UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


Washington,
D.C. 20549




FORM 10-K





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





For
the fiscal year ended December 31, 2008.





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





For
the transition period to .





Commission
File Number







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 the Exchange Act:





Title
      of Each Class
            
            Name
      of Each Exchange
              on
      Which RegisteredCommon
      Stock, $0.01 par value
            
            N/AWarrants
      to Purchase Common Stock
            
            N/A





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





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





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





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





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





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





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





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





The
aggregate market value of the voting and non-voting common equity held by
non-affiliates of the registrant, based on the closing sales price of the
issuer’s Common Stock on June 30, 2008, as reported on the Over-the-Counter
Bulletin Boardwas
approximately $8,418,701.  Excluded from this computation were 612,461
shares of Common Stock held by all current executive officers and directors and
4,565,427 shares held by each person who is known by the registrant to own 5% or
more of the outstanding Common Stock.  Share ownership information of
certain persons known by the issuer to own greater than 5% of the outstanding
Common Stock for purposes of the preceding calculation is based solely on
information on Schedule 13G filed with the Commission and is as of
June 30, 2008. Exclusion of shares held by any person or entity should not
be construed to indicate that such person or entity possesses the power,
directly or indirectly, to direct or cause the direction of the management or
the policies of the Registrant.





The
number of shares of the registrant’s common stock outstanding as of January 28,
2010 was 22,104,483.





1








IMAGEWARE
SYSTEMS, INC.


2008
ANNUAL REPORT ON FORM 10-K


TABLE
OF CONTENTS





PART I
            
            3Item 1.
            Business
            3Item 1A.
            Risk
      Factors
            14Item 1B.
            Unresolved
      Staff Comments
            22Item 2.
            Properties
            22Item 3.
            Legal
      Proceedings
            22Item 4.
            Submission
      of Matters to a Vote of Security Holders
            22PART II
            
            22Item 5.
            Market
      for Registrant’s Common Equity, Related Stockholder Matters and Issuer
      Purchases of Equity Securities
            22Item 7.
            Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
            24Item 8.
            Consolidated
      Financial Statements and Supplementary Data
            34Item 9.
            Changes
      in and Disagreements With Accountants on Accounting and Financial
      Disclosure
            34Item 9A.
            Controls
      and Procedures
            34Item 9B.
            Other
      Information
            35PART III
            
            36Item 10.
            Directors,
      Executive Officers and Corporate Governance
            36Item 11.
            Executive
      Compensation
            38Item 12.
            Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters
            48Item 13.
            Certain
      Relationships and Related Transactions
            50Item 14.
            Principal
      Accountant Fees and Services
            52PART IV
            
            53Item 15.
            Exhibits
      and Financial Statement Schedules
            53Exhibit Index
            54Signatures
            57Index
      to Consolidated Financial Statements
            58





2


Forward-Looking
Statements





The
statements contained in this Annual Report of Form 10-K that are not
historical are forward-looking statements within the meaning of Section 27A
of the Securities Act of 1933, as amended (the “Securities Act”), and
Section 21E of the Securities Exchange Act of 1934, as amended (the
“Exchange Act”), including statements regarding our expectations, beliefs,
intentions or strategies regarding the future. Forward-looking statements
include, without limitation, statements regarding the extent and timing of
future revenues and expenses and customer demand, statements regarding
deployment of our products, and statements regarding reliance on third parties.
All forward-looking statements included in this report are based on information
available to us as of the date hereof and we assume no obligation to update any
forward-looking statements. 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 different from
any future results, performance or achievements expressed or implied by such
forward-looking statements. Factors that could cause or contribute to such
differences 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 introductions by
competitors, technological changes in the digital imaging industry,
uncertainties regarding intellectual property rights, delays in the awarding or
funding of government contracts and the other factors referred to herein
including, but not limited to, those items discussed under “Risk Factors”
below.





