity securities |       | —            |       | —            |       | —            |       | —                |       | —                  |       | —      |       | 71,225            |       | 712             |       | —          |       | —     |       | 230,769     |       | —     |       | — |   | 231,481 |   |
|                                                                           |       |              |       |              |       |              |       |                  |       |                    |       |        |       |              |       |            |       |            |       |       |       |        |       |       |       |   |   |   |   |
| Issuance of  common stock as compensation                                      |       | —            |       | —            |       | —            |       | —                |       | —                  |       | —      |       | 90,481            |       | 905             |       | —          |       | —     |       | 347,447     |       | —     |       | — |   | 348,352 |   |
|                                                                           |       |              |       |              |       |              |       |                  |       |                    |       |        |       |              |       |            |       |            |       |       |       |        |       |       |       |   |   |   |   |
| Issuance of  common stock pursuant to option and warrant exercise for cash     |       | —            |       | —            |       | —            |       | —                |       | —                  |       | —      |       | 26,284            |       | 263             |       | —          |       | —     |       | 62,390      |       | —     |       | — |   | 62,653 |   |
|                                                                           |       |              |       |              |       |              |       |                  |       |                    |       |        |       |              |       |            |       |            |       |       |       |        |       |       |       |   |   |   |   |
| Dividends on  Series B Preferred stock                                    |       | —            |       | —            |       | —            |       | —                |       | —                  |       | —      |       | —            |       | —          |       | —          |       | —     |       | —      |       | —     |       | (52,998 | ) | (52,998 | ) |
|                                                                           |       |              |       |              |       |              |       |                  |       |                    |       |        |       |              |       |            |       |            |       |       |       |        |       |       |       |   |   |   |   |
| Additional  minimum pension liability                                          |       | —            |       | —            |       | —            |       | —                |       | —                  |       | —      |       | —            |       | —          |       | —          |       | —     |       | —      |       | (280,668   | )          | — |   | (280,668 | ) |
|                                                                           |       |              |       |              |       |              |       |                  |       |                    |       |        |       |              |       |            |       |            |       |       |       |        |       |       |       |   |   |   |   |
| Foreign currency  translation adjustment                                       |       | —            |       | —            |       | —            |       | —                |       | —                  |       | —      |       | —            |       | —          |       | —          |       | —     |       | —      |       | (87,861    | )          | — |   | (87,861 | ) |
|                                                                           |       |              |       |              |       |              |       |                  |       |                    |       |        |       |              |       |            |       |            |       |       |       |        |       |       |       |   |   |   |   |
| Net loss                                                                       |       | —            |       | —            |       | —            |       | —                |       | —                  |       | —      |       | —            |       | —          |       | —          |       | —     |       | —      |       | —     |       | (8,355,704 | ) | (8,355,704 | ) |
|                                                                           |       |              |       |              |       |              |       |                  |       |                    |       |        |       |              |       |            |       |            |       |       |       |        |       |       |       |   |   |   |   |
| Balance at  December 31, 2005                                             |       | 249,400           |       | 2,494             |       | —            |       | —                |       | —                  |       | —      |       | 13,554,366        |       | 134,295         |       | (6,704          | )          | (63,688    | )          | 67,650,157  |       | (36,104    | )          | (64,321,552 | ) | 3,365,602 |   |
|                                                                           |       |              |       |              |       |              |       |                  |       |                    |       |        |       |              |       |            |       |            |       |       |       |        |       |       |       |   |   |   |   |
| Warrants issued  in conjunction with secured debt                              |       | —            |       | —            |       | —            |       | —                |       | —                  |       | —      |       | —            |       | —          |       | —          |       | —     |       | 418,500     |       | —     |       | — |   | 418,500 |   |
|                                                                           |       |              |       |              |       |              |       |                  |       |                    |       |        |       |              |       |            |       |            |       |       |       |        |       |       |       |   |   |   |   |
| Warrant price  reduction issued as consideration for debt acceleration waiver  |       | —            |       | —            |       | —            |       | —                |       | —                  |       | —      |       | —            |       | —          |       | —          |       | —     |       | 27,693      |       | —     |       | — |   | 27,693 |   |
|                                                                           |       |              |       |              |       |              |       |                  |       |                    |       |        |       |              |       |            |       |            |       |       |       |        |       |       |       |   |   |   |   |
| Warrants issued  as consideration for debt acceleration waiver                 |       | —            |       | —            |       | —            |       | —                |       | —                  |       | —      |       | —            |       | —          |       | —          |       | —     |       | 174,910     |       | —     |       | — |   | 174,910 |   |
|                                                                           |       |              |       |              |       |              |       |                  |       |                    |       |        |       |              |       |            |       |            |       |       |       |        |       |       |       |   |   |   |   |
| Issuance of  preferred stock for cash, net of financing commissions            |       | —            |       | —            |       | 2,500             |       | 25                    |       | —                  |       | —      |       | —            |       | —          |       | —          |       | —     |       | 2,063,151   |       | —     |       | — |   | 2,063,176 |   |
|                                                                           |       |              |       |              |       |              |       |                  |       |                    |       |        |       |              |       |            |       |            |       |       |       |        |       |       |       |   |   |   |   |
| Beneficial  conversion feature of series C preferred stock                     |       | —            |       | —            |       | —            |       | —                |       | —                  |       | —      |       | —            |       | —          |       | —          |       | —     |       | 33,000      |       | —     |       | (33,000 | ) | — |   |
|                                                                           |       |              |       |              |       |              |       |                  |       |                    |       |        |       |              |       |            |       |            |       |       |       |        |       |       |       |   |   |   |   |
| Preferred Stock  conversion to common stock                                    |       | (10,000           | )          | (100              | )          | —            |       | —                |       | —                  |       | —      |       | 1,895             |       | 19              |       | —          |       | —     |       | 81          |       | —     |       | — |   | — |   |
|                                                                           |       |              |       |              |       |              |       |                  |       |                    |       |        |       |              |       |            |       |            |       |       |       |        |       |       |       |   |   |   |   |
| Issuance of  common stock as compensation                                      |       | —            |       | —            |       | —            |       | —                |       | —                  |       | —      |       | 144,588           |       | 1,445           |       | —          |       | —     |       | 474,596     |       | —     |       | — |   | 476,041 |   |
|                                                                           |       |              |       |              |       |              |       |                  |       |                    |       |        |       |              |       |            |       |            |       |       |       |        |       |       |       |   |   |   |   |
| Stock-based  compensation option expense                                       |       | —            |       | —            |       | —            |       | —                |       | —                  |       | —      |       | —            |       | —          |       | —          |       | —     |       | 711,241     |       | —     |       | — |   | 711,241 |   |
|                                                                           |       |              |       |              |       |              |       |                  |       |                    |       |        |       |              |       |            |       |            |       |       |       |        |       |       |       |   |   |   |   |
| Dividends on  Series B Preferred stock                                    |       | —            |       | —            |       | —            |       | —                |       | —                  |       | —      |       | —            |       | —          |       | —          |       | —     |       | —      |       | —     |       | (51,935 | ) | (51,935 | ) |
|                                                                           |       |              |       |              |       |              |       |                  |       |                    |       |        |       |              |       |            |       |            |       |       |       |        |       |       |       |   |   |   |   |
| Additional  minimum pension liability                                          |       | —            |       | —            |       | —            |       | —                |       | —                  |       | —      |       | —            |       | —          |       | —          |       | —     |       | —      |       | 177,203    |       | — |   | 177,203 |   |
|                                                                           |       |              |       |              |       |              |       |                  |       |                    |       |        |       |              |       |            |       |            |       |       |       |        |       |       |       |   |   |   |   |
| Unrealized  holding losses on securities                                       |       | —            |       | —            |       | —            |       | —                |       | —                  |       | —      |       | —            |       | —          |       | —          |       | —     |       | —      |       | (39,311    | )          | — |   | (39,311 | ) |
|                                                                           |       |              |       |              |       |              |       |                  |       |                    |       |        |       |              |       |            |       |            |       |       |       |        |       |       |       |   |   |   |   |
| Foreign currency  translation adjustment                                       |       | —            |       | —            |       | —            |       | —                |       | —                  |       | —      |       | —            |       | —          |       | —          |       | —     |       | —      |       | (77,015    | )          | — |   | (77,015 | ) |
|                                                                           |       |              |       |              |       |              |       |                  |       |                    |       |        |       |              |       |            |       |            |       |       |       |        |       |       |       |   |   |   |   |
| Net loss                                                                       |       | —            |       | —            |       | —            |       | —                |       | —                  |       | —      |       | —            |       | —          |       | —          |       | —     |       | —      |       | —     |       | (5,926,215 | ) | (5,926,215 | ) |
|                                                                           |       |              |       |              |       |              |       |                  |       |                    |       |        |       |              |       |            |       |            |       |       |       |        |       |       |       |   |   |   |   |
| Balance at  December 31, 2006                                             |       | 239,400           |       | 2,394             |       | 2,500             |       | 25                    |       | —                  |       | —      |       | 13,700,849        |       | 135,759         |       | (6,704          | )          | (63,688    | )          | 71,553,329  |       | 24,773     |       | (70,332,702 | ) | 1,319,890 |   |

 

53

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**ImageWareSystems, Inc.**

**Consolidated Statements of Shareholders’ Equity(Deficit)**

**for theYears Ended December 31, 2005, 2006, and 2007 (continued)**

 
| ** **                                                                    | ** ** | **Series B** | ** ** | ** **        | ** ** | ** **        | ** ** | ** **            | ** ** | ** **              | ** ** | ** **  | ** ** | ** **        | ** ** | ** **      | ** ** | ** **      | ** ** | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** |
|-------------------------------------------------------------------------------|------------|-------------------|------------|-------------------|------------|-------------------|------------|-----------------------|------------|-------------------------|------------|-------------|------------|-------------------|------------|-----------------|------------|-----------------|------------|------------|------------|-------------|------------|------------|------------|
| ** **                                                                    | ** ** | **Convertible,**  | ** ** | **Series C** | ** ** | **Series D** | ** ** | ** **            | ** ** | ** **              | ** ** | ** **  | ** ** | ** **        | ** ** | ** **      | ** ** | **Accumulated** | ** ** | ** ** | ** ** | ** **  | ** ** |
| ** **                                                                    | ** ** | **Redeemable**    | ** ** | **Convertible,**  | ** ** | **Convertible,**  | ** ** | ** **            | ** ** | ** **              | ** ** | ** **  | ** ** | ** **        | ** ** | **Additional**  | ** ** | **Other**       | ** ** | ** ** | ** ** | ** **  | ** ** |
| ** **                                                                    | ** ** | **Preferred**     | ** ** | **Preferred**     | ** ** | **Preferred**     | ** ** | **Common Stock** | ** ** | **Treasury Stock** | ** ** | **Paid-In** | ** ** | **Comprehensive** | ** ** | **Accumulated** | ** ** | ** **      | ** ** |
| ** **                                                                    | ** ** | **Shares**        | ** ** | **Amount**        | ** ** | **Shares**        | ** ** | **Amount**            | ** ** | **Shares**              | ** ** | **Amount**  | ** ** | **Shares**        | ** ** | **Amount**      | ** ** | **Shares**      | ** ** | **Amount** | ** ** | **Capital** | ** ** | **Loss**   | ** ** | **Deficit** | ** ** | **Total** | ** ** |
| Balance at  December 31, 2006                                            |       | 239,400           |       | 2,394             |       | 2,500             |       | 25                    |       | —                  |       | —      |       | 13,700,849        |       | 135,759         |       | (6,704          | )          | (63,688    | )          | 71,553,329  |       | 24,773     |       | (70,332,702 | ) | 1,319,890 |   |
|                                                                          |       |              |       |              |       |              |       |                  |       |                    |       |        |       |              |       |            |       |            |       |       |       |        |       |       |       |   |   |   |   |
| Issuance of  common stock pursuant to warrant exercises                       |       | —            |       | —            |       | —            |       | —                |       | —                  |       | —      |       | 795,956           |       | 7,960           |       | —          |       | —     |       | 1,112,747   |       | —     |       | — |   | 1,120,707 |   |
|                                                                          |       |              |       |              |       |              |       |                  |       |                    |       |        |       |              |       |            |       |            |       |       |       |        |       |       |       |   |   |   |   |
| Issuance of  common stock as compensation                                     |       | —            |       | —            |       | —            |       | —                |       | —                  |       | —      |       | 63,240            |       | 632             |       | —          |       | —     |       | 202,540     |       | —     |       | — |   | 203,172 |   |
|                                                                          |       |              |       |              |       |              |       |                  |       |                    |       |        |       |              |       |            |       |            |       |       |       |        |       |       |       |   |   |   |   |
| Issuance of  common stock and warrants for cash, net of financing commissions |       | —            |       | —            |       | —            |       | —                |       | —                  |       | —      |       | 2,016,666         |       | 20,167          |       | —          |       | —     |       | 2,601,306   |       | —     |       | — |   | 2,621,472 |   |
|                                                                          |       |              |       |              |       |              |       |                  |       |                    |       |        |       |              |       |            |       |            |       |       |       |        |       |       |       |   |   |   |   |
| Issuance of  common stock for asset purchase                                  |       | —            |       | —            |       | —            |       | —                |       | —                  |       | —      |       | 935,089           |       | 9,351           |       | —          |       | —     |       | 1,468,090   |       | —     |       | — |   | 1,477,441 |   |
| ** **                                                                    | ** ** | ** **        | ** ** | ** **        | ** ** | ** **        | ** ** | ** **            | ** ** | ** **              | ** ** | ** **  | ** ** | ** **        | ** ** | ** **      | ** ** | ** **      | ** ** | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Issuance of  preferred stock for cash, net of financing commissions           |       | —            |       | —            |       | —            |       | —                |       | 1,500                   |       | 15          |       | —            |       | —          |       | —          |       | —     |       | 1,232,689   |       | —     |       | — |   | 1,232,704 |   |
|                                                                          |       |              |       |              |       |              |       |                  |       |                    |       |        |       |              |       |            |       |            |       |       |       |        |       |       |       |   |   |   |   |
| Financing related  expenses                                                   |       | —            |       | —            |       | —            |       | —                |       | —                  |       | —      |       | —            |       | —          |       | —          |       | —     |       | (54,257     | )          | —     |       | — |   | (54,257 | ) |
|                                                                          |       |              |       |              |       |              |       |                  |       |                    |       |        |       |              |       |            |       |            |       |       |       |        |       |       |       |   |   |   |   |
| Beneficial  conversion feature of series D preferred stock                    |       | —            |       | —            |       | —            |       | —                |       | —                  |       | —      |       | —            |       | —          |       | —          |       | —     |       | 814,000     |       | —     |       | (814,000 | ) | — |   |
|                                                                          |       |              |       |              |       |              |       |                  |       |                    |       |        |       |              |       |            |       |            |       |       |       |        |       |       |       |   |   |   |   |
| Stock-based  compensation option expense                                      |       | —            |       | —            |       | —            |       | —                |       | —                  |       | —      |       | —            |       | —          |       | —          |       | —     |       | 359,040     |       | —     |       | — |   | 359,040 |   |
|                                                                          |       |              |       |              |       |              |       |                  |       |                    |       |        |       |              |       |            |       |            |       |       |       |        |       |       |       |   |   |   |   |
| Foreign currency  translation adjustment                                      |       | —            |       | —            |       | —            |       | —                |       | —                  |       | —      |       | —            |       | —          |       | —          |       | —     |       | —      |       | (94,472    | )          | — |   | (94,472 | ) |
|                                                                          |       |              |       |              |       |              |       |                  |       |                    |       |        |       |              |       |            |       |            |       |       |       |        |       |       |       |   |   |   |   |
| Unrealized  holding losses on securities                                      |       | —            |       | —            |       | —            |       | —                |       | —                  |       | —      |       | —            |       | —          |       | —          |       | —     |       | —      |       | 39,311     |       | — |   | 39,311 |   |
|                                                                          |       |              |       |              |       |              |       |                  |       |                    |       |        |       |              |       |            |       |            |       |       |       |        |       |       |       |   |   |   |   |
| Additional  minumum pension liability                                         |       | —            |       | —            |       | —            |       | —                |       | —                  |       | —      |       | —            |       | —          |       | —          |       | —     |       | —      |       | 37,371     |       | — |   | 37,371 |   |
|                                                                          |       |              |       |              |       |              |       |                  |       |                    |       |        |       |              |       |            |       |            |       |       |       |        |       |       |       |   |   |   |   |
| Preferred Stock  conversion to common stock                                   |       | —            |       | —            |       | (300              | )          | (3                    | )          | (112                    | )          | (1          | )          | 286,026           |       | 2,860           |       | —          |       | —     |       | 4,016       |       | —     |       | (6,872 | ) | 0 |   |
|                                                                          |       |              |       |              |       |              |       |                  |       |                    |       |        |       |              |       |            |       |            |       |       |       |        |       |       |       |   |   |   |   |
| Dividends on  Series B Preferred stock                                   |       | —            |       | —            |       | —            |       | —                |       | —                  |       | —      |       | —            |       | —          |       | —          |       | —     |       | —      |       | —     |       | (50,872 | ) | (50,872 | ) |
|                                                                          |       |              |       |              |       |              |       |                  |       |                    |       |        |       |              |       |            |       |            |       |       |       |        |       |       |       |   |   |   |   |
| Net loss                                                                      |       | —            |       | —            |       | —            |       | —                |       | —                  |       | —      |       | —            |       | —          |       | —          |       | —     |       | —      |       | —     |       | (4,684,769 | ) | (4,684,769 | ) |
|                                                                          |       |              |       |              |       |              |       |                  |       |                    |       |        |       |              |       |            |       |            |       |       |       |        |       |       |       |   |   |   |   |
| Balance at  December 31, 2007                                            |       | 239,400           |       | 2,394             |       | 2,200             |       | 22                    |       | 1,388                   |       | 14          |       | 17,797,826        |       | 176,729         |       | (6,704          | )          | (63,688    | )          | 79,293,500  |       | 6,983      |       | (75,889,215 | ) | 3,526,739 |   |

 

The accompanyingnotes are an integral part of these consolidated financial statements.

 

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**IMAGEWARESYSTEMS, INC.**

 

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**DECEMBER 31, 2007, 2006 AND 2005**

 

**1.****                                     ****DESCRIPTION OF BUSINESSAND OPERATIONS**

 

*Overview*

 

ImageWare Systems, Inc.is a leader in the emerging market for software-based identity management solutions,providing biometric, secure credential, law enforcement and enterpriseauthorization.  Our “flagship” product is the IWS Biometric Engine. Scalable for small city business or worldwide deployment, our biometric engineis a multi-biometric platform that is hardware and algorithm independent,enabling the enrollment and management of unlimited population sizes.  Ouridentification products are used to manage and issue secure credentials,including national IDs, passports, driver licenses, smart cards and accesscontrol credentials. Our law enforcement products provide law enforcement withintegrated mug shot, fingerprint LiveScan and investigative capabilities. Wealso provide comprehensive authentication security software, as well asreal-time voice recognition, multilingual speech translation and voiceanalytics technologies.  Biometric technology is now an integral part ofall markets we address, and all of our products are integrated into theBiometric Engine Platform.  Elements of the IWS Biometric Engine can beused as investigative tools for law enforcement utilizing multiple biometricsand forensic data elements, and to enhance security and authenticity of publicand private sector credentials.

 

Our biometric technologyis a core software component of an organization’s security infrastructure andincludes a multi-biometric identity management solution for enrolling,managing, identifying and verifying the identities of people by the physicalcharacteristics of the human body. We develop, sell and support variousidentity management capabilities within government (federal, state and local),law enforcement, commercial enterprises, and transportation and aviationmarkets for identification and verification purposes. Our IWS Biometric Engineis a biometric identity management platform for multi-biometric enrollment,management and authentication, managing population databases of virtuallyunlimited sizes. It is also offered as a Software Development Kit (SDK) basedsearch engine, enabling developers and system integrators to implement abiometric solution or integrate biometric capabilities into existingapplications without having to derive biometric functionality from pre-existingapplications.  The IWS Biometric Engine combined with our secure credentialplatform, IWS EPI Builder, provides a comprehensive, integrated biometric andsecure credential solution that can be leveraged for high-end applications suchas passports, driver licenses, national IDs, and other secure documents. It canalso be utilized within our law enforcement systems to incorporate any numberof various multiple biometrics into one system.

 

We recently added nextgeneration voice recognition, multilingual speech translation and voiceanalytics capabilities to our suite of biometric identity management solutions,enabling users to facilitate and improve communication across major languagegroups globally. The ImageWare Mediator products are offered standalone orintegrated with our Biometric Engine platform providing an advanced multilingualcommunications capability. Government, intelligence, defense, public safety andborder control customers are able to realize language translation and voicerecognition capabilities whereby an English-speaking user can understand and beunderstood in numerous languages including Spanish, German, French, Korean,Arabic and Polish, among others. ImageWare Mediator products support speech tospeech translation, multilingual collaboration, conversational environments,which are represented for both voice and text and include biometricfunctionality for speaker identification and voice analytics.

 

Our law enforcementsolutions enable agencies to quickly capture, archive, search, retrieve, andshare digital images, fingerprints and criminal history records on astand-alone, networked, wireless or Web-based platform. We develop, sell andsupport a suite of modular software products used by law enforcement and publicsafety agencies to create and manage criminal history records and toinvestigate crime. Our IWS Law Enforcement solution consists of six softwaremodules: a Capture and Investigative module, which provides a criminal bookingsystem and related database; a Facial Recognition module, which uses biometricfacial recognition to identify suspects; a Suspect ID module, which facilitatesthe creation of full-color, photo-realistic suspect composites; a wirelessmodule, which provides access to centrally stored records over the Internet ina connected or wireless fashion; a PDA add-on module, which enables access tocentrally stored records while in the field on a handheld Pocket PC compatibledevice combined with central repository services which allows for inter-agencydata sharing on a local, regional, and/or national level; and a LiveScanmodule, which incorporates LiveScan capabilities into IWS Law Enforcementproviding integrated fingerprint and palm print biometric management for civiland law enforcement use.

 

55

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Our Secure Credential IDsolutions empower customers to create secure and smart digital identificationdocuments with complete ID systems. We develop, sell and support software anddesign systems which utilize digital imaging in the production of photoidentification cards and credentials and identification systems. Our productsin this market consist of IWS EPI Suite, IWS EPI Builder (SDK), Identifier forWindows and ID Card Maker.  These products allow for the production ofdigital identification cards and related databases and records and can be usedby, among others, schools, airports, hospitals, corporations orgovernments.  We have recently added the ability to incorporate multiplebiometrics into the ID systems we offer with the addition of our new IWSBiometric Engine to our product line.

 

Our enterpriseauthentication software includes the IWS Desktop Security product which is acomprehensive authentication management infrastructure solution providing addedlayers of security to workstations, networks and systems through advanced encryptionand authentication technologies. IWS Desktop Security is optimized to enhancenetwork security and usability, and uses multi-factor authentication methods toprotect access, verify identity and help secure the computing environmentwithout sacrificing ease-of-use features such as quick login. Additionally, IWSDesktop Security provides an easy integration with various smart card-basedcredentials including the Common Access Card (CAC), Homeland SecurityPresidential Directive 12 (HSPD-12) Personal Identity Verification (PIV)credential, and Transportation Worker Identification Credential (TWIC) with anorganization’s access control process. IWS Desktop Security provides thecrucial end-point component of a Logical Access Control System (LACS), and whencombined with a Physical Access Control System (PACS), organizations benefitfrom a complete door to desktop access control and security model.

 

*Going Concern*

 

Asreflected in the accompanying consolidated financial statements, the Companyhas continuing losses, negative working capital and negative cash flows fromoperations. These matters raise substantial doubt about the Company’s abilityto continue as a going concern.

 

Newfinancing will be required to fund working capital and operations should theCompany be unable to generate positive cash flow from operations in the nearfuture. The Company is exploring the possible sale of equity securities and/ordebt financing. In the event financing is not available in the time framerequired, the Company will be forced to sell certain of its assets or licenseits technologies to others. These actions, while necessary for the continuanceof operations during a time of cash constraints and a shortage of workingcapital, could adversely affect the Company’s business.

 

As a result of theCompany’s continuing losses and negative cash flows from operations, theCompany currently does not meet certain listing standards of the American StockExchange (“AMEX”) Company Guide.  On December 14,2007, we received a letter from AMEX indicating that we do not comply with AMEX’scontinued listing standards due to our inability to maintain compliance withSections 1003(a)(ii), 1003(a)(iii) and 1003(a)(iv) of the CompanyGuide and that AMEX intends to remove our common stock from listing andregistration on AMEX by filing a delisting application with the Securities andExchange Commission (“SEC”).  The letterfrom AMEX states that we were not in compliance with (i) Section 1003(a)(ii) ofthe Company Guide because our shareholders’ equity was less than $4,000,000 andwe sustained losses from continuing operations and/or net losses in three outof our four most recent fiscal years, and (ii) Section 1003(a)(iii) ofthe Company Guide because our shareholders’ equity was less than $6,000,000 andwe sustained losses from continuing operations and/or net losses in our fivemost recent fiscal years.  We had alsobeen notified by AMEX that we were not in compliance with Section 1003(a)(iv) ofthe Company Guide in that we had sustained losses which are so substantial inrelation to our overall operations or our existing financial resources, or ourfinancial condition had become so impaired that it appeared questionable, inthe opinion of AMEX, as to whether we would be able to continue operationsand/or meet our obligations as they matured.

 

We filed an appeal ofAMEX’s determination and requested an oral hearing before an AMEX ListingQualifications Panel (a “Qualifications Panel”).  On March 10, 2008, we received a letterfrom AMEX granting our request.  Ourhearing with a Qualifications Panel is scheduled for April 16, 2008.  If the Qualifications Panel does not grantthe relief sought, our common stock will be delisted from AMEX following whichit is expected that our common stock would be quoted on the Over-the-CounterBulletin Board.  As a consequence of anysuch delisting, the public price of our common stock could be adverselyaffected and a stockholder would likely find it more difficult to dispose of,or to obtain accurate quotations as to the prices of, our common stock.

 

Insufficient funds will require the Company to sell certain of theCompany’s assets or license the Company’s technologies to others and if theCompany is unable to obtain additional funding there is substantial doubt aboutthe Company’s ability to continue as a going concern.

 

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Inview of the matters described in the preceding paragraph, recoverability of amajor portion of the recorded asset amounts shown in the accompanyingconsolidated balance sheet is dependent upon continued operations of theCompany, which, in turn, is dependent upon the Company’s ability to continue toraise capital and generate positive cash flows from operations. Theconsolidated financial statements do not include any adjustments relating tothe recoverability and classification of recorded asset amounts or amounts andclassifications of liabilities that might be necessary should the Company beunable to continue its existence.

 

TheCompany operates in markets that are emerging and highly competitive. There isno assurance that the Company will operate at a profit in the future.

 

**2.****                                     ****SUMMARY OF SIGNIFICANTACCOUNTING POLICIES**

 

*Principles of consolidation*

 

Theconsolidated financial statements include the accounts of the Company and itswholly-owned subsidiaries. All significant intercompany transactions andbalances have been eliminated.

 

*Use of estimates*

 

Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America (“U.S. GAAP”) requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and disclosure of contingent assets and liabilitiesat the date of the financial statements, and the reported amounts of revenueand expense during the reporting period. Significant estimates include theallowance for doubtful accounts receivable, calculation of our tax provision,inventory obsolescence reserve, the determination of other than temporaryimpairment on our marketable securities, deferred tax asset valuationallowances, accounting for loss contingencies, recoverability of goodwill andacquired intangible assets and amortization periods, assumptions used in theBlack-Scholes model to calculate the fair value of share based payments,assumptions used in the application of fair value methodologies to calculatethe fair value of acquired assets and revenue and cost of revenues recognizedunder the percentage of completion method. Actual results could differ fromestimates.

 

*Cash and Cash Equivalents*

 

Cash and cash equivalents consist primarily of cashon deposit, certificates of deposit, money market accounts, and investmentgrade commercial paper that are readily convertible into cash with originalmaturities of three months or less or that are redeemable upon demand.

 

*Allowance for Doubtful Accounts*

 

The Company records itsallowance for doubtful accounts based upon its assessment of various factors.The Company considers historical experience, the age of the accounts receivablebalances, the credit quality of its customers, current economic conditions andother factors that may affect customers’ ability to pay to determine thelevel of allowance required.

 

*Fair Value of Financial Instruments*

 

For certain of the Company’s financial instruments,including accounts receivable, accounts payable, accrued expenses and deferredrevenues the carrying amounts approximate fair value due to their relativelyshort maturities.

 

*Property, equipment and leasehold improvements*

 

Propertyand equipment, consisting of furniture and equipment, are stated at cost andare being depreciated on a straight-line basis over the estimated useful livesof the assets, which range from three to five years. Maintenance and repairsare charged to expense as incurred. Major renewals or improvements arecapitalized. When assets are sold or abandoned, the cost and relatedaccumulated depreciation are removed from the accounts and the resulting gainor loss is recognized. Expenditures for leasehold improvements are capitalized.Depreciation of leasehold improvements is computed using the straight-linemethod over the shorter of the remaining lease term or the estimated usefullives of the improvements.

 

*Goodwill:*

 

Goodwill arising fromthe acquisition of Sol Logic, G & A Imaging and Castleworks andE-Focus was first attributed to developed technology, trademarks andtradenames, patents, agreements not-to-compete and customer 

 

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relationshipbased upon their estimated fair value at the date of acquisition. Theseintangible assets are being amortized over their estimated useful lives, whichrange from 3-15 years. Goodwill acquired willbe reviewed for impairment pursuant to SFAS No. 142.

 

The Company accounts for its intangible assets underthe provisions of SFAS No. 142, “Goodwill and Other Intangible Assets”. Inaccordance with SFAS No. 142, intangible assets with a definite life areaccounted for impairment under SFAS No. 144 and intangible assets with anindefinite life are accounted for impairment under SFAS No. 142. Inaccordance with SFAS No. 142, goodwill, or the excess of cost over fairvalue of net assets acquired, is no longer amortized but is tested forimpairment using a fair value approach at the “reporting unit” level. Areporting unit is the operating segment, or a business one level below thatoperating segment (referred to as a component) if discrete financialinformation is prepared and regularly reviewed by management at the componentlevel. The Company recognizes an impairment charge for any amount by which thecarrying amount of a reporting unit’s goodwill exceeds its fair value. TheCompany uses fair value methodologies to establish fair values. When availableand as appropriate, comparative market multiples to corroborate discounted cashflow results is used. When a business within a reporting unit is disposed of,goodwill is allocated to the gain or loss on disposition using the relativefair value methodology.

 

For the twelve months ended December 31, 2005,the Company recorded goodwill impairment charges of approximately $1,245,000for goodwill carried in the Company’s former Digital Photography segment. Theimpairment was a result of changes resulting from the effect of projectingrecent performance variances on future periods. The Company did not record any goodwill impairment charges for thetwelve months ended December 31, 2006 and 2007.

 

*Intangible and Long-lived assets*

 

In October 2001,the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposalof Long-Lived Assets”, which supersedes SFAS No. 121, “Accounting for theImpairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of”,and the accounting and reporting provision of APB Opinion No. 30, “Reportingthe Results of Operations-Reporting the Effects of Disposal of a Segment of aBusiness, and Extraordinary, Unusual and Infrequently Occurring Events andTransactions”, for the disposal of a segment of a business.  This statement also amends ARB No. 51, “ConsolidatedFinancial Statements”, to eliminate the exception to consolidation for asubsidiary for which control is likely to be temporary. SFAS No. 144requires that long-lived assets to be disposed of by sale, including those ofdiscontinued operations, be measured at the lower of carrying amount or fairvalue less cost to sell, whether reported in continuing operations or indiscontinued operations. SFAS No. 144 broadens the reporting ofdiscontinued operations to include all components of an entity with operationsthat can be distinguished from the rest of the entity and that will beeliminated from the ongoing operations of the entity in a disposal transaction.SFAS No. 144 also establishes a “primary-asset” approach to determine thecash flow estimation period for a group of assets and liabilities thatrepresents the unit of accounting for a long-lived asset to be held and used.At December 31, 2005, the Company recorded impairment losses on certainlong-lived assets aggregating $253,000. At December 31, 2006 and 2007, there was no impairment of theCompany’s intangible or long-lived assets.

 

*Concentration of credit risk*

 

Financialinstruments which potentially subject the Company to concentrations of creditrisk consist principally of cash and trade accounts receivable. The Companyplaces its cash with high quality financial institutions and at timesmay exceed the FDIC $100,000 insurance limit. Sales are typically made oncredit and the Company generally does not require collateral. The Companyperforms ongoing credit evaluations of its customers’ financial condition andmaintains an allowance for doubtful accounts. Accounts receivable are presentednet of an allowance for doubtful accounts of $0 and $483,132 at December 31,2007 and 2006, respectively.

 

Forthe twelve months ended December 31, 2007 one customer accounted forapproximately 18% of total revenues. For the twelve months ended December 31,2006 one customer accounted for approximately 21% of total revenues.  For the twelve months ended 2005 there wereno customers who accounted for more than 10% of the Company’s revenues.

 

As of December 31,2007, there was one customer who accounted for more than 10% of total accountsreceivable.  As of December 31,2006, there were three customers who each accounted for more than 10% of totalaccounts receivable and who collectively comprised approximately 52% of totalaccounts receivable.   At December 31,2006, two of these accounts were in good standing with the third account fullyreserved.

 

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*Stock-based compensation*

 

At December 31,2007, the Company had three stock-based compensation plans for employees andnonemployee directors which authorize the granting of various equity-basedincentives including stock options and restricted stock.

 

Priorto January 1, 2006, the Company accounted for the measurement andrecognition of stock-based compensation under the provisions of APB Opinion No. 25,“Accounting for Stock Issued to Employees,” and related Interpretations,permitted under Statement of Financial Accounting Standard No. 123, “Accountingfor Stock-Based Compensation” (SFAS No. 123). As a result, employee stockoption based compensation was included as a pro forma disclosure in the Notesto the Company’s financial statements for prior year periods.