Trademarks





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





All other
trademarks, service marks and/or trade names appearing in this document are 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 management solutions, providing biometric, secure credential, law
enforcement and enterprise authorization.  Our “flagship” product is the
IWS Biometric Engine.  Scalable for small city business or worldwide
deployment, our biometric engine is a multi-biometric platform that is hardware
and algorithm independent, enabling the enrollment and management of unlimited
population sizes.  Our identification products are used to manage and issue
secure credentials, including national IDs, passports, driver licenses, smart
cards and access control credentials. Our law enforcement products provide law
enforcement with integrated mug shot, fingerprint LiveScan and investigative
capabilities. We also provide comprehensive authentication security
software.  Biometric technology is now an integral part of all markets we
address, and all of our products are integrated into the Biometric Engine
Platform.  Elements of the IWS Biometric Engine can be used as
investigative tools for law enforcement utilizing multiple biometrics and
forensic data elements, and to enhance security and authenticity of public and
private sector credentials.





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





3


Our law
enforcement solutions enable agencies to quickly capture, archive, search,
retrieve, and share digital images, fingerprints and criminal history records on
a stand-alone, networked, wireless or Web-based platform. We develop, sell and
support a suite of modular software products used by law enforcement and public
safety agencies to create and manage criminal history records and to investigate
crime. Our IWS Law Enforcement solution consists of six software modules: a
Capture and Investigative module, which provides a criminal booking system and
related database; a Facial Recognition module, which uses biometric facial
recognition to identify suspects; a Suspect ID module, which facilitates the
creation of full-color, photo-realistic suspect composites; a wireless module,
which provides access to centrally stored records over the Internet in a
connected or wireless fashion; a PDA add-on module, which enables access to
centrally stored records while in the field on a handheld Pocket PC compatible
device combined with central repository services which allows for inter-agency
data sharing on a local, regional, and/or national level; and a LiveScan module,
which incorporates LiveScan capabilities into IWS Law Enforcement providing
integrated fingerprint and palm print biometric management for civil and law
enforcement use.





Our
Secure Credential ID solutions empower customers to create secure and smart
digital identification documents with complete ID systems. We develop, sell and
support software and design systems which utilize digital imaging in the
production of photo identification cards and credentials and identification
systems. Our products in this market consist of IWS EPI Suite, IWS EPI Builder
(SDK) and Identifier for Windows.  These products allow for the production
of digital identification cards and related databases and records and can be
used by, among others, schools, airports, hospitals, corporations or
governments.  We have added the ability to incorporate multiple biometrics
into the ID systems with the integration of IWS Biometric Engine to our Secure
Credential ID product line.





Our
enterprise authentication software includes the IWS Desktop Security product
which is a comprehensive authentication management infrastructure solution
providing added layers of security to workstations, networks and systems through
advanced encryption and authentication technologies. IWS Desktop Security is
optimized to enhance network security and usability, and uses multi-factor
authentication methods to protect access, verify identity and help secure the
computing environment without sacrificing ease-of-use features such as quick
login. Additionally, IWS Desktop Security provides an easy integration with
various smart card-based credentials including the Common Access Card (CAC),
Homeland Security 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 provides the crucial end-point component of a Logical Access Control
System (LACS), and when combined with a Physical Access Control System (PACS),
organizations benefit from a complete door to desktop access control and
security model.