 

Priorto the adoption of Statement of Financial Accounting Standards No. 123(R),“Share-Based Payment”, (SFAS 123(R)), the Company provided the disclosuresrequired under SFAS No. 123. The pro forma effect on net income and netincome per share as if the fair value of stock-based compensation had beenrecognized as compensation expense for the twelve month periods ending December 31,2005 was as follows:

 
| ** **                                                       | ** ** | **Twelve  Months Ended  December 31,****2005** | ** ** |
|------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                       | ** ** | ** **                                               | ** ** |
| Net Loss:                                                        |       |                                                     |       |
| As reported                                                      |       | $                                                        | (8,355,704 | ) |
| Stock-based  compensation included in net loss                   |       | $                                                        | 310,597    |   |
| Stock-based  employee compensation under fair value based method |       | $                                                        | (848,534   | ) |
| Pro forma net  loss                                              |       | $                                                        | (8,893,641 | ) |
|                                                             |       |                                                     |       |
| Basic and  diluted loss per common share:                        |       |                                                     |       |
| As reported                                                      |       | $                                                        | (0.66      | ) |
| Pro forma                                                        |       | $                                                        | (0.70      | ) |

 

On January 1,2006, the Company adopted the provisions of SFAS 123(R) using the modifiedprospective transition method.  SFAS 123(R) requirescompanies to measure and recognized the cost of employee services received inexchange for awards of equity instruments based on the grant date fair value ofthose awards. For share option instruments issued subsequent to the adoption ofSFAS 123(R), compensation cost is recognized ratably using the straight-lineattribution method over the expected vesting period. For equity options issuedprior to the adoption of SFAS 123(R), compensation cost is recognized using agraded vesting attribution method. In addition, pursuant to SFAS 123(R), we arerequired to estimate the amount of expected forfeitures when calculatingcompensation costs, instead of accounting for forfeitures as incurred, whichwas our previous method. Prior periods are not restated under this transitionmethod. Options previously awarded and classified as equity instrumentscontinue to maintain their equity classification under SFAS 123(R).  Stock-based compensation expense related toequity options was approximately $359,000 and $711,000 for the twelve monthended December 31, 2007 and 2006, respectively.

 

Priorto adopting SFAS No. 123(R), the Company presented all excess taxbenefits, if any, resulting from the exercise of stock options as operatingcash flows in the Statement of Cash Flows. SFAS No. 123(R) requirescash flows resulting from excess tax benefits to be classified as a financingactivity. Excess tax benefits are realized from tax deductions for exercisedoptions in excess of the deferred tax asset attributable to stock compensationcosts for such options. The Company did not record any excess tax benefits as aresult of adopting SFAS 123(R) in the twelve months ended December 31,2006 because the Company is currently providing a full valuation on future taxbenefits realized in the United States until it can sustain a level ofprofitability that demonstrates its ability to utilize the assets.

 

SFAS No. 123(R) requiresthe use of a valuation model to calculate the fair value of stock-based awards.For the twelve months ended December 31, 2006 and 2007, the Company haselected to use the Black-Scholes option-pricing model, which incorporatesvarious assumptions including volatility, expected life, and interest rates.The Company is required to make various assumptions in the application of theBlack-Scholes option pricing model. The Company has determined that the bestmeasure of expected volatility is based on the historical weekly volatility ofthe Company’s common stock. Historical volatility factors utilized in theCompany’s Black-Scholes computations range from 64.4% to 98.5%. The Company haselected to estimate the expected life of an award based upon the SEC approved “simplifiedmethod” noted 

 

59

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under the provisions ofStaff Accounting Bulletin No. 107. Under this formula, the expected termis equal to: ((weighted-average vesting term + original contractual term)/2).The expected term used by the Company as computed by this method range from 3.5years to 6.1 years. The interest rate used is the risk free interest rate andis based upon U. S. Treasury rates appropriate for the expected term. Interestrates used in the Company’s Black-Scholes calculations range from 2.7% to 4.6%.Dividend yield is zero as we do not expect to declare any dividends on ourcommon shares in the foreseeable future.

 

Inaddition to the key assumptions used in the Black-Scholes model, the estimatedforfeiture rate at the time of valuation is a critical assumption.  The Company has estimated an annualizedforfeiture rate of approximately 10% for corporate officers, 4% for members ofthe Board of Directors and 24% for all other employees.  The Company reviews the expected forfeiturerate annually to determine if that percent is still reasonable based onhistorical experience.

 

Asummary of the activity under the Company’s stock option plans for the twelvemonths ended December 31, 2007 is as follows:

 
| ** **                         | ** ** | **Options** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** | **Weighted-  Average  Remaining  Contractual  Term (Years)** | ** ** |
|------------------------------------|------------|-------------|------------|-----------------------------------------|------------|-------------------------------------------------------------------|------------|
|                               |       |        |       |                                    |       |                                                              |       |
| Balance at  December 31, 2006 |       | 1,603,164   |       | $                                       | 2.45       |                                                              | 7.84       |   |
| Granted                            |       | 165,250     |       | $                                       | 2.38       |                                                              | 9.32       |   |
| Forfeited                          |       | (103,206    | )          | $                                       | 2.58       |                                                              | 5.69       |   |
| Exercised                          |       | —      |       | $                                       | —     |                                                              | —     |   |
|                               |       |        |       |                                    |       |                                                              |       |
| Balance at  December 31, 2007 |       | 1,665,208   |       | $                                       | 2.44       |                                                              | 7.74       |   |

 

Optionsexercisable at December 31, 2007 totaled 1,212,753 at a weighted-averageprice of $2.50, with a remaining weighted average contractual term ofapproximately 6.7 years.

 

Theweighted-average grant date fair value of options granted during the twelvemonths ended December 31, 2007 was $1.48.

 

Thefollowing table sets forth a summary of the status and changes of the Company’sunvested shares related to its stock option plans as of and during the twelvemonths ended December 31, 2007:

 
| ** **                         | ** ** | **Options** | ** ** | **Weighted-  Average  Grant Date  Fair Value  Per Share** | ** ** |
|------------------------------------|------------|-------------|------------|--------------------------------------------------------------------------|------------|
|                               |       |        |       |                                                                     |       |
| Balance at  December 31, 2006 |       | 761,782     |       | $                                                                        | 1.63       |   |
| Granted                            |       | 165,250     |       | $                                                                        | 1.48       |   |
| Vested                             |       | (418,529    | )          | $                                                                        | 1.64       |   |
| Forfeited                          |       | (56,048     | )          | $                                                                        | 1.61       |   |
|                               |       |        |       |                                                                     |       |
| Balance at  December 31, 2007 |       | 452,455     |       | $                                                                        | 1.57       |   |

 

At December 31,2007, the total remaining unrecognized compensation cost related to unvestedstock options amounted to approximately $308,897, which will be amortized overthe weighted-average remaining requisite service period of 1.41 years.

 

On March 30,2004, the Company entered into a stock exchange agreement with certainemployees whereby the employees would receive 255,792 shares of restrictedstock in exchange for 426,321 options previously granted under various stockoption plans. Under the terms of the agreement, the employees will receivethree shares of restricted stock for each five options exchanged. Therestricted stock will vest over three years on a quarterly basis and will fullyvest upon either a change in control or the sale of the Company.

 

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On September 27, 2005, the Company issued tocertain employees 162,300 shares of restricted stock. The restricted stock willvest over three years on a quarterly basis and will fully vest upon either achange in control or the sale of the Company.

 

In conjunction with these restricted stockagreements, the Company has recognized stock-based compensation expense of$197,000, $406,000 and $311,000 for the twelve months ended December 31,2007, 2006 and 2005, respectively.

 

*Income taxes*

 

Currentincome tax expense or benefit is the amount of income taxes expected to bepayable or refundable for the current year. A deferred income tax asset orliability is computed for the expected future impact of differences between thefinancial reporting and tax bases of assets and liabilities and for theexpected future tax benefit to be derived from tax credits and losscarryforwards. Deferred tax assets are reduced by a valuation allowance when,in the opinion of management, it is more likely than not that some portion orall of the deferred tax assets will not be realized.

 

*Foreign currency translation*

 

Thefinancial position and results of operations of the Company’s foreignsubsidiaries are measured using the foreign subsidiary’s local currency as thefunctional currency. Revenues and expenses of such subsidiaries have beentranslated into U.S. dollars at average exchange rates prevailing during theperiod. Assets and liabilities have been translated at the rates of exchange onthe balance sheet date. The resulting translation gain and loss adjustments arerecorded directly as a separate component of shareholders’ equity, unless thereis a sale or complete liquidation of the underlying foreign investments. TheCompany translates foreign currencies of its German and Canadian subsidiaries.The cumulative translation adjustment account, which is part ofaccumulated other comprehensive income, decreased approximately $94,000 for thetwelve months ended December 31, 2007, decreased approximately $77,000 forthe twelve months ended December 31, 2006, and increased approximately$88,000 for the twelve months ended December 31, 2005.

 

*Comprehensive Income*

 

Comprehensiveincome consists of net gains and losses affecting shareholders’ equity that,under generally accepted accounting principles, are excluded from net income(loss). For the Company, the only items are the cumulative translationadjustment, unrealized holding losses on marketable securities classified asavailable-for-sale and the additional minimum liability related to the Company’sdefined benefit pension plan, recognized pursuant to Statement of FinancialAccounting Standards No. 87 (“SFAS 87”), Employers’ Accounting forPensions and Statement of Financial Accounting Standards No 158, “Employers’ Accounting for Defined BenefitPension and Other Postretirement Plans (an amendment of FASB Statements No. 87,88, 106, and 132R)”.

 

*Revenue recognition*

 

TheCompany recognizes revenue from the following major revenue sources:

 

·                  Long-term fixed-price contracts involvingsignificant customization

·                  Fixed-price contracts involving minimalcustomization

·                  Software licensing

·                  Sales of computer hardware andidentification media

·                  Postcontract customer support (PCS)

 

TheCompany’s revenue recognition policies are consistent with U. S. GAAP includingStatements of Position 97-2 “Software Revenue Recognition” and 98-9 “Modificationof SOP 97-2, Software Revenue Recognition With Respect to Certain Transactions”,Securities and Exchange Commission Staff Accounting Bulletin 104 , EmergingIssues Task Force Issue 00-21 “Revenue Arrangements with Multiple Deliverables”,and Emerging Issues Task Force Issue 03-05 “Applicability of AICPA Statement ofPosition 97-2 to Non-Software Deliverables in an Arrangement ContainingMore-Than-Incidental Software”. Accordingly, the Company recognizes revenuewhen all of the following criteria are met: persuasive evidence of anarrangement exists, delivery has occurred or services have been rendered, thefee is fixed or determinable, and collectibility is reasonable assured.

 

TheCompany recognizes revenue and profit as work progresses on long-term,fixed-price contracts involving 

 

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significant amount ofhardware and software customization using the percentage of completion methodbased on costs incurred to date compared to total estimated costs atcompletion. Revenue from contracts for which we cannot reliably estimate totalcosts or there are not significant amounts of customization are recognized uponcompletion. The Company also generates non-recurring revenue from the licensingof its software. Software license revenue is recognized upon the execution of alicense agreement, upon deliverance, when fees are fixed and determinable, whencollectibility is probable and when all other significant obligations have beenfulfilled. The Company also generates revenue from the sale of computerhardware and identification media. Revenue for these items is recognized upondelivery of these products to the customer. Our revenue from periodicmaintenance agreements is generally recognized ratably over the respectivemaintenance periods provided no significant obligations remain andcollectibility of the related receivable is probable. Sales tax collected fromcustomers is excluded from revenue.

 

*Capitalized software development costs*

 

Softwaredevelopment costs incurred prior to the establishment of technologicalfeasibility are charged to research and development expense as incurred.Technological feasibility is established upon completion of a working model.Software development costs incurred subsequent to the time a product’stechnological feasibility has been established, through the time the product isavailable for general release to customers, are capitalized, if material. Todate, the Company has not capitalized any software costs as the period betweenachieving technological feasibility and the general availability of the relatedproducts has been short and software development costs qualifying forcapitalization have been insignificant.

 

*Advertising costs*

 

TheCompany expenses advertising costs as incurred. Advertising expense totaledapproximately $29,000, $122,000 and $68,000 for the years ended December 31,2007, 2006 and 2005, respectively.

 

*Loss per share*

 

Basicloss per common share is calculated by dividing net income (loss) available tocommon shareholders for the period by the weighted-average number of commonshares outstanding during the period. Diluted loss per common share iscalculated by dividing net loss available to common shareholders for the periodby the weighted-average number of common shares outstanding during the period,increased to include, if dilutive, the number of additional common shares thatwould have been outstanding if the potential common shares had been issued atthe date of issuance. The dilutive effect of outstanding stock options isincluded in the calculation of diluted loss per common share, if dilutive,using the treasury stock method. During the years ended December 31, 2007,2006 and 2005, the Company has excluded the following securities from thecalculation of diluted loss per share, as their effect would have beenanti-dilutive due to the Company’s net loss:

 
| **Potential Dilutive Securities:**      | ** ** | **Number of  Common Shares  Convertible into  at  December 31,  2007** | ** ** | **Number of  Common Shares  Convertible into  at  December 31,  2006** | ** ** | **Number of  Common Shares  Convertible into  at  December 31,  2005** | ** ** |
|---------------------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|
|                                              |       |                                                                                       |       |                                                                                       |       |                                                                                       |       |
| Convertible  preferred stock – Series B |       | 45,384                                                                                     |       | 45,384                                                                                     |       | 47,280                                                                                     |       |
| Convertible preferred  stock – Series C |       | 1,466,666                                                                                  |       | 1,666,664                                                                                  |       | —                                                                                     |       |
| Convertible  preferred stock – Series D |       | 925,333                                                                                    |       | —                                                                                     |       | —                                                                                     |       |
| Stock options                                     |       | 1,665,208                                                                                  |       | 1,603,164                                                                                  |       | 1,474,093                                                                                  |       |
| Warrants                                          |       | 5,955,830                                                                                  |       | 5,821,149                                                                                  |       | 4,293,305                                                                                  |       |

 

Thefollowing table sets forth the computation of basic and diluted loss per sharefor the years ended December 31, 2007, 2006 and 2005:

 

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| ** **                                                            | ** ** | ** ** | ** ** | **TWELVE MONTHS ENDED  DECEMBER 31,** | ** ** |
|-----------------------------------------------------------------------|------------|------------|------------|------------------------------------------------------|------------|
| ** **                                                            | ** ** | **2007**   | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| Numerator – loss  from continuing operations:                    |       |       |       |                                                 |       |   |   |
| Net loss from  continuing operations                                  |       | $          | (4,734,769 | )                                                    | $          | (5,518,276 | ) | $ | (6,696,778 | ) |
| Less preferred  stock dividends                                       |       | (1,171,258 | )          | (110,998                                             | )          | (52,997 | ) |
| Net loss from  continuing operations available to common shareholders |       | $          | (5,906,027 | )                                                    | $          | (5,629,274 | ) | $ | (6,749,775 | ) |
|                                                                  |       |       |       |                                                 |       |   |   |
| Numerator – gain  (loss) from discontinued operations:           |       |       |       |                                                 |       |   |   |
| Net loss from  discontinued operations                                |       | 50,000     |       | (407,939                                             | )          | (1,658,926 | ) |
|                                                                  |       |       |       |                                                 |       |   |   |
| Denominator                                                           |       |       |       |                                                 |       |   |   |
| Weighted-average  shares outstanding                                  |       | 15,070,308 |       | 13,592,841                                           |       | 12,731,304 |   |
|                                                                  |       |       |       |                                                 |       |   |   |
| Basic and  Diluted loss per share:                                    |       |       |       |                                                 |       |   |   |
| Continuing  operations                                                |       | $          | (0.31      | )                                                    | $          | (0.41 | ) | $ | (0.53 | ) |
| Discontinued  operations                                              |       | $          | —     |                                                 | $          | (0.03 | ) | $ | (0.13 | ) |
| Preferred  dividends                                                  |       | $          | (0.08      | )                                                    | $          | — |   | $ | — |   |
| Net loss per  share                                                   |       | $          | (0.39      | )                                                    | $          | (0.44 | ) | $ | (0.66 | ) |

 

*Segment information*

 

Priorto its acquisitions during 2001 of G & A, Castleworks and E-Focus, theCompany operated in one business segment. With its acquisition of G &A, Castleworks and E-Focus, the Company determined it was comprised of threereportable segments based on the management approach as prescribed by Statementof Financial Accounting Standards No. 131 (As Amended), “Disclosures aboutSegments of an Enterprise and Related Information”, (“SFAS 131”).  These segments were determined to be: LawEnforcement, Identification and Digital Photography.  With the sale of its entire DigitalPhotography product line in November 2006, the Company reassessed thecomposition of its operating segments and determined that it no longer operatesin separate, distinct market segments but rather operates in one marketsegment, that segment being identity management.  The Company’s determination was based onfundamental changes in the Company’s business structure due to theconsolidation of operations, restructuring of the Company’s operations andmanagement team, and the integration of what where previously distinct,mutually exclusive technologies.  Thishas resulted in changes in the manner by which the Company’s chief decisionmaker assesses performance and makes decisions concerning resource allocation.

 

As ofresult of the Company’s determination that operates in one market segment, thatsegment being identify management, the Company has amended its segmentdisclosure beginning with its annual report as filed on Form 10-K for thetwelve months ended December 31, 2006.

 

*NewAccounting Pronouncements*

 

In September 2006,the Financial Accounting Standards Board (“FASB”) issued Statement ofFinancial Accounting Standards (“SFAS”) No. 157, *Fair Value Measurements*(SFAS No. 157).SFAS No. 157 replaces the different definitions of fair value in theaccounting literature with a single definition. It defines fair value as theprice that would be received to sell an asset or paid to transfer a liabilityin an orderly transaction between market participants at the measurement date.SFAS No. 157 is effective for fair-value measurements alreadyrequired or permitted by other standards for financial statements issued forfiscal years beginning after November 15, 2007 and interim periods withinthose fiscal years, with earlier adoption encouraged. The FASB has deferred theimplementation of SFAS 157 by one year for certain non-financial assetsand liabilities such as this will be effective for the fiscal years beginningafter November 15, 2008. We are currently in the process of determiningthe impact, if any, of adopting the provisions of SFAS No. 157 on ourresults of operations or financial position.

 

In February 2007,the FASB issued SFAS No. 159, *The FairValue Option for Financial Assets and Financial Liabilities—Including anamendment of FASB Statement No. 115*(“SFAS No. 159”). SFASNo. 159 provides companies with an option to report selected financialassets and liabilities at fair value. The objective of SFAS No. 159 is toreduce both the complexity in accounting for financial instruments and thevolatility in earnings caused by measuring related assets and liabilitiesdifferently. SFAS No. 159 also establishes presentation and disclosurerequirements designed to facilitate 

 

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comparisons between companies that choose differentmeasurement attributes for similar types of assets and liabilities. SFAS No. 159is effective for fiscal years beginning after November 15, 2007, withearlier adoption permitted. We are currently in the process of determining theimpact of adopting the provisions of SFAS No. 159 on our results ofoperations or statement of financial position.

 

In December 2007,the FASB issued SFAS No. 141(R), “Business Combinations” and SFAS No. 160,“Non-controlling Interests in Consolidated Financial Statements”. The standardsare intended to improve, simplify, and converge internationally the accountingfor business combinations and the reporting of non-controlling interests inconsolidated financial statements. SFAS No. 141(R) requires the acquiring entity in a businesscombination to recognize all (and only) the assets acquired and liabilitiesassumed in the transaction; establishes the acquisition-date fair value as themeasurement objective for all assets acquired and liabilities assumed; andrequires the acquirer to disclose to investors and other users all of theinformation they need to evaluate and understand the nature and financial effectof the business combination. SFAS No. 141(R) is effective for fiscalyears, and interim periods within those fiscal years, beginning on or after December 15,2008. SFAS No. 141(R) applies prospectively to business combinationsfor which the acquisition date is on or after the beginning of the first annualreporting period beginning on or after December 15, 2008. Earlier adoptionis prohibited. The Company is currently evaluating the impact of this standardon its consolidated financial statements.

 

SFAS No. 160 isdesigned to improve the relevance, comparability, and transparency of financialinformation provided to investors by requiring all entities to reportnon-controlling (minority) interests in subsidiaries in the same way—as equityin the consolidated financial statements. Moreover, SFAS No. 160eliminates the diversity that currently exists in accounting for transactionsbetween an entity and non-controlling interests by requiring they be treated asequity transactions. SFAS No. 160 is effective for fiscal years, andinterim periods within those fiscal years, beginning on or after December 15,2008. Earlier adoption is prohibited. In addition, SFAS No. 160 shall beapplied prospectively as of the beginning of the fiscal year in which it isinitially applied, except for the presentation and disclosure requirements. Thepresentation and disclosure requirements shall be applied retrospectively forall periods presented. We do not have an outstanding non-controlling interestin one or more subsidiaries and therefore, SFAS No. 160 is not applicableto us at this time.

 

*Reclassifications*

 

Certainreclassifications were made to prior years’ consolidated financial statementsto conform to the current year presentation.

 

**3.****                                     ****Intangible Assets**

 

Thefollowing disclosure presents certain information about the Company’s acquiredintangible assets as of December 31, 2007 and 2006. All intangible assetsare being amortized over their estimated useful lives, as indicated below, withno estimated residual values.

 

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| **Acquired Intangible Assets** | ** ** | **Amortization  Period** | ** ** | **Gross  Carrying  Amount  After  Impairment  Charge** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Balance** | ** ** |
|------------------------------------------|------------|--------------------------|------------|--------------------------------------------------------|------------|-------------------------------|------------|------------------|------------|
| At  December 31, 2007               |       |                     |       |                                                   |       |                          |       |             |       |
| Amortized  acquired intangible assets:   |       |                     |       |                                                   |       |                          |       |             |       |
| Technology                               |       | 5 years                  |       | $                                                      | 3,178,242  |                          | $          | (1,160,000       | )          | $ | 2,018,242 |   |
| Trademarks and  tradenames               |       | 14.5 years               |       | 377,000                                                |       | (251,426                      | )          | 125,574          |       |
| Customer  relationship                   |       | 5 years                  |       | 293,000                                                |       | (200,000                      | )          | 93,000           |       |
| Non-compete  Agreements                  |       | 3 years                  |       | 324,760                                                |       | (125,000                      | )          | 199,760          |       |
| Patents                                  |       | 4 years                  |       | 60,000                                                 |       | (60,000                       | )          | —           |       |
|                                     |       |                     |       | $                                                      | 4,233,002  |                          | $          | (1,796,426       | )          | $ | 2,436,576 |   |
| At  December 31, 2006               |       |                     |       |                                                   |       |                          |       |             |       |
| Amortized  acquired intangible assets:   |       |                     |       |                                                   |       |                          |       |             |       |
| Technology                               |       | 5 years                  |       | $                                                      | 1,160,000  |                          | $          | (1,160,000       | )          | $ | — |   |
| Trademarks and  tradenames               |       | 14.5 years               |       | 377,000                                                |       | (235,706                      | )          | 141,294          |       |
| Customer  relationship                   |       | 5 years                  |       | 200,000                                                |       | (200,000                      | )          | —           |       |
| Non-compete  Agreements                  |       | 3 years                  |       | 125,000                                                |       | (125,000                      | )          | —           |       |
| Patents                                  |       | 4 years                  |       | 60,000                                                 |       | (60,000                       | )          | —           |       |
|                                     |       |                     |       | $                                                      | 1,922,000  |                          | $          | (1,780,706       | )          | $ | 141,294 |   |

 

Asmore fully described in Note 6 to these consolidated financial statements, in December 2007,the Company completed the acquisition of substantially all the assets of SolLogic, Inc. resulting in acquired intangible assets of approximately$2,311,000.  Based on fair valuemethodologies employed by a professional, independent valuation firm, theCompany recorded approximately $2,018,000 in intangibles assets for developedtechnology, $93,000 in customer relationship intangible assets and $200,000 fora non-compete agreement.

 

In 2005, we recorded animpairment charge of approximately $253,000 related to our intangible asset forcertain trademark and tradenames carried in our former Identification segment.This loss reflects the amount by which the carrying value of this assetexceeded its estimated fair value determined by the assets’ future discountedcash flows. The impairment loss is recorded as a component of “Operatingexpenses” in the Consolidated Statement of Operations for 2005.  There were no impairment losses recorded forthe years ended December 31, 2007 and 2006.

 

Amortizationexpense for the twelve months ended December 31, 2007, 2006 and 2005, wasapproximately $16,000, $77,000 and $293,000, respectively.

 

Theestimated acquired intangible amortization expense for the next five fiscalyears is as follows:

 
| **Fiscal Year Ended December 31,** | ** ** | **Estimated Amortization Expense** | ** ** |
|--------------------------------------------------------|------------|----------------------------------------------|------------|
| 2008                                                   |       | 505,000                                      |       |
| 2009                                                   |       | 505,000                                      |       |
| 2010                                                   |       | 505,000                                      |       |
| 2011                                                   |       | 438,000                                      |       |
| 2012                                                   |       | 438,000                                      |       |
| Thereafter                                             |       | 45,294                                       |       |

 

**4.****                                      Goodwill**

 

Thechanges in the carrying amount of goodwill for the years ended December 31,2005, 2006 and 2007 are as follows:

 

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| ** **                                                | ** ** | **Total**  | ** ** |
|-----------------------------------------------------------|------------|------------|------------|
| Balance of  Goodwill as of January 1, 2005           |       | $          | 5,297,627  |   |
|                                                      |       |       |       |
| Goodwill  acquired                                        |       | —     |       |
| Impairment  losses                                        |       | (1,245,353 | )          |
| Imaging Asia  Pacific component of Identification segment |       | (636,627   | )          |
|                                                      |       |       |       |
| Balance of  Goodwill as of December 31, 2005         |       | $          | 3,415,647  |   |
|                                                      |       |       |       |
| Goodwill  acquired                                        |       | —     |       |
| Impairment  losses                                        |       | —     |       |
| Balance of  goodwill as of December 31, 2006         |       | $          | 3,415,647  |   |
|                                                      |       |       |       |
| Goodwill  acquired                                        |       | 1,036,395  |       |
| Impairment  losses                                        |       | —     |       |
|                                                      |       |       |       |
| Balance of  Goodwill as of December 31, 2007         |       | $          | 4,452,042  |   |

 

Asmore fully described in Note 6 to these consolidated financial statements, in December 2007,the Company completed the acquisition of substantially all the assets of SolLogic, Inc. resulting in goodwill acquired of approximately $1,036,000.

 

TheCompany annually, or more frequently if events or circumstances indicate aneed, tests the carrying amount of goodwill for impairment. The Companyperforms its annual impairment test in the fourth quarter of each year. Atwo-step impairment test is used to first identify potential goodwillimpairment and then measure the amount of goodwill impairment loss, if any. Thesetests were conducted by determining and comparing the fair value of ourreporting units, as defined in SFAS 142, to the reporting unit’s carryingvalue. In 2006, we determined that our only reporting unit is IdentityManagement. Based on the results of these impairment tests, we determined thatour goodwill assets were not impaired as of December 31, 2007 and 2006.

 

During2005, the Company determined that because of a change in competitive dynamicsthe fair value of the Company’s former Digital Photography unit had beenreduced to an amount less that the reporting unit’s carrying amount, andaccordingly the Company recorded a pre-tax, non-cash goodwill impairment chargeof approximately $1,245,000 as a component of general and administrativeexpenses. The Company utilized the assistance of an unaffiliated third-partyvaluation specialist who employed various fair value methodologies, includingpresent value techniques and prices of comparable businesses, to determine theimplied fair value of the Company’s goodwill in its 2005 impairment testing.

 

**5.****                                      Investments**

 

Inconjunction with the sale of the Company’s wholly-owned subsidiary, DigitalImaging Asia Pacific, as more fully described in Note 7 to these consolidatedfinancial statements, in March 2005, the Company and Argus Solutions Ltd eachagreed to purchase $250,000 of each others common stock at a per share priceequal to 108% of the closing price of each others’ stock as determined by theAmerican Stock Exchange and Australian Stock Exchange, respectively. As legalconsideration, each Company paid the other cash of $250,000. The Company andArgus consummated the transaction through the exchange of common shares. TheCompany exchanged 71,225 shares of its common stock for 1,929,914 shares ofcommon stock of Argus Solutions Ltd., which represents approximately onepercent of the voting equity of Argus. In accordance with Statement ofFinancial Accounting Standards No. 153, “Exchange of Nonmonetary Assets,an amendment of APB Opinion No. 29”, the Company has recorded thistransaction as a nonmonetary exchange based on the fair value of the sharesexchanged as determined by the closing price of the Company’s shares on theAmerican Stock Exchange on the transaction date of $3.25 or $231,000.

 

Inaccordance with Statement of Financial Accounting Standards (“SFAS”) No. 115,“Accounting for Certain Investments in Debt and Equity Securities” and based onour intentions regarding these instruments, we classify marketable equitysecurities into trading or available-for-sale categories. Marketable securitiesthat are bought and held principally for the purpose of selling them in thenear term are classified as trading securities and are reported at fair value,with unrealized gains and losses recognized in earnings. Marketable securitiesnot classified as trading are classified as available-for-sale and are carriedat fair market value, with the unrealized gains and losses, net of tax,included in the determination of comprehensive income and reported inshareholders’ equity. Marketable equity securities are included in othernon-current 

 

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assets. The Companyreviews its marketable equity holdings in publicly-traded companies on aregular basis to determine if any security has experienced another-than-temporary decline in fair value. The Company considers the investeecompany’s cash position, earnings and revenue outlook, and stock priceperformance, among other factors, in its review. If it is determined that another-than-temporary decline exists in a marketable equity security, theCompany writes down the investment to its market value and records the relatedwrite-down as an investment loss in its Statement of Operations.

 

At December 31,2007, the Company wrote down to fair market value its remaining investment inArgus common stock.  The write-downamounted to $39,000 and was due to a decline in the fair value of the equitysecurity which, in the opinion of management, was considered to be other thantemporary.  The write-down is included inthe caption “Other income, net” in the accompanying Statement of Operations forthe twelve months ended December 31, 2007. At December 31, 2005, theCompany wrote down to fair market value its investment in Argus common stock. Thewrite-down amounted to $146,000 and was due to a decline in the fair value ofthe equity security which, in the opinion of management, was considered to beother than temporary. The write-down is included in the caption “Other income,net” in the accompanying Statement of Operations for the twelve months ended December 31,2005.

 

**6.****              Acquisition**

 

In December 2007,the Company entered into an agreement for the purchase of certain assets of SolLogic, Inc. (“Sol Logic”) pursuant to an Asset Purchase Agreement (the “AssetPurchase Agreement”).  The assets acquired include certain customercontracts, software licenses and intellectual property (collectively, the “AcquiredAssets”).  As a result of this asset acquisition, the Company expects tointegrate real-time voice recognition, multiple language translation and voiceanalytic capabilities into its biometric offerings.  The Asset Purchase Agreement containscustomary representations and warranties on behalf of Sol Logic.

 

In consideration for theacquisition of the Acquired Assets, the Company: (1) issued to Sol Logicon December 19, 2007 (the “Closing”) 935,089 shares of restricted commonstock of the Company (the “Initial Shares”), and (2) on June 19, 2008(the “Additional Issuance Date”) will issue to Sol Logic that number of sharesof restricted common stock (the “Additional Shares” and collectively with theInitial Shares, the “Shares”) equal to the quotient obtained by dividing$1,502,000 by the greater of (A) $1.633 and (B) the volume weightedaverage closing price of the Company’s common stock over the 20 trading-dayperiod ending on June 18, 2008, as reported on The American Stock Exchange(“AMEX”) or the Over-the-Counter Bullet Board (“OTCBB”).  Fifty percent ofthe Initial Shares and ten percent of the Additional Shares will be held inescrow until the one-year anniversary of the Closing.  The Company has recorded the obligation toissue the required number of shares on the Additional Issuance Date as acurrent liability in the accompanying Consolidated Balance Sheet as of December 31,2007 under the caption “Acquisition related obligation”.

 

The aggregate purchaseprice, not including direct transaction costs of $218,000, was approximately$3,171,000 and consisted of $147,000 in cash and other non-equity considerationof $45,000 and common stock valued at $2,979,000. The value of the 935,089common shares issued was determined based on the average market price of theCompany’s common shares over the 2-day period before and after the terms of theacquisition were consummated on December 19, 2007 in accordance with EITF99-12, “Determination of the Measurement Date for the Market Price of AcquirerSecurities Issued in a Purchase Business Combination”.

 

The following tablepresents the allocation of the acquisition cost, including professional feesand other related acquisition costs, to the assets acquired and liabilitiesassumed, based on their fair values:

 
| Property, plant  and equipment |   | $         | 42,000    |   |
|--------------------------------|--------|-----------|-----------|--------|
| Intangible  assets             |   | 2,311,000 |      |
| Goodwill                       |   | 1,036,000 |      |
| Total assets  acquired         |   | $         | 3,389,000 |   |

 

The following (unaudited)pro forma consolidated results of operations have been prepared as if theacquisition of Sol Logic, Inc. had occurred at January 1, 2006:

 

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| ** **                                           | ** ** | **December 31, 2007** | ** ** | **December 31, 2006** | ** ** |
|------------------------------------------------------|------------|---------------------------------|------------|---------------------------------|------------|
|                                                 |       | **(unaudited)**                 | ** ** | **(unaudited)**                 |       |
| Sales                                                |       | $                               | 8,902,000  |                            | $          | 10,611,000 |   |
| Net loss  available to common shareholders           |       | $                               | (6,960,000 | )                               | $          | (6,796,000 | ) |
| Net loss per  share available to common shareholders |       | $                               | (0.44      | )                               | $          | (0.47 | ) |

 

Thepro forma information is presented for informational purposes only and is notnecessarily indicative of the results of operations that actually would havebeen achieved had the acquisition been consummated as of that time, nor is itintended to be a projection of future results.