CORPORATE
HISTORY





ImageWare
Systems, Inc., formerly known as ImageWare Software, Inc., was
incorporated in the State of California on February 6,
1987.  From the inception until 1995, we designed and sold software
products for the photo entertainment industry.  In late 1994, we sold
our photo entertainment line of products, and utilized our core technologies to
develop and sell products to law enforcement agencies.  In 1994 our
company was sold to a new ownership and we embarked upon the design and creation
of digital imaging based software products for law enforcement.  From
1995 to early 2000 our business consisted only of our law enforcement
products.  We completed our initial public offering in
April 2000.  At that time we recognized that our core imaging
technology and industry expertise positioned us to enter other and larger
markets, and we targeted the digital identification market for
diversification.  It was a fragmented market which offered us the
opportunity to establish market share through an acquisition
program.  On August 22, 2000, we acquired Imaging Technology
Corporation (“ITC”), a privately held developer of software and software systems
for digital identification documents.  On September 29, 2000, we
purchased Goddard Technology Corporation (“Goddard”), a privately held developer
of software identification badging systems. On March 30, 2001, we purchased
substantially all the assets of G & A Imaging Ltd. (“G &
A”), a privately held developer of software and software systems for digital
identification documents.  These three acquisitions, along with the
internal development of digital ID solutions for some of our law enforcement
customers, firmly placed us in the market for digital ID software.  In
2001, ID software and systems became our largest product segment.  On
December 19, 2007, we added next generation voice recognition, multilingual
speech translation and voice analytics capabilities to our suite of biometric
identity management solutions, enabling users to facilitate and improve
communication across major language groups globally through our acquisition of
Sol Logic, Inc., a privately held developer of voice recognition
technologies.





RECENT
EVENTS





Significant
developments around national and homeland security, specifically identity
management, are direct results of the terrorist attacks of September 11,
2001, demonstrating the risks with insufficient credentialing and access control
systems. Although the U.S. Government has taken strong initiatives to help
combat terrorism and other identity related challenges, the industry is still in
flux with inadequate equipment and appropriate funding causing a delay in
deployments. The growing rate of identity theft is also pervasive and becoming
of great concern.





4


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





As a
result of our strategy to address international markets for large identity
management projects, we sold our Singapore subsidiary in 2005 and closed our
German sales office in 2006. We now address this market through local and U.S.
based strategic partners and systems integrators with local sales and service
presence, and manage international channel partners for our boxed ID Software
from our U.S. offices.





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





In
furtherance of our strategy to more efficiently address both domestic and
international markets for large-scale identity management projects, we completed
the sale of our entire Professional Digital Photography (“PDI”) product line in
the fourth quarter of 2006.  We sold this component because it had incurred
significant operating losses and had lost significant market share.  The
assets sold consisted primarily of a suite of software and related inventory
including source, copyrights, trademarks, documentation and client
base.




In the
fourth quarter of 2007, we acquired the assets of Sol Logic, Inc., a
leading provider of voice recognition and multilingual translation technology.
This acquisition was in line with our strategic plan to expand our biometric
product portfolio and enable us to enter new markets including military and
defense. In the fourth quarter of 2008, we recorded an impairment charge of
approximately $742,000 against the intangible assets acquired as part of the Sol
Logic transaction in 2007.





INDUSTRY
BACKGROUND





Biometrics
and Secure Credential Markets





We
believe the biometric identity management market will continue to grow as the
role of biometrics becomes more widely adopted for enhancing security and
complying with new government regulations such as HSPD-12. Our biometric and
secure credentialing solutions are meeting the demands for true multi-modal
biometric identity management systems, as well as providing scalability to
support evolving functionality.





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





Our
technology also has applications in markets related to secure credentials,
identification and access control (physical and logical) in the public and
private sectors.  Organizations concerned with security can use our
technology to create secure “smart” identification cards that can be instantly
checked against a database of facial images or other biometrics to prevent
unauthorized access to secure areas. We believe potential customers in these
markets include, among others, large corporations, border crossings (land, air
and sea), airports, hospitals, universities and government
agencies.





Identification
systems have historically been sold based upon the cost-savings digital systems
offer over traditional photo-based systems. We believe that the ability to
easily capture images and data in a digital database and to enable immediate and
widespread access to that database for remote identification/verification will
be a functionality that customers will require in the future and that such
functionality will be one of the primary drivers for future growth within this
market. We are able to provide field-proven identification products with high
quality reference accounts across the board in terms of size and complexity of
systems and user requirements. When combined with our proven biometric and Web
capabilities, we believe we can provide a leading product offering into the
biometrically-enabled secure credential market.