 

Asmore fully described in Note 20 to these consolidated financial statements, in March 2008,the Company and Sol Logic, Inc. agreed to amend the Asset PurchaseAgreement.  The Amendment providesthat in consideration for the Acquired Assets, the Company will adjust thenumber of shares issued to the Seller to 677,940 shares of restricted commonstock of the Company (the “Initial Shares”).  In addition to the InitialShares, the Company will issue to Sol Logic certain additional shares uponachievement of a milestone.  In the event the Company’s revenues oncertain specified products (the “Products”) equals or exceeds $3,000,000 forthe six-month period commencing on March 6, 2008 and ending on September 6,2008, the Company will issue to Sol Logic that number of shares of the Company’scommon stock (the “Additional Shares”) equal to (A) the quotient obtainedby dividing $1,008,224 by the greater of (i) the volume weighted averageclosing price of the Company’s common stock (“Common Stock”) over the 20trading-day period ending on the date immediately preceding the AdditionalIssuance Date and (ii) $1.10 (the “Additional Per Share Price”), anddeposit into an escrow account (“the Escrow Account”) that number of shares ofthe Company’s common stock (the “Escrow Shares”) equal to the quotient obtainedby dividing $913,700 by the Additional Per Share Price.  In the event theCompany does not achieve the $3,000,000 product revenue milestone, the revenuedetermination period will be extended and the Company will issue Sol Logic theAdditional Shares if the Company’s revenues on the Products equals or exceeds$5,000,000 for the 18-month period commencing on March 6, 2008 and endingon September 8, 2009.

 

The Company will recordthe provisions of the amended Asset Purchase Agreement during the first fiscalquarter of 2008.

 

**7.****                                      Sale ofBusinesses and Discontinued Operations**

 

On November 30,2006, the Company completed the sale of its entire Digital Photography (“PDI”)product line and inventory (the “PDI Products”) to an unaffiliated third partyfor a total of $400,000, including an initial cash payment of $25,000.  The purchaser is required to pay up to thefull remaining amount of $375,000 in a series of quarterly installments equalto 12.5% of all newly acquired sales and license revenues relating to the PDIproduct line (the “Percentage Payments”). Until such time when the Company has received the full purchase price of$400,000, during any 12-month period during which the aggregate PercentagePayments to the Company are less than $50,000, the purchaser will pay theCompany the difference between the Percentage Payments and $50,000.  This component of the Company’s business waspreviously classified as the Company’s Digital Photography segment.

 

The Company decided tosell this component because it has incurred significant operating losses ineach of the last five years and has lost significant market share in the lastthree years.  The assets sold consistedprimarily of a suite of software and related inventory including source,copyrights, trademarks, documentation and client base.

 

In 2007, the Companyrecognized a gain of approximately $50,000 from the disposal of this componentrepresenting the cash proceeds received less the value of net assets sold.  At December 31, 2007, the Company hasrecorded the fair value of the remaining amount due of $325,000 offset by afull valuation allowance due to the uncertainty of the ultimate collectibilityof such amounts. This determination was based upon the maximum repayment periodof 6.5 years of amounts owing the Company combined with the purchaser operatingin a highly competitive business environment evidenced by rapid technologicalchange.  Accordingly, the Company hasdeferred any remaining gain from the disposal of this component until such timeas the Company determines that the realization of the remaining amounts owed isreasonably assured.

 

Digital Photographysales, reported in discontinued operations, for the years ended December 31,2006 and 2005 were $176,000 and 345,000, respectively.  Digital Photography’s pretax loss, reportedin discontinued operations for the years ended December 31, 2006 and 2005were $408,000 and $1,881,000, respectively.

 

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Net assets sold of theDigital Photography component were inventory and equipment of $5,000.  All software related assets such as source,copyrights, trademarks, documentation and client base were either fully expensedor fully amortized and had a net carrying value of zero at the date of sale.

 

On March 3,2005, the Company sold its wholly-owned Singapore subsidiary, Digital ImagingAsia Pacific Pte. Ltd., for cash of $1,300,000, (the”DIAP transaction”). TheCompany decided to sell this subsidiary as part of its overall strategicpartnership with Argus Solutions Ltd (“Argus”), as a means of strengthening itsposition in the Asia-Pacific region. In conjunction with this strategy, theCompany entered into an International Distributor Agreement with Argus pursuantto which Argus will distribute the Company’s biometric engine, law enforcementand secure credential solutions in the Asia-Pacific region, excluding Japan andKorea, for a period of three years.

 

Inaccordance with SFAS 144, this subsidiary, previously included in the Company’sformer Identification segment, was treated as a discontinued operation. The netloss for this subsidiary for the twelve months ended December 31, 2005 isreflected in the Company’s Consolidated Statement of Operations as loss fromdiscontinued operations. Included in the 2005 loss results is a gain on sale ofsubsidiary of $233,000 net of direct transaction costs of $49,000 and includingthe allocation of $637,000 of goodwill.

 

Theassets and liabilities sold as part of the DIAP transaction included thefollowing:

 
| Cash                                            |   | $       | 41,000    |   |
|-------------------------------------------------|--------|---------|-----------|--------|
| Accounts  receivable                            |   | 80,000  |      |
| Inventories                                     |   | 242,000 |      |
| Prepaid expenses  and other current assets      |   | 18,000  |      |
| Property and  equipment, net                    |   | 17,000  |      |
| Goodwill                                        |   | 637,000 |      |
|                                            |   | $       | 1,035,000 |   |
|                                            |   |    |      |
| Accounts payable  and other current liabilities |   | $       | 17,000    |   |

 

DigitalImaging Asia Pacific’s sales, reported in discontinued operations, for thetwelve months ended December 31, 2005 were $42,000. Digital Imaging AsiaPacific’s pretax loss, reported in discontinued operations for the twelvemonths ended December 31, 2005, was $10,000.

 

Priorperiod financial statements for the twelve months ended December 31, 2005have been restated to present the operations of Digital Photography and DigitalImaging Asia Pacific as discontinued operations.

 

**8.****                                      Related Parties**

 

Subsequentto the Company’s sale of its wholly-owned subsidiary, Digital Imaging AsiaPacific Pte. Ltd., to Argus Solutions Ltd (“Argus’), as more fully described inNote 7 to these consolidated financial statements, the Company’s ChiefExecutive Officer accepted an invitation to become a member of Argus’ Board ofDirectors. Prior to the closing of the Company’s sale transaction with Argus,the Company had no material relationship with Argus Solutions.  Effective December 31, 2006, the Company’sChief Executive Officer resigned from the Argus Board.

 

**9.****                                      Inventory**

 

Inventoriesat December 31, 2007 were comprised of work in process of $29,000representing direct labor costs on in-process projects and finished goods of$101,000 net of reserves for obsolete and slow-moving items of $16,000.  Inventories at December 31, 2006consisted of finished goods of $58,000 net of reserves of $52,000. Appropriateconsideration is given to obsolescence, excessive levels, deterioration, andother factors in evaluating net realizable value and required reserve levels.

 

**10.****                               Property and Equipment**

 

Propertyand equipment at December 31, 2007 and 2006, consists of:

 

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| ** **                     | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|--------------------------------|------------|------------|------------|------------|------------|
| ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Equipment                      |       | $          | 1,411,000  |       | $          | 1,193,222 |   |
| Leasehold  improvements        |       | 149,020    |       | 131,057    |       |
| Furniture                      |       | 161,808    |       | 161,808    |       |
|                           |       | 1,721,828  |       | 1,486,087  |       |
| Less accumulated  depreciation |       | (1,433,839 | )          | (1,134,387 | )          |
|                           |       | $          | 287,989    |       | $          | 351,700 |   |

 

Totaldepreciation expense for the years ended December 31, 2007, 2006 and 2005was approximately $242,000, $230,000 and $307,000, respectively.

 

**11.****                               Accrued Liabilities**

 

**Principal components of accrued liabilities consist of:**

 
| ** **                   | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|------------------------------|------------|------------|------------|------------|------------|
| ** **                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Compensated  absences        |       | $          | 214,595    |       | $          | 236,161 |   |
| Wages and sales  commissions |       | 112,571    |       | 146,436    |       |
| Customer  deposits           |       | 266,801    |       | 212,945    |       |
| Liquidated  damages          |       | 279,896    |       | 279,896    |       |
| Royalties                    |       | 251,105    |       | 46,150     |       |
| Professional  fees           |       | 73,199     |       | 52,637     |       |
| Other                        |       | 142,780    |       | 164,493    |       |
|                         |       | 1,340,947  |       | $          | 1,138,718  |   |
|                              |            |            |            |            |            |  |  |

 

**12.****                               Notes Payable and Lineof Credit**

 

Notes payable consist ofthe following:

 
| ** **                                                                                                                                                                      | ** ** | **2007** | ** ** | **2006**   | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|------------|------------|
| Notes payable to third parties:                                                                                                                                                 |       |     |       |       |       |
| Senior secured  promissory notes to accrue interest at 8%. Face value of note $1,310,000. Discount  on note at December 31, 2006 is $212,622. Note due March 17, 2006 |       | —   |       | $          | 1,097,378  |   |
| Short-term note  payable to certain vendors                                                                                                                                     |       | —   |       | $          | —     |   |
| Total notes  payable to third parties                                                                                                                                           |       | —   |       | 1,097,378  |       |
|                                                                                                                                                                            |       |     |       |       |       |
| Total notes  payable                                                                                                                                                            |       | —   |       | $          | 1,097,378  |   |
| Less current  portion                                                                                                                                                           |       | —   |       | (1,097,378 | )          |
| Long-term notes  payable                                                                                                                                                        |       | —   |       | $          | —     |   |
|                                                                                                                                                                                 |            |          |            |            |            |  |  |  |

 

In March 2006,the Company completed a secured debt financing in the aggregate amount of$1,550,000, with net proceeds to Company approximating $1,452,000. The Companyissued a series of secured promissory notes (“the Notes”) aggregating$1,550,000 which bear interest at 8% per annum, with interest compoundedmonthly and payable quarterly. The principal balance becomes due in one year orearlier upon the occurrence of the following contractually defined events: (i) paymentsreceived by the Company in connection with contracts with Grupo Inffinix andArgus Solutions or any affiliate thereof, or any extension, renewal oramendment of such contracts; or (ii) payments made against any new contractsigned by the Company which contract amount is in excess of $1,500,000; or (iii) thereceipt by the Company of proceeds from the sale of equity or equity-linkedsecurities by the Company; or (iv) receipt of proceeds from the issuanceby the Company of any type of debt instruments, including lines of credit. Inaddition, the Company may prepay the notes in whole or in part uponfive days prior written notice.  As acondition to the loan, the Company entered into a security agreement wherebythe Company granted a security interest in all of the Company’s goods andequipment, inventory, contract rights and general intangibles, accounts orother obligations owing to the Company, and cash deposit accounts and otherinvestment property to secure payment of the note.

 

70

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Also acondition to the loan, the Company issued warrants to purchase 387,500 sharesof the Company’s common stock. Such warrants have a 5-year term and an exerciseprice $2.30 per share.  Common sharesunderlying the warrants have piggyback registration rights and cashlessexercise after 12 months from closing date if there is no effectiveregistration statement covering the underlying shares.

 

TheCompany initially recorded the secured debt financing net of a discount equalto the fair value allocated to the warrants using the relative fair valuemethod of approximately $419,000. The Company estimated the fair value of thewarrants using the Black-Scholes option pricing model and the followingassumptions: term of 5 years, a risk free interest rate of 4.52%, a dividendyield of 0%, and volatility of 82%.

 

Asmore fully discussed in Note 15 to these consolidated financial statements, in November andDecember 2006, the Company issued a total of 2,500 shares of its Series CPreferred Stock.  The issuance of Series Cpreferred stock triggered a Right of Acceleration included in the Notes.  As consideration for the note holders waivingthis Right of Acceleration, the Company issued 200,250 warrants to purchasecommon stock at an exercise price of $1.80 per share and reduced the exerciseprice of 387,500 warrants to purchase common stock from $2.30 per share to$1.80 per share.

 

TheCompany has calculated the fair value of the 200,250 warrants using theBlack-Scholes option pricing model with the following assumptions: risk freeinterest rate of 4.52%; dividend yield of 0%; volatility factor of the expectedmarket price of the Company’s common stock of 82%; and an expected life of thewarrant of 5 years.  The fair value ofthe warrants was approximately $175,000.

 

TheCompany has computed the fair value of the modification to the 387,500 warrantsto be approximately $28,000.  The Companycalculated the fair value of these warrants immediately before and after themodification using the Black-Scholes option pricing model with the followingassumptions: risk free interest rate of 4.52%; dividend yield of 0%; volatilityfactor of the expected market price of the Company’s common stock of 82%; andan expected life of the warrant of 5 years.

 

Thetotal of the fair value of the new warrants and the modification of existingwarrants of approximately $203,000 has been recorded as an increase to thediscount on the notes payable and an increase to additional paid incapital.  The discount will be amortizedover the remaining term of the notes.

 

Asmore fully described in Note 15 below, the issuance of the Series DPreferred Stock caused all amounts outstanding under the Senior SecuredPromissory Notes, due March 17, 2007 (the “Notes”) to become immediatelydue and payable in full.  As of March 9,2007 there was $1,196,259 in principal and $19,319 in accrued but unpaidinterest outstanding under the Notes. Upon receipt of the funds from the issuance of the Series D PreferredStock, the Company immediately repaid, in full, all outstanding principal andaccrued but unpaid interest due under the Notes, and the Notes have terminatedin their entirety. The remaining debt discount was amortized over the remainingterm of the note to the date the notes were repaid in full, resulting in theCompany recording approximately $213,000 of debt discount amortization duringthe twelve months ended December 31, 2007. During the twelve months ended December 31, 2006, the Company recordedapproximately $408,000 in debt discount amortization. These amortizationexpenses are included as a component of net interest expense in the Company’sConsolidated Statement of Operations.

 

**13.****                               Income Taxes**

 

Thesignificant components of the income tax provision (benefit) are as follows:

 

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| ** **   | ** ** | **December 31,** | ** ** |
|--------------|------------|-----------------------|------------|
| ** **   | ** ** | **2007**              | ** ** | **2006** | ** ** |
| **Current**  |       |                  |       |   |   |
| Federal      |       | $                     | —     |   | $ | — |   |
| State        |       | —                |       | — |   |
| Foreign      |       | —                |       | — |   |
|         |       |                  |       |   |   |
| **Deferred** |       |                  |       |   |   |
| Federal      |       | —                |       | — |   |
| State        |       | —                |       | — |   |
| Foreign      |       | —                |       | — |   |
|         |       |                  |       |   |   |
|         |       | $                     | —     |   | $ | — |   |

 

Theprincipal components of the Company’s deferred tax assets (liabilities) at December 31,2007 and 2006 are as follows:

 
| ** **                        | ** ** | **2007**    | ** ** | **2006**    | ** ** |
|-----------------------------------|------------|-------------|------------|-------------|------------|
|                              |       |        |       |        |       |
| Net operating  loss carryforwards |       | $           | 16,117,685 |        | $          | 14,779,554 |   |
| Intangible  Assets                |       | 713,288     |       | 761,466     |       |
| Stock based  compensation         |       | 426,340     |       | 283,319     |       |
| Reserves and  accrued expenses    |       | (3,668      | )          | 203,273     |       |
| Other                             |       | (46,372     | )          | (46,916     | )          |
|                              |       | 17,207,273  |       | 15,980,696  |       |
| Less valuation  allowance         |       | (17,207,273 | )          | (15,980,696 | )          |
|                              |       |        |       |        |       |
| Net deferred tax  assets          |       | $           | —     |        | $          | — |   |

 

Areconciliation of the provision (benefit) for income taxes to the amountcomputed by applying the statutory income tax rates to loss before income taxesis as follows:

 
| ** **                                      | ** ** | **2007**  | ** ** | **2006**  | ** ** |
|-------------------------------------------------|------------|-----------|------------|-----------|------------|
|                                            |       |      |       |      |       |
| Amounts computed  at statutory rates            |       | $         | (1,592,821 | )         | $          | (2,014,913 | ) |
| State income  tax, net of federal benefit       |       | (125,545  | )          | (224,438  | )          |
| Expiration of  net operating loss carryforwards |       | 485,383   |       | 382,645   |       |
| Federal research  and development credit        |       | —    |       | 513,013   |       |
| Other                                           |       | 6,106     |       | 6,824     |       |
| Net change in  valuation allowance              |       | 1,226,877 |       | 1,336,869 |       |
|                                            |       |      |       |      |       |
|                                            |       | $         | —     |      | $          | — |   |

 

TheCompany has established a valuation allowance against its deferred tax assetdue to the uncertainty surrounding the realization of such asset. Managementperiodically evaluates the recoverability of the deferred tax asset. At suchtime as it is determined that is more likely than not that deferred tax assetsare realizable, the valuation allowance will be reduced.

 

At December 31,2007 and 2006, the Company had federal net operating loss carryforwards ofapproximately $42,330,000 and $38,814,000, respectively, state net operatingloss carryforwards of approximately $29,576,000 and $27,126,000, respectively,which may be available to offset future taxable income for tax purposes.The federal net operating loss carryforwards expire at various dates from 2008through 2027. The state net operating loss carryforwards expire at variousdates from 2008 through 2017.