5


Law
Enforcement and Public Safety Markets





The
United States law enforcement and public safety markets are composed of federal,
state and local law enforcement agencies.  Our target customers
include local police departments, sheriffs’ departments and offices, primary
state law enforcement agencies, prisons, special police agencies, county
constable offices, and federal agencies such as the FBI and the
DEA.  We are also targeting agencies in foreign countries for our
biometric and law enforcement solutions.





We
believe the September 11, 2001, terrorist attacks and subsequent creation
of the Department of Homeland Security has accelerated the adoption of digital
identification systems. Law enforcement customers are demanding end-to-end
solutions that incorporate robust features and functionalities such as biometric
and secure credentialing capabilities, as well as instant access to centrally
maintained records for real time verification of identity and
privileges.




PRODUCTS
AND SERVICES





Our
identity management solutions are primarily focused around biometrics and secure
credentials providing complete, cross-functional and interoperable systems. Our
biometric and secure credentialing products provide complete and interoperable
solutions with features and functions required throughout the entire identity
management life-cycle, enabling users the flexibility to make use of any desired
options, such as identity proofing and enrollment, card issuance, maintenance
and access control. Our solutions offer a significant benefit that one vendor’s
solution is used throughout the various stages, from establishing an applicant’s
verified identity, to issuance of smart card based credentials, to the usage and
integration to physical and logical access control systems.


These
solutions improve global communication, the integrity and authenticity of access
control to facilities and information systems, as well as enhances security,
increase efficiency, reduce identity fraud, and protect personal
privacy.





We
categorize our identity management products and services into three basic
markets: (1) Biometrics, (2) Secure Credential, and (3) Law
Enforcement and Public Safety. Our biometric product line consists of the
following:





Biometrics





IWS
BIOMETRIC ENGINE





This is a
biometric identity management platform for multi-biometric enrollment,
management and authentication, managing population databases of unlimited sizes
without regard to hardware or algorithm.  Searches can be 1:1
(verification), 1:N (identification), X:N (investigative) and N:N (database
integrity). IWS Biometric Engine is technology and biometric agnostic, enabling
the use of biometric devices and algorithms from any vendor, and the support of
the following biometric types: finger, face, iris, hand geometry, palm,
signature, DNA, voice, 3D face and retina. IWS Biometric Engine is a
second-generation solution from ImageWare Systems that is based on field-proven
ImageWare technology solutions that have been used to manage millions of
biometric records since 1997 and is ideal for a variety of applications
including: criminal booking, background checks (civil and criminal), watch list,
visa/passport and border control (air, land and sea), physical and logical
access control, and other highly-secure identity management
environments.





IWS
Biometric Engine is scalable, and biometric images and templates can be enrolled
either live or offline.   Because it stores the enrolled images,
a new algorithm can be quickly converted to support new or alternate algorithms
and capture devices. The Biometric Engine is built to be hardware “agnostic”,
and currently supports over 107 hardware capture devices and over 93 biometric
algorithms.




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





·
            HSPD-12 Personal Identity
      Verification (PIV)





·
            Border
      Management





·
            ePassport &
      eVisa





·
            Applicant Identity
      Vetting





6


·
            Mobile
      Acquisition





·
            Physical Access
      Control





·
            Single-Sign-On and Logical Access
      Control





IWS
PIV MANAGEMENT APPLICATION





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





IWS
PIV MIDDLEWARE





The IWS
PIV Middleware product, 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 the hardware side with a software application. The library
implements the specified PIV Middleware API functions that support
interoperability of PIV Cards.  This ImageWare software has been
developed in conformance with the FIPS-201 specification, and the software has
been certified by the NIST Personal Identification Verification Program (NPIVP)
Validation Authority as being compliant.





IWS
BACKGROUND SERVER





The IWS
Background Server is a software application designed specifically for government
and law enforcement organizations to support the first stage of biometric
identity management functions such as identity proofing and vetting. IWS
Background Check Server automatically processes the submission of an applicant’s
demographic and biographic data to investigative bureaus for background checks
prior to issuing a credential.





IWS
DESKTOP SECURITY





IWS
Desktop Security is a highly flexible, scalable and modular authentication
management platform that is optimized to enhance network security and usability.
This architecture provides an additional layer of security to workstations,
networks and systems through advanced encryption and authentication
technologies. Biometric technologies (face, fingerprint, iris, voice or
signature), can be seamlessly coupled with TPM chips to further enhance
corporate security. USB tokens, smart cards and RFID technologies can also be
readily integrated.Additional features
include:




·
              Support for multiple
      authentication tools including Public Key Infrastructure (PK) within a
      uniformed platform and privilege Management Infrastructure (PMI)
      technology to provide more advanced access control services and assure
      authentication and data
integrity.




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





·
            Integration with IWS EPI Builder
      for the production and management of secure
    credentials





·
            Support for both BioAPI and BAPI
      standards





·
            Supports a single sign-on feature
      that securely manages Internet Explorer and Windows application ID and
      password information.





·
            Supports file and folder
      encryption features.





·
            Supports various operating
      systems, including Microsoft Windows 2000, Windows XP, and Windows Server
      2003.





IWS BIOMETRIC QUALITY
ASSESSMENT & ENHANCEMENT (IWS Biometric IQA&E)





The IWS
Biometric IQA&E is a biometric image enhancement and assessment solution
that assists government organizations with the ability to evaluate and enrich
millions of biometric images automatically, saving time and costs associated
with biometric enrollment while maintaining image and database
integrity.





7


The IWS
Biometric IQA&E improves the accuracy and effectiveness of biometric
template enrollments. The software may be used stand-alone or in conjunction
with the IWS Biometric Engine. IWS Biometric IQA&E provides automated image
quality assessment with respect to relevant image quality standards from
organizations such as International Civil Aviation Organization (ICAO) National
Institute of Standards and Technology (NIST), International Organization for
Standards (ISO) and American Association of Motor Vehicle Association (AAMVA).
IWS Biometric IQA&E also enables organizations to conduct multi-dimensional
facial recognition which further enhances accuracy for numerous applications
including driver licenses, passports and watch lists.





IWS
Biometric IQA&E automatically provides real-time biometric image quality
analysis and feedback to improve the overall effectiveness of biometric images
thus increasing the biometric verification performance, and maintaining database
and image data integrity. IWS Biometric IQA&E provides a complete platform
that includes an image enhancement library for biometric types including face,
finger and iris.





Secure
Credential





Our
Identification and Secure Credential Products consist of the following
products:





IWS
CARD MANAGEMENT





The IWS
Card Management System (CMS) is a comprehensive solution to support and manage
the issuance of smart cards complete with the following
capabilities:





·
              Biometric enrollment and identity
      proofing with Smart Card encoding of
  biometrics





·
            Flexible models of central or
      distributed issuance of
credentials





·
            Customizable card life-cycle
      workflow managed by the CMS





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







IWS
EPI SUITE





This is
an ID software solution for producing, issuing, and managing secure credentials
and personal identification cards. Users can efficiently manage large amounts of
data, images and card designs, as well as track and issue multiple cards per
person; automatically populate multiple cards and eliminate redundant data
entry. IWS EPI Suite was designed to integrate with our customers’ existing
security and computing infrastructure. We believe that this compatibility may be
an appealing feature to corporations, government agencies, transportation
departments, school boards, and other public institutions.