 

TheInternal Revenue Code (“the Code”) limits the availability of certain taxcredits that arose prior to certain cumulative changes in a corporation’sownership resulting in a change of control of the Company.  The Company has reduced its deferred taxassets to zero relating to its federal and state research credits because ofsuch limitations.

 

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TheCode also limits the availability of net operating losses that arose prior tocertain cumulative changes in a corporation’s ownership resulting in a changeof control of the Company. The Company’s use of its net operating losscarryforwards and tax credit carryforwards will be significantly limitedbecause the Company underwent “ownership changes” in 1991, 1995, 2000, 2003 and2004.

 

In June 2006, the FASB issued Interpretation No. 48,“Accounting for Uncertainty in Income Taxes, an interpretation of FASBStatement No. 109” (“FIN 48”), which clarifies the accounting foruncertainty in income taxes recognized in a company’s financial statements. Theinterpretation prescribes a recognition threshold and measurement attributecriteria for the financial statement recognition and measurement of anuncertain tax position taken or expected to be taken in a tax return. Theinterpretation also provides guidance on derecognition, classification,interest and penalties, accounting in interim periods, disclosure andtransition.

 

The Company adopted the provisions of FIN 48 on January 1,2007. The implementation of FIN 48 did not have a material impact on theCompany’s financial statements. At the adoption date on January 1, 2007,and as of December 31, 2007, the Company recorded no cumulative effectadjustments related to the adoption of FIN 48.

 

Upon adoption of FIN 48 on January 1, 2007, andas of December 31, 2007, the Company had no unrecognized tax benefits oraccruals for the potential payment or interest and penalties. For the twelvemonths ended December 31, 2007, no interest or penalties were recorded.

 

The Company files tax returns in the U.S. federaljurisdiction, and in various states and foreign jurisdictions. The Company isnot aware of any jurisdictions currently under examination by tax authorities.

 

**14.****          Commitments and Contingencies**

 

*Employment Agreements*

 

TheCompany has employment agreements with its Chief Executive Officer and SeniorVice President of Administration and Chief Financial Officer. The Companymay terminate the agreements with or without cause. Subject to theconditions and other limitations set forth in each respective employmentagreement, each executive will be entitled to the following severance benefitsif we terminate the executive’s employment without cause or in the event of aninvoluntary termination  (as defined inthe employment agreements) by us or by the executive: (i) a lump sum cashpayment equal to twenty-four months and twelve months of base salary,respectively; (ii) continuation of the executive’s fringe benefits andmedical insurance for a period of three years; and (iii) immediate vestingof 50% of each executive’s outstanding stock options and restricted stockawards. In the event that the executive’s employment is terminated within thesix months prior to or the thirteen months following a change of control (asdefined in the employment agreements), the executive is entitled to theseverance benefits described above, except that 100% of each executive’soutstanding stock options and restricted stock awards will immediately vest.Each executive’s eligibility to receive any severance payments or otherbenefits upon his termination is conditioned upon him executing a generalrelease of liability.

 

*Letter of Credit*

 

Ascollateral for performance on certain software installation and implementationcontracts, the Company is contingently liable under two irrevocable standbyletters of credit in an aggregate amount of approximately $169,000. The lettersof credit expire on March 30, 2008 in the amount of $37,000 and on December 26,2008 in the amount of $132,000. As a condition to the letter of credit expiringon December 26, 2008, the bank requires the Company to invest an equalamount in the form of certificate of deposit. As of December 31,2007, there were no drawings against the outstanding balances. This certificateof deposit is included as a component of other current assets in the Company’sConsolidated Balance Sheets at December 31, 2007 and as a component ofnoncurrent other assets at December 31, 2006.

 

*Litigation*

 

TheCompany is involved in certain legal proceedings generally incidental to itsnormal business activities. While the outcome of such proceedings cannot beaccurately predicted, the Company does not believe the ultimate resolution ofany such existing matters should have a material effect on its financialposition, results of operations or cash flows.

 

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*Leases*

 

TheCompany currently leases office and research and development space underoperating leases which expire at various dates through December 2009.

 

At December 31,2007, future minimum lease payments are as follows:

 
| 2008   |   | $ | 492,000 |   |
|--------|--------|---|---------|--------|
| 2009   |   | $ | 158,000 |   |
| 2010   |   | $ | —  |   |
| 2011   |   | $ | —  |   |
| 2012   |   | $ | —  |   |
|   |   | $ | 650,000 |   |

 

Rentalexpense from continuing operations incurred under operating leases for theyears ended December 31, 2007, 2006 and 2005, was approximately $579,000,$562,000 and $750,000 respectively. Rent expense for the year 2005 containsapproximately $124,000 in accrued for exit activity costs related to theclosure of our office in Stuttgart, Germany.

 

*Registration Payment Arrangements*

 

On September 25, 2007, the Company sold tocertain accredited investors a total of 2,016,666 shares of the Company’scommon stock, par value $0.01 per share, at a purchase price of $1.50 per sharefor aggregate gross proceeds of $3,025,003 (the “Common Stock Financing”). Aspart of the Common Stock Financing, the Company entered into a RegistrationPayment Arrangement as defined by FASB Staff Position No. EITF 00-19-2, “Accountingfor Registration Payment Arrangements” (“EITF 00-19-2”).  EITF 00-19-2 specifies that the contingentobligation to make future payments orotherwise transfer consideration under a registration payment arrangementshould be separately recognized and measured in accordance with SFAS No. 5“Accounting for Contingencies” (“SFAS No. 5”). EITF 00-19-2 is effectivefor registration payment arrangements entered into after December 21, 2006or for the fiscal year beginning after December 15, 2006.  The Company determined that no losscontingency related to the Common Stock Financing registration paymentarrangement was required to be recorded as of December 31, 2007.

 

As part of the September 25, 2007 Common Stockregistration payment arrangement, the Company agreed to register the shares ofcommon stock issued in the financing and the shares of common stock underlyingthe warrants issued to the investors in the Common Stock Financing with the SECwithin certain contractually specified time periods.  The Company also agreed to use its bestefforts to keep the registration statement continuously effective until theearlier of either the second year after the date the registration statement isdeclared effective by the SEC or the date when all the common stock, includingthe common stock underlying the warrants have been sold or may be sold withoutvolume limitations.  If the Company isunable to register the shares of common stock with the SEC or keep the registrationstatement continuously effective in accordance with the Securities PurchaseAgreement dated September 25, 2007, between the Company and certainaccredited investors, the Company is subject to a liquidated damages penaltyequal to 1% of the aggregate purchase price paid for each month theregistration statement is not effective, provided that such liquidated damagesshall not exceed 12% of the aggregate purchase price.  The maximum exposure at December 31,2007 is approximately $363,000. The Company has met the requirements of theCommon Stock Financing registration payment arrangement by filing the requiredregistration statement with the SEC within the time frame specified by theagreement.  Company management believesthat it will be able to maintain current filing status with the SEC over theprescribed period.

 

On March 9, 2007, the Company entered into aSecurities Purchase Agreement with certain accredited investors pursuant towhich the Company sold to the investors an aggregate of 1,500 shares of theCompany’s Series D 8% Convertible Preferred Stock (the “Series DPreferred Stock”) at a stated value of $1,000 per share for aggregate grossproceeds of $1,500,000 and issued to the investors warrants to purchase up toan aggregate of 59,207 shares of common stock of the Company.  As part of the Series D Preferred Stockfinancing, the Company entered into a Registration Payment Arrangement asdefined by FSP No. EITF 00-19-2. EITF 00-19-2 specifies that the contingent obligation to make future payments or otherwise transfer consideration undera registration payment arrangement should be separately recognized andmeasured in accordance with SFAS No. 5. EITF 00-19-2 is effective forregistration payment arrangements entered into after December 21, 2006 orfor the fiscal year beginning after December 15, 2006.  The Company determined that no losscontingency 

 

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related to the Series D Preferred Stockregistration payment arrangement was required to be recorded as of December 31,2007.

 

As part of the Series D Preferred Stockregistration payment arrangement, the Company agreed to register the shares ofcommon stock the Series D Preferred Stock is convertible into and theshares of common stock underlying the warrants issued to the investors in the Series DPreferred Stock financing with the SEC within certain contractually specifiedtime periods.  The Company also agreed touse its best efforts to keep the registration statement continuously effectiveuntil the earlier of either the fifth year after the date the registrationstatement is declared effective by the SEC or the date when all the commonstock, including the common stock underlying the warrants have been sold.  If the Company is unable to register theshares of common stock with the SEC or keep the registration statementcontinuously effective in accordance with the Securities Purchase Agreementdated March 9, 2007, between the Company and certain accredited investors,the Company is subject to a liquidated damages penalty equal to 1% of theaggregate purchase price paid for each month the registration statement is noteffective, provided that such liquidated damages shall not exceed 12% of theaggregate purchase price.  The maximumexposure at December 31, 2007 is approximately $180,000. The Company hasmet the requirements of the Series D Preferred Stock registration paymentarrangement by filing the required registration statement with the SEC withinthe time frame specified by the agreement.  Company management believes that it will beable to maintain current filing status with the SEC over the prescribed period.

 

In November and December of 2006, theCompany entered into a Securities Purchase Agreement with certain accreditedinvestors to which the Company sold to the investors an aggregate of 2,500shares of the Company’s Series C 8% Convertible Preferred Stock (the “Series CPreferred Stock”) at a stated value of $1,000 per share for aggregate grossproceeds of $2,500,000 and issued to the investors warrants to purchase up toan aggregate of 125,000 shares of the Company’s common stock. As part of the Series CPreferred Stock financing consummated in November and December of2006, the Company entered into a Registration Payment Arrangement as defined byEITF 00-19-2.  EITF 00-19-2 specifiesthat the contingent obligation to make future payments or otherwise transferconsideration under a registration payment arrangement should be separatelyrecognized and measured in accordance with SFAS No. 5, “Accounting forContingencies”.   EITF 00-19-2 iseffective for registration payment arrangements entered into after December 21,2006 or for the fiscal year beginning after December 15, 2006, howeverearly adoption is permitted for interim or annual periods for which financialstatements have not been issued.  TheCompany adopted the provisions of FSP EITF 00-19-2 for the annual period endingDecember 31, 2006.  The Companydetermined that no loss contingency related to the Series C PreferredStock registration payment arrangement was required to be recorded as of December 31,2007.

 

As part of the Series C Preferred Stockregistration payment arrangement, the Company agreed to register the shares ofcommon stock the Series C Preferred Stock is convertible into and theshares of common stock underlying the warrants issued to the Series Cinvestors with the SEC within certain contractually specified timeperiods.  The Company also agreed to useits best efforts to keep the registration statement continuously effectiveuntil the earlier of either the fifth year after the date the registrationstatement is declared effective by the SEC or the date when all the commonstock, including the common stock underlying the warrants have been sold.  If the Company is unable to register theshares of common stock with the SEC or keep the registration statementcontinuously effective in accordance with the Securities Purchase Agreementdated November 14, 2006, between the Company and certain accreditedinvestors,  the Company is subject to aliquidated damages penalty equal to 1% of the aggregate purchase price paid foreach month the registration statement is not effective, provided that suchliquidated damages shall not exceed 12% of the aggregate purchase price.  The maximum exposure at December 31,2007 is approximately $300,000. The Company has met the requirements of the Series CPreferred Stock registration payment arrangement by registering the shares ofcommon stock with the SEC within the time frame specified by the agreement andhas kept the registration continuously effective thereafter.  Company management believes that it will beable to maintain current filing status with the SEC over the prescribed period.

 

**15.****                               Equity**

 

TheCompany’s Articles of Incorporation were amended effective August 31, 1994and authorize the issuance of two classes of stock to be designated “CommonStock” and “Preferred Stock,” provide that both Common and Preferred Stockshall have a par value of $.01 per share and authorize the Company to issue50,000,000 shares of Common Stock and 4,000,000 shares of Preferred Stock. ThePreferred Stock may be divided into such number of series and withthe rights, preferences, privileges and restrictions as the Board of Directorsmay determine.

 

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*Series B Convertible, Redeemable Preferred Stock*

 

In April 1995,the Company’s Articles of Incorporation were amended to authorize 750,000shares of Series B Convertible Redeemable Preferred Stock (“Series B”).Each 5.275 shares of Series B are convertible into one share of theCompany’s common stock.

 

Theholders of Series B are entitled to cumulative preferred dividends payableat the rate of $.2125 per share per annum commencing April 30, 1996,subject to legally available funds. The Series B plus accrued but unpaiddividends are convertible at the option of the holder into shares of commonstock at a conversion price equal to the original Series B issue price asadjusted to prevent dilution. The Series B will automatically be convertedinto shares of common stock upon the closing of an underwritten public offeringat a price per common share of not less than $31.65. If the public offeringprice is less than $31.65 but at least $21.10 per share, the conversion shallstill be automatic upon written consent of a majority of the then outstandingshareholders of Series B.

 

Theholders of Series B, on an as-converted basis, have the same voting rightsper share as the Company’s common shares; provided, that the holders of Series Bhas a special right to elect one director if the Company defaults in thepayment of any dividend to the holders of Series B. The holders of Series Bare entitled to initial distributions of $2.50 per share of Series Boutstanding, upon liquidation and in preference to common shares and any otherseries of preferred stock plus all accrued but unpaid dividends.

 

Anytime after December 31, 2000, the Company has the right to redeem all orsome of the outstanding shares of Series B at a price equal to theoriginal issue price, plus all accrued but unpaid dividends.

 

TheCompany had 239,400 shares of Series B outstanding as of December 31,2007 and 2006.  At December 31, 2007and 2006, the Company had cumulative undeclared dividends of approximately$9,000.

 

Duringthe twelve months ended December 31, 2006, 10,000 shares of Series Bwere converted into 1,895 shares of the Company’s common stock.  There were no conversions during thecorresponding period in 2007.

 

*Series C Convertible, Non-Redeemable Preferred Stock*

 

In November 2006,the Company’s Articles of Incorporation were amended to authorize 3,500 sharesof Series C Convertible Preferred Stock (“Series C”). Each share of Series Chas a par value of $0.01, a stated value of $1,000 and is convertible into666.66 shares of the Company’s common stock. The Series C preferred stock does not have voting rights.

 

Theholders of Series C are entitled to receive cumulative dividends, at theoption of the Company, (i) in common stock upon conversion of the Series Cpreferred stock, or (ii) in cash after the payment of cash dividends tothe holders of Series B Preferred Stock at the rate per share (as apercentage of the stated value per share) of 8% per annum.

 

Theholders of Series C are entitled to initial distributions of $1,000 pershare of Series C outstanding, upon liquidation and in preference tocommon shares and any other series of preferred stock with the exceptionof Series B Preferred Stock, plus all accrued but unpaid dividends.

 

TheCompany had 2,200 and 2,500 shares of Series C outstanding as of December 31,2007 and 2006, respectively.  At December 31,2007 and 2006, the Company had cumulative undeclared dividends of approximately$234,000 and $25,000.

 

Duringthe twelve months ended December 31, 2007, 300 shares of Series Cwere converted into 206,778 shares of the Company’s common stock.  There were no conversions during thecorresponding period in 2006.

 

*Series D Convertible, Non-Redeemable Preferred Stock*

 

In March 2007, the Company’sArticles of Incorporation were amended to authorize 2,000 shares of Series D8% Convertible Preferred Stock (“Series D Preferred Stock”). Each share ofSeries D Preferred Stock has a parvalue of $0.01, a statedvalue of $1,000 and is convertible into the Company’s common stockat an initial conversion price of $1.90 per share. The Series D PreferredStock does not have voting rights.

 

TheCompany had 1,388 and 0 shares of Series D outstanding as of December 31,2007 and 2006, respectively.  At December 31,2007 and 2006, the Company had cumulative undeclared dividends of approximately$98,000 and $0.

 

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Duringthe twelve months ended December 31, 2007, 112 shares of Series Dwere converted into 79,248 shares of the Company’s common stock.  There were no conversions during thecorresponding period in 2006.

 

In conjunction with the issuance of the Series DPreferred Stock, the Company issued warrants to the holders of the Series DPreferred Stock to purchase 59,207 shares of the Company’s common stock at$2.33 per share. These warrants have been classified as equity instruments onthe balance sheet.  The proceeds from theSeries D Preferred Stock financing were allocated to the warrants and the Series DPreferred Stock based on the relative fair value of each on the date ofissuance.  This allocation processresulted in the initial recognition of a discount attributable to an embeddedbeneficial conversion feature of approximately $344,000.  The discount was amortized over the minimumperiod from the date of issuance to the date at which the preferredshareholders are permitted to convert as a dividend to the Series DPreferred Stock shareholders.

 

The issuance of common stock and warrants pursuant tothe Common Stock Financing triggered certain antidilution clauses in theCompany’s Series D Preferred Stock agreement. As a result of theseantidilution clauses, the Company wasrequired to adjust the conversion price of the Series D Preferred Stockfrom $1.90 per share to $1.50 per share. This antidilution feature will cause an additional 210,528 common sharesto be issued upon conversion of the Series D Preferred Stock into commonstock. In accordance with EITF Issue 00-27, “Application of Issue No. 98-5to Certain Convertible Instruments”, this antidilution feature resulted in theadditional recognition of a discount attributable to an embedded beneficialconversion feature of approximately $470,000. This discount was amortized over the minimum period from the date of theconversion price adjustment to the date at which the preferred shareholders arepermitted to convert as a dividend to the Series D Preferred Stockshareholders.

 

*CommonStock*

 

On September 25, 2007, the Company sold tocertain accredited investors a total of 2,016,666 shares of the Company’scommon stock, par value $0.01 per share, at a purchase price of $1.50 per sharefor aggregate gross proceeds of $3,025,003 (the “Common Stock Financing”).

 

In conjunction with the issuance of the common stock,the Company issued to the investors warrants (the “Investor Warrants”) topurchase up to an aggregate of 1,008,333 shares of Common Stock with anexercise price of $1.67 per share. The Investor Warrants have been classifiedas equity instruments on the balance sheet in accordance with the provisions ofEmerging Issues Task Force (“EITF”) Issue 00-19, “Accounting for DerivativeFinancial Instruments Indexed to, and Potentially Settled in, a Company’s OwnStock”.

 

The issuance of common stock and warrants pursuant tothe Common Stock Financing triggered certain antidilution and exercise pricereduction clauses in existing warrant agreements. As a result of thesemodifications, the Company was required toissue an additional 113,834 warrants and reduce the exercise price ofcertain previously issued warrants. As these warrants were classified aspermanent equity, and the adjustment was related to antidilution featureswithin these financial instruments, this increase in warrants and reduction ofexercise price resulted in no adjustment to the financial statements.

 

As compensation to the placement agent for the CommonStock Financing, the Company paidapproximately $212,000 in placement agent fees and agreed to reimburseup to $25,000 of placement agent legal expense incurred in connection with thisfinancing.  In addition, the Companyissued the placement agent for the financing, and certain of its affiliates, a5.5 year warrant (the “Placement Agent Warrants”) to purchase up to anaggregate of 151,249 shares of Common Stock on the same terms and conditionsincluded in the Investor Warrants. The cash payment has been recorded asadjustment to additional paid in capital as a reduction of net proceeds.  The Placement Agent Warrants have beenclassified as equity instruments on the balance sheet.

 

During twelve monthperiods ended December 31, 2007 and 2006, the Company issued 63,240 and144,588 shares of its common stock, respectively, pursuant to stock-basedcompensation agreements with certain employees. During the twelve months ended December 31, 2007 the Company issued206,778 shares of its common stock pursuant to the conversion of 300 shares of Series CPreferred Stock and issued 79,248 shares of its common stock pursuant to theconversion of 112 shares of Series D Preferred Stock.  During the twelve months ended December 31,2006 the Company issued 1,895 shares of its common stock pursuant to theconversion of 10,000 shares of Series B Preferred Stock.

 

During the twelve monthsended December 31, 2007, the Company issued 795,956 shares of its commonstock pursuant to the exercise of common stock purchase warrants.  The Company received gross proceeds ofapproximately $1,121,000 from these warrant exercises.

 

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In December 2007,the Company issued 935,089 shares of its common stock pursuant to itsacquisition of substantially all the assets of Sol Logic, Inc.

 

During the twelve monthsended December 31, 2007, 300 shares of Series C were converted into206,778 shares of the Company’s common stock. During the twelve months ended December 31, 2007, 112 shares of Series Dwere converted into 79,248 shares of the Company’s common stock.

 

*Warrants*

 

As of December 31,2007, warrants to purchase 5,955,830 shares of common stock at prices rangingfrom $1.43 to $5.48 were outstanding. All warrants are exercisable as of December 31,2007, and expire at various dates through March 2013.

 

**The following table summarizes warrant activity for the following periods:**

 
| ** **                             | ** ** | **Warrants**  | ** ** | **Weighted- Average   Exercise Price** | ** ** |
|----------------------------------------|------------|---------------|------------|-------------------------------------------------------|------------|
|                                   |       |          |       |                                                  |       |
| **Balance  at December 31, 2005** | ** ** | **4,293,305** | ** ** | **$**                                                 | **2.94**   | ** ** |
| **Granted**                            | ** ** | **1,527,844** | ** ** | **$**                                                 | **1.70**   | ** ** |
| **Expired  / Canceled**                | ** ** | **0**         | ** ** | **$**                                                 | **0**      | ** ** |
| **Exercised**                          | ** ** | **(0**        | **)**      | **$**                                                 | **0**      | ** ** |
| **Balance  at December 31, 2006** | ** ** | **5,821,149** | ** ** | **$**                                                 | **2.37**   | ** ** |
| **Granted**                            | ** ** | **1,286,776** | ** ** | **$**                                                 | **1.34**   | ** ** |
| **Expired  / Canceled**                | ** ** | **(224,998**  | **)**      | **$**                                                 | **3.16**   | ** ** |
| **Exercised**                          | ** ** | **(927,097**  | **)**      | **$**                                                 | **1.59**   | ** ** |
| **Balance  at December 31, 2007** | ** ** | **5,955,830** | ** ** | **$**                                                 | **2.24**   | ** ** |

 

The following tablesummarized information about warrants outstanding and exercisable at December 31,2007:

 
| **Exercise Price** | ** ** | **Number   Outstanding** | ** ** | **Weighted—Average   Remaining Life  (Years)** | ** ** | **Weighted—Average   Exercise Price** | ** ** |
|-------------------------|------------|-------------------------------|------------|---------------------------------------------------------------|------------|------------------------------------------------------|------------|
|                    |       |                          |       |                                                          |       |                                                 |       |
| $                       | 1.43       |                          | 75,149     |                                                          | 2.0        |                                                 | $          | 1.43 |   |
|                    |       |                          |       |                                                          |       |                                                 |       |
| $                       | 1.50       |                          | 2,292,982  |                                                          | 2.3        |                                                 | $          | 1.50 |   |
|                    |       |                          |       |                                                          |       |                                                 |       |
| $                       | 1.67       |                          | 1,159,582  |                                                          | 5.2        |                                                 | $          | 1.67 |   |
|                    |       |                          |       |                                                          |       |                                                 |       |
| $                       | 1.83       |                          | 29,070     |                                                          | 0.9        |                                                 | $          | 1.83 |   |
|                    |       |                          |       |                                                          |       |                                                 |       |
| $                       | 2.14       |                          | 344,951    |                                                          | 0.9        |                                                 | $          | 2.14 |   |
|                    |       |                          |       |                                                          |       |                                                 |       |
| $                       | 2.40       |                          | 381,737    |                                                          | 0.9        |                                                 | $          | 2.40 |   |
|                    |       |                          |       |                                                          |       |                                                 |       |
| $                       | 2.58       |                          | 473,824    |                                                          | 0.9        |                                                 | $          | 2.58 |   |
|                    |       |                          |       |                                                          |       |                                                 |       |
| $                       | 2.97       |                          | 635,767    |                                                          | 2.6        |                                                 | $          | 2.97 |   |
|                    |       |                          |       |                                                          |       |                                                 |       |
| $                       | 4.66       |                          | 63,012     |                                                          | 1.1        |                                                 | $          | 4.66 |   |
|                    |       |                          |       |                                                          |       |                                                 |       |
| $                       | 5.48       |                          | 499,756    |                                                          | 1.1        |                                                 | $          | 5.48 |   |
|                    |       |                          |       |                                                          |       |                                                 |       |
|                    |       | 5,955,830                     |       |                                                          |       |                                                 |       |

 

In conjunction with the Common Stock Financing, theCompany issued to the investors warrants (the “Investor Warrants”) to purchaseup to an aggregate of 1,008,333 shares of Common Stock with an exercise priceof $1.67 per share. The Investor Warrants have been classified as equityinstruments on the balance sheet in accordance with the provisions of 

 

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Emerging Issues Task Force (“EITF”) Issue 00-19, “Accountingfor Derivative Financial Instruments Indexed to, and Potentially Settled in, aCompany’s Own Stock”.

 

The issuance of common stock and warrants pursuant tothe Common Stock Financing triggered certain antidilution and exercise pricereduction clauses in existing warrant agreements. As a result of thesemodifications, the Company was required to issue an additional 67,987 warrantsand reduce the exercise price of certain previously issued warrants. As thesewarrants were classified as permanent equity, and the adjustment was related toantidilution features within these financial instruments, this increase inwarrants and reduction of exercise price resulted in no adjustment to thefinancial statements.

 

As partial compensation to the placement agent for theCommon Stock Financing, the Company issued the placement agent for thefinancing, and certain of its affiliates, a 5.5 year warrant (the “PlacementAgent Warrants”) to purchase up to an aggregate of 151,249 shares of CommonStock on the same terms and conditions included in the Investor Warrants. Thecash payment has been recorded as adjustment to additional paid in capital as areduction of net proceeds.  The PlacementAgent Warrants have been classified as equity instruments on the balance sheet.

 

In conjunction with the issuance of the Series DPreferred Stock, the Company issued warrants to the holders of the Series DPreferred Stock to purchase 59,207 of the Company’s common stock at $2.33 pershare.  These warrants have beenclassified as equity instruments on the balance sheet.

 

In 2007, the holders of the Company’s common stockwarrants exercised 927,097 warrants in a combination of cash exercised andcashless exercises pursuant to which the Company issued 795,956 shares of itscommon stock.

 

**16.****                               StockOption Plans**

 

On August 31, 1994,the directors of the Company adopted the Company’s 1994 Employee Stock OptionPlan (the “1994 Plan”) and the 1994 Nonqualified Stock Option Plan (the “NonqualifiedPlan”). The 1992 Stock Option Plan and options previously granted were canceledby the Board of Directors.

 

The 1994 Plan originallyprovided for officers and other key employees to receive nontransferableincentive stock options to purchase up to 170,616 shares of the Company’scommon stock. The number of stock options issued and outstanding and the numberof stock options remaining available for future issuance are shown in the tablebelow. The option price per share must be at least equal to 100% of the marketvalue of the Company’s common stock on the date of grant and the termmay not exceed ten years.

 

The Nonqualified Planoriginally provided for directors and consultants to receive nontransferableoptions to purchase up to 18,957 shares of the Company’s common stock. Thenumber of options issued and outstanding and the number of options remainingavailable for future issuance are shown in the table below. The option priceper share must be at least equal to 85% of the market value of the Company’scommon stock on the date of grant and the term may not exceed five years.

 

Both the 1994 Plan andthe Nonqualified Plan are administered by the Board of Directors or a Committeeof the Board which determines the employees, directors or consultants whichwill be granted options and the terms of the options, including vestingprovisions which to date has been over a three year period. Both the 1994 Planand the Nonqualified Plan expired on August 31, 2004.

 

On December 17, 1999,the Company’s Board of Directors adopted the ImageWare Systems, Inc.Amended and Restated 1999 Stock Option Plan (the “1999 Plan”). Under the termsof the 1999 Plan, the Company could, originally, issue up to 350,000non-qualified or incentive stock options to purchase common stock of theCompany. The number of options issued and outstanding and the number of optionsremaining available for future issuance are shown in the table below. The 1999Plan has substantially the same terms as the 1994 Employee Stock Option Planand the 1994 Nonqualified Stock Option Plan and expires on December 17,2009.

 

On September 12,2001, the Company’s Board of Directors approved adoption of the 2001 EquityIncentive Plan (the “2001 Plan”). Under the terms of the 2001 Plan, the Companymay issue stock awards to employees, directors and consultants of theCompany, and such stock awards may be given for non-statutory stockoptions (options not intended to qualify as an “incentive stock option” withinthe meaning of Section 422 of the Internal Revenue Code of 1986, as amended),stock bonuses, and rights to acquire restricted stock. The Company originallyreserved 1,000,000 shares of its common stock for issuance under the 2001 Plan.The number of options issued and outstanding and the number of optionsremaining 

 

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available for future issuance are shown in the table below.

 

The 2001 Plan isadministered by the Board of Directors or a Committee of the Board as providedin the 2001 Plan. Options granted under the 2001 Plan shall not be less than85% of the market value of the Company’s common stock on the date of the grant,and, in some cases, may not be less than 110% of such fair market value.The term of options granted under the 2001 Plan as well as their vesting aredetermined by the Board and to date, options have been granted with a ten yearterm and vesting over a three year period. While the Board may suspend orterminate the 2001 Plan at any time, if not terminated earlier, it willterminate on the day before its tenth anniversary of the date of adoption.

 

On June 7, 2005, theshareholders approved the Amendment and Restatement of the 1999 Stock AwardPlan. Key changes that were made to the plan in the amendment and restatementincluded:

 

·                                          We increasedthe share reserve of the amended and restated 1999 plan by 883,000 shares ofour common stock. This number consists of an increase in the share reserve of800,000 of our shares of common stock and 83,000 shares of our common stockthat were reserved and available for grants under the 2001 Equity IncentivePlan, which we refer to as the 2001 plan. Prior to amendment, the 1999 plan had350,000 shares reserved for issuance under the 1999 plan.

 

·                                          Any sharesnot issued in connection with awards outstanding under the 2001 plan or the1994 Employee Stock Option Plan (which we refer to as the 1994 plan) on June 7,2005, will become available for issuance under the amended and restated 1999plan.

 

·                                          Any sharesnot issued in connection with awards granted under the 1999 plan, will becomeavailable for issuance under the amended and restated 1999 plan.

 

·                                          The amendedand restated 1999 plan prohibits the grant of stock option or stockappreciation right awards with an exercise price less than fair market value ofCommon Stock on the date of grant.

 

·                                          The amendedand restated 1999 plan also generally prohibits the “re-pricing” of stockoptions or stock appreciation rights, although awards may be bought outfor a payment in cash or our stock.

 

·                                          The amended andrestated 1999 plan permits the grant of stock based awards other than stockoptions, including the grant of “full value” awards such as restricted stock,stock units and performance shares.

 

·                                          The amendedand restated 1999 plan permits the qualification of awards under the plan(payable in either stock or cash) as “performance-based compensation” withinthe meaning of Section 162(m) of the Internal Revenue Code.

 

On November 9,2007, the Company’s Board of Directors approved an amendment to the 1999 Plan,subject to shareholder approval, pursuant to which an additional 1,000,000shares would be reserved for issuance under the plan.  In December 2007, the Company’sshareholders approved this amendment resulting in 1,000,000 shares being addedto the 1999 Plan.

 

# StockOption PlansAs of December 31, 2007

 

| ** **         | ** ** | **Number of securities to be  issued upon exercise of   outstanding options ****(a)** | ** ** | **Number of securities   remaining available for   future issuance under equity   compensation plans  (excluding securities   reflected in column (a))** | ** ** |
|--------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| 1994 Plan          |       | 23,750                                                                                                                                  |       | -0-                                                                                                                                                                                                                                      |       |
| Nonqualified  Plan |       | —                                                                                                                                  |       | -0-                                                                                                                                                                                                                                      |       |
| 1999 Plan          |       | 1,377,698                                                                                                                               |       | 1,037,255                                                                                                                                                                                                                                |       |
| 2001 Plan          |       | 344,904                                                                                                                                 |       | -0-                                                                                                                                                                                                                                      |       |
| Total              |       | 1,746,352                                                                                                                               |       | 1,037,255                                                                                                                                                                                                                                |       |

 

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The following tablesummarizes employee stock option activity since December 31, 2004:

 
| ** **                         | ** ** | **Options** | ** ** | **Weighted-  Average  Exercise Price** | ** ** |
|------------------------------------|------------|-------------|------------|---------------------------------------------|------------|
|                               |       |        |       |                                        |       |
| Balance at  December 31, 2004 |       | 894,359     |       | $                                           | 2.72       |   |
| Granted                            |       | 677,300     |       | $                                           | 2.59       |   |
| Expired/canceled                   |       | (71,282     | )          | $                                           | 2.32       |   |
| Exercised                          |       | (26,284     | )          | $                                           | 2.38       |   |
|                               |       |        |       |                                        |       |
| Balance at  December 31, 2005 |       | 1,474,093   |       | $                                           | 2.68       |   |
| Granted                            |       | 363,000     |       | $                                           | 1.90       |   |
| Expired/canceled                   |       | (233,929    | )          | $                                           | 3.17       |   |
| Exercised                          |       | —      |       | $                                           | —     |   |
|                               |       |        |       |                                        |       |
| Balance at  December 31, 2006 |       | 1,603,164   |       | $                                           | 2.45       |   |
|                               |       |        |       |                                        |       |
| Granted                            |       | 165,250     |       | $                                           | 2.38       |   |
| Expired/canceled                   |       | (103,206    | )     | $                                           | 2.58       |   |
| Exercised                          |       | —      |       | $                                           |       |   |
|                               |       |        |       |                                        |       |
| Balance at  December 31, 2007 |       | 1,665,208   |       | $                                           | 2.44       |   |
|                                    |            |             |            |                                             |            |  |  |

 

At December 31,2007, a total of 1,212,753 options were exercisable at a weighted average priceof $2.50 per share. At December 31, 2006, a total of 810,527 options wereexercisable at a weighted average price of $2.66 per share. At December 31,2005, a total of 624,163 options were exercisable at a weighted average priceof $2.87 per share.

 

The intrinsic value ofoptions exercised during the twelve months ended December 31, 2007, 2006and 2005 were $0, $0, and $22,000, respectively. The intrinsic value of optionsexercisable at December 31, 2007, 2006 and 2005 was $0.

 

The following tablesummarizes information about employee stock options outstanding and exercisableat December 31, 2007:

 
| ** **              | ** ** | **Options Outstanding**  | ** ** | ** **                                                       | ** ** | **Options Exercisable**                | ** ** |
|-------------------------|------------|-------------------------------|------------|------------------------------------------------------------------|------------|---------------------------------------------|------------|
| **Exercise Price** | ** ** | **Number   Outstanding** | ** ** | **Weighted-   Average  Remaining Life   (Years)** | ** ** | **Weighted-  Average  Exercise Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted-  Average  Exercise Price** | ** ** |
|                    |       |                          |       |                                                             |       |                                        |       |   |   |   |   |
| $ 1.65 - 1.71      |       | 167,750                       |       | 8.5                                                              |       | $                                           | 1.66       |   | 77,834 |   | $ | 1.67 |   |
| $ 1.97 – 2.15 |       | 226,000                       |       | 6.7                                                              |       | $                                           | 2.01       |   | 163,515 |   | $ | 2.02 |   |
| $ 2.20 – 2.45 |       | 503,304                       |       | 7.3                                                              |       | $                                           | 2.36       |   | 440,688 |   | $ | 2.36 |   |
| $ 2.62 – 2.74 |       | 565,000                       |       | 7.8                                                              |       | $                                           | 2.60       |   | 337,562 |   | $ | 2.63 |   |
| $ 3.00 – 6.51 |       | 203,154                       |       | 4.5                                                              |       | $                                           | 3.32       |   | 193,154 |   | $ | 3.32 |   |
| **Total**               | ** ** | **1,665,208**                 | ** ** | ** **                                                       |       |                                        |       | **1,212,753** |   |   |   |

 

The weighted-averagegrant-date fair value per share of options granted to employees during theyears ended December 31, 2007 and 2006 was $1.48 and $1.38, respectively.

 

**17.****          Employee Benefit Plan**

 

During 1995, the Companyadopted a defined contribution 401(k) retirement plan (the “Plan”). AllU.S. based employees aged 21 years and older are eligible to becomeparticipants after the completion of 60 days employment. The Plan provides forannual contributions by the Company of 50% of employee contributions not toexceed 8% of employee compensation. Participants may contribute up to 100% of the annual contributionlimitations determined by the Internal Revenue Service.

 

Employees are fullyvested in their share of the Company’s contributions after the completion offive years of 

 

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service. The Company made contributions in 2006 of approximately$15,000 for the 2005 plan year and $75,000 for the 2006 plan year.   In 2007, the Company made contributions ofapproximately $28,000 for the 2006 plan year and made contributions ofapproximately $75,000 for the 2007 plan year and has accrued a contribution ofapproximately $6,000 for the 2007 plan year which was paid in January 2008.

 

**18.****          Pension Plan**

 

One of the Company’sforeign subsidiaries maintains a defined benefit pension plan that providesbenefits based on length of service and final average earnings.

 

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The following table setsforth the benefit obligation, fair value of plan assets, and the funded statusof the Company’s plan; amounts recognized in the Company’s consolidatedfinancial statements; and the assumptions used in determining the actuarialpresent value of the benefit obligations as of December 31:

 
| ** **                                                                                                                | ** ** | **2007**   | ** ** | **2006**   | ** ** | **2005**   | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| Change in  benefit obligation:                                                                                            |       |       |       |       |       |       |       |
| Benefit  obligation at beginning of year                                                                                  |       | $          | 1,457,082  |       | $          | 1,520,238  |       | $ | 1,153,882 |   |
| Service cost                                                                                                              |       | 1,759      |       | 1,794      |       | 249        |       |
| Interest cost                                                                                                             |       | 75,633     |       | 66,903     |       | 57,554     |       |
| Actuarial gain  (loss)                                                                                                    |       | (8,104     | )          | (173,963   | )          | 261,181    |       |
| Effect of  exchange rate changes                                                                                          |       | 109,169    |       | 42,110     |       | 47,372     |       |
| Effect of  curtailment                                                                                                    |       | —     |       | —     |       | —     |       |
| Benefits paid                                                                                                             |       | —     |       | —     |       | —     |       |
| Benefit  obligation at end of year                                                                                        |       | 1,635,539  |       | 1,457,082  |       | 1,520,238  |       |
|                                                                                                                      |       |       |       |       |       |       |       |
| Change in plan  assets                                                                                                    |       |       |       |       |       |       |       |
| Fair value of  plan assets at beginning of year                                                                           |       | 440,790    |       | 390,708    |       | 342,194    |       |
| Actual return of  plan assets                                                                                             |       | 11,441     |       | 9,474      |       | 8,261      |       |
| Company  contributions                                                                                                    |       | 44,397     |       | 40,608     |       | 40,253     |       |
| Benefits paid                                                                                                             |       | —     |       | —     |       | —     |       |
| Fair value of  plan assets at end of year                                                                                 |       | 496,628    |       | 440,790    |       | 390,708    |       |
|                                                                                                                      |       |       |       |       |       |       |       |
| Funded status                                                                                                             |       | (1,138,911 | )          | (1,016,292 | )          | (1,129,530 | )          |
| Unrecognized  actuarial loss (gain)                                                                                       |       | 342,493    |       | 343,018    |       | 502,488    |       |
| Unrecognized  prior service (benefit) cost                                                                                |       | —     |       | —     |       | —     |       |
| Additional  minimum liability                                                                                             |       | (342,493   | )          | (343,018   | )          | (502,488   | )          |
| Unrecognized  transition (asset) liability                                                                                |       | —     |       | —     |       | —     |       |
| Net amount  recognized                                                                                                    |       | (1,138,911 | )          | $          | (1,016,292 | )          | $          | (1,129,530 | ) |
|                                                                                                                      |       |       |       |       |       |       |       |
| The weighted  average assumptions used to determine benefit obligations for the years ended  December 31 were:       |       |       |       |       |       |       |       |
| Discount rate                                                                                                             |       | 4.60       | %          | 4.60       | %          | 4.15       | %          |
| Expected return  on plan assets                                                                                           |       | 4.00       | %          | 4.00       | %          | 4.5        | %          |
| Rate of  compensation increase                                                                                            |       | N/A        |       | N/A        |       | N/A        |       |
|                                                                                                                      |       |       |       |       |       |       |       |
| Plan Assets                                                                                                               |       |       |       |       |       |       |       |
| Pension plan  assets were comprised of the following asset categories at December 31,                                |       |       |       |       |       |       |       |
| Equity  securities                                                                                                        |       | 6.90       | %          | 8.20       | %          | 9.90       | %          |
| Debt securities                                                                                                           |       | 89.50      | %          | 87.90      | %          | 85.20      | %          |
| Other                                                                                                                     |       | 3.60       | %          | 3.90       | %          | 4.90       | %          |
| Total                                                                                                                     |       | 100        | %          | 100        | %          | 100        | %          |
|                                                                                                                      |       |       |       |       |       |       |       |
| Components of  net periodic benefit cost are as follows:                                                                  |       |       |       |       |       |       |       |
| Service cost                                                                                                              |       | 1,759      |       | 1,794      |       | 200        |       |
| Interest cost on  projected benefit obligations                                                                           |       | 75,634     |       | 66,903     |       | 46,240     |       |
| Expected return  on plan assets                                                                                           |       | —     |       | —     |       | 76         |       |
| Amortization of  prior service costs                                                                                      |       | —     |       | —     |       | —     |       |
| Amortization of  actuarial loss                                                                                           |       | —     |       | —     |       | —     |       |
| Net periodic  benefit costs                                                                                               |       | 77,393     |       | 68,697     |       | 46,516     |       |
|                                                                                                                      |       |       |       |       |       |       |       |
| The weighted  average assumptions used to determine net periodic benefit cost for the years  ended December 31, were |       |       |       |       |       |       |       |
| Discount rate                                                                                                             |       | 4.60       | %          | 4.60       | %          | 4.15       | %          |
| Expected return  on plan assets                                                                                           |       | 4.00       | %          | 4.00       | %          | 4.5        | %          |
| Rate of  compensation increase                                                                                            |       | N/A        |       | N/A        |       | N/A        |       |
|                                                                                                                           |            |            |            |            |            |            |            |  |  |  |

 

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| The following  discloses information about our defined benefit pension plan that had an  accumulated benefit obligation in excess of plan assets as of  December 31, |   |      |   |      |   |      |   |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------|--------|-----------|--------|-----------|--------|
| Projected  benefit obligation                                                                                                                                             |   | 1,635,539 |   | 1,457,082 |   | 1,520,238 |   |
| Accumulated  benefit obligation                                                                                                                                           |   | 1,635,539 |   | 1,457,082 |   | 1,520,238 |   |
| Fair value of  plan assets                                                                                                                                                |   | 496,628   |   | 440,790   |   | 390,708   |   |

 

Thefollowing benefit payments are expected to be paid as follows:

 
| 2008             |   | — |   |
|------------------|--------|--------|--------|
| 2009             |   | — |   |
| 2010             |   | — |   |
| 2011             |   | — |   |
| 2012             |   | — |   |
| 2013 — 2017 |   | 77,623 |   |

 

The Company expects tomake contributions to the plan of approximately $32,500 during 2008.

 

The investment objectivesfor the plan are the preservation of capital, current income and long-termgrowth of capital. All plan assets are managed in a policyholder pool inGermany by outside investment managers. The expected long-term return on planassets is between 4.0% to 4.5%. The measurement date used to determine thebenefit information of the plan was January 1, 2008.

 

**19.****                               QuarterlyFinancial Data (Unaudited)**

 

The following table sets forth selected quarterlyfinancial data for 2007 and 2006 (in thousands, except per share data):

 
| ** **                       | ** ** | **2007 (by quarter)** | ** ** |
|----------------------------------|------------|---------------------------------|------------|
| ** **                       | ** ** | **1**                           | ** ** | **2** | ** ** | **3** | ** ** | **4** | ** ** |
|                             |       |                            |       |   |   |   |   |   |   |
| Revenues                         |       | $                               | 1,336      |   | $ | 1,778 |   | $ | 3,510 |   | $ | 1,865 |   |
| Cost of Sales                    |       | 479                             |       | 592 |   | 791 |   | 684 |   |
| Operating  expenses              |       | 3,084                           |       | 2,513 |   | 2,308 |   | 2,536 |   |
| Loss from  Operations            |       | (2,227                          | )          | (1,327 | ) | 411 |   | (1,355 | ) |
| Interest expense  (income), net  |       | 243                             |       | (5 | ) | (2 | ) | (21 | ) |
| Other expense  (income), net     |       | (38                             | )          | 82 |   | (6 | ) | (16 | ) |
| Loss from continuing  operations |       | (2,432                          | )          | (1,404 | ) | 419 |   | (1,317 | ) |
| Discontinued  operations         |       | —                          |       | 11 |   | 6 |   | 33 |   |
| Net loss                         |       | (2,432                          | )          | (1,393 | ) | 425 |   | (1,284 | ) |
| Preferred  dividends             |       | (433                            | )          | (88 | ) | (555 | ) | (95 | ) |
| Net loss                         |       | (2,865                          | )          | (1,481 | ) | (130 | ) | (1,379 | ) |
|                             |       |                            |       |   |   |   |   |   |   |
| Net loss per  share:             |       |                            |       |   |   |   |   |   |   |
| Loss from  continuing operations |       | $                               | (0.18      | ) | $ | (0.09 | ) | $ | 0.03 |   | $ | (0.08 | ) |
| Discontinued  operations         |       | $                               | —     |   | $ | — |   | $ | — |   | $ | — |   |
| Preferred  dividends             |       | $                               | (0.03      | ) | $ | (0.01 | ) | $ | (0.04 | ) | $ | — |   |
| Net loss per  share              |       | $                               | (0.21      | ) | $ | (0.10 | ) | $ | (0.01 | ) | $ | (0.08 | ) |

 

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| ** **                       | ** ** | **2006 (by quarter)** | ** ** |
|----------------------------------|------------|---------------------------------|------------|
| ** **                       | ** ** | **1**                           | ** ** | **2** | ** ** | **3** | ** ** | **4** | ** ** |
|                             |       |                            |       |   |   |   |   |   |   |
| Revenues                         |       | $                               | 2,765      |   | $ | 2,867 |   | $ | 2,177 |   | $ | 2,381 |   |
| Cost of Sales                    |       | 842                             |       | 920 |   | 752 |   | 815 |   |
| Operating  expenses              |       | 3,241                           |       | 2,992 |   | 2,923 |   | 2,778 |   |
| Loss from  Operations            |       | (1,318                          | )          | (1,045 | ) | (1,498 | ) | (1,212 | ) |
| Interest expense  (income), net  |       | 26                              |       | 157 |   | 156 |   | 226 |   |
| Other expense  (income), net     |       | (69                             | )          | (37 | ) | (5 | ) | (8 | ) |
| Loss from  continuing operations |       | (1,275                          | )          | (1,165 | ) | (1,649 | ) | (1,429 | ) |
| Discontinued operations          |       | (73                             | )          | (159 | ) | (114 | ) | (62 | ) |
| Net loss                         |       | (1,348                          | )          | (1,324 | ) | (1,763 | ) | (1,491 | ) |
| Preferred  dividends             |       | (13                             | )          | (13 | ) | (13 | ) | (72 | ) |
| Net loss                         |       | (1,361                          | )          | (1,337 | ) | (1,776 | ) | (1,563 | ) |
|                             |       |                            |       |   |   |   |   |   |   |
| Net loss per  share:             |       |                            |       |   |   |   |   |   |   |
| Loss from  continuing operations |       | $                               | (0.10      | ) | $ | (0.09 | ) | $ | (0.12 | ) | $ | (0.11 | ) |
| Discontinued  operations         |       | $                               | —     |   | $ | (0.01 | ) | $ | (0.01 | ) | $ | (0.00 | ) |
| Preferred  dividends             |       | $                               | —     |   | $ | — |   | $ | — |   | $ | — |   |
| Net loss per  share              |       | $                               | (0.10      | ) | $ | (0.10 | ) | $ | (0.13 | ) | $ | (0.11 | ) |

 

**20.****                               SubsequentEvent**

 

In March 2008, the Company and Sol Logic agreedto amend the Asset Purchase Agreement. The Amendment provides that in consideration for the Acquired Assets,the Company issued to the Seller 677,940 shares of restricted common stock ofthe Company (the “Initial Shares”).  In addition to the Initial Shares,the Company will issue to Sol Logic certain additional shares upon achievementof a milestone.  In the event the Company’s revenues on certain specifiedproducts (the “Products”) equals or exceeds $3,000,000 for the six-month periodcommencing on March 6, 2008 and ending on September 6, 2008, theCompany will issue Sol Logic that number of shares of the Company’s commonstock (the “Additional Shares”) equal to (A) the quotient obtained bydividing $1,008,224 by the greater of (i) the volume weighted averageclosing price of the Company’s common stock (“Common Stock”) over the 20trading-day period ending on the date immediately preceding the AdditionalIssuance Date and (ii) $1.10 (the “Additional Per Share Price”) and depositinto an escrow account (“the Escrow Account”) that number of shares of theCompany’s common stock (the” Escrow Shares”) equal to the quotient obtained bydividing $913,700 by the Additional Per Share Price.  In the event theCompany does not achieve the $3,000,000 product revenue milestone, the revenuedetermination period will be extended and the Company will issue Sol Logic theAdditional Shares if the Company’s revenues on the Products equals or exceeds$5,000,000 for the 18-month period commencing on March 6, 2008 and endingon September 8, 2009.

 

On March 12, 2008,ImageWare Systems, Inc. (the “Company”) received $541,666 from theexercise of 541,666 warrants to purchase shares of the Company’s common stock,par value $0.01 per share. The warrants were originally issued in connectionwith a private placement of Common Stock to certain accredited investors (the “Investors”).The Financing was previously reported in a Current Report on Form 8-Kfiled on September 26, 2007. The Company agreed to reprice all warrantsissued in the Financing, which originally had an exercise price of $1.67 pershare, to an exercise price of $1.00 per share, in consideration for theirimmediate exercise (the “Warrant Repricing”) by the Investors who participatedin the Warrant Repricing or their transferees, as applicable (the “ParticipatingInvestors”).

 

In connection with theWarrant Repricing, the Company also issued to the Participating Investors newwarrants (the “Warrants”) to purchase up to an aggregate of 270,833 shares ofCommon Stock with an exercise price of $1.20 per share. The Warrants may beexercised at any time from March 12, 2008 until March 12, 2013. Inaddition, if the shares of Common Stock issuable upon exercise of the Warrantsare not registered for resale with the Securities and Exchange Commission on orbefore the later of September 12, 2008 or the end of the applicableholding period for resales of securities by non-affiliates under Rule 144of the Securities Act, but in any event no later than March 12, 2009, theWarrants may be exercised by the Participating Investors by “cashless”exercise.

 

The net proceeds to theCompany from the Warrant Repricing, after deducting for expenses, wereapproximately $540,000. The Company intends to use the net proceeds from theWarrant Repricing to fund ongoing operations.

 

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