IWS
EPI BUILDER





This is a
software developer’s kit and a leading secure credential component of identity
management and security solutions, providing all aspects of ID functionality
from image and biometric capture to the enrollment, issuance and management of
secure documents. It contains components which developers or systems integrators
can use to support and produce secure credentials including national IDs,
passports, International Civil Aviation Office (ICAO)-compliant travel
documents, smart cards and driver licenses. IWS EPI Builder enables
organizations to develop custom identification solutions or incorporate
sophisticated identification capabilities into existing applications including
the ability to capture images, biometric and demographic data; enable biometric
identification and verification (1:1 and 1:X) as well as support numerous
biometric hardware and software venders. It also enables users to add electronic
identification functionality for other applications, including access control,
tracking of time and attendance, point of sale transactions, human resource
systems, school photography systems, asset management, inventory control,
warehouse management, facilities management and card production
systems.





IDENTIFIER
FOR WINDOWS





This
family of products combines the ability to capture photographic images digitally
with the ability to create a database and to print identification cards.
Identifier for Windows offers a powerful, versatile, and user-friendly
application which can be used by schools, hospitals, corporations and
governments.





8


IWS
PRINTFARM





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





IWS
PIV ENCODER





PIV smart
cards must be programmed with specific mandatory data, digital signatures and
programs in order to maintain the interoperability as well as the security
features specified for the cards. The IWS PIV Encoder could be considered to be
a complex device driver that properly programs the PIV smart
cards.  The Encoder interacts with the Card Management System for data
payload elements. It interacts with the Certificate Authority to encrypt or sign
the PIV smart card data with trusted certificates. Finally, it acts as the
application-level device driver to make the specific PIV smart card encoding
system properly program the smart card, regardless if the system is a standalone
encoding system or one integrated into a card printer.





Law
Enforcement and Public Safety





We
believe our integrated suite of software products significantly reduces the
inefficiencies and expands the capabilities of traditional booking and mugshot
systems. Using our products, an agency can create a digital database of
thousands of criminal history records, each including one or more full-color
facial images, finger and palm prints, text information and images of other
distinctive physical features such as scars, marks and tattoos. This database
can be quickly searched using text queries or by using our biometric facial
recognition or AFIS technology which can compare biometric characteristics of an
unknown suspect with those in the database.





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





Our IWS
Law Enforcement solution consists of software modules, which may also be
purchased individually. The IWS Law Enforcement Capture and Investigative module
make up our booking system and database. Our add-on modules include Livescan,
Facial Recognition, Suspect ID, a Wireless module, and a PDA add-on
module.





IWS
LAW ENFORCEMENT





IWS Law
Enforcement is a digital booking, identification and investigative solution that
enables users to digitally capture, search, store and retrieve images and
demographic data including mug shots, scars, marks and tattoos (SMTs) and
fingerprints. Law enforcement can submit fingerprint data directly to the State
AFIS, FBI criminal repository, or other agencies as required. Additional
features and functionality include real-time access to images and data, creation
of digital composite sketches, photo lineups, and production of identification
cards and credentials.  IWS Law Enforcement also uses off-the-shelf
hardware and is designed to comply with open industry standards so that it can
operate on an array of systems ranging from a stand-alone personal computer to a
wide area network. To avoid duplication of entries, the system can be integrated
easily with several other information storage and retrieval systems, such as a
records management system or an automated fingerprint identification
system.





CAPTURE





This
software module allows users to capture and store facial images as well as
images of distinguishing features such as scars, tattoos and other marks. Each
entry contains both images and text information in an easy-to-view format made
up of distinct fields. Current customers of this module range from agencies that
capture a few thousand mugshots per year to those that capture hundreds of
thousands of mugshots each year.





LIVESCAN





This
software module is FBI certified which complies with the FBI Integrated
Automated Fingerprint Identification System (IAFIS) Image Quality Specifications
(IQS) while utilizing the latest FBI certified Livescan device from most major
vendors. Livescan allows users to capture single to ten prints and palm data,
providing an integrated biometric management for civil and law enforcement use.
By adding Livescan capabilities, law enforcement organizations further enhance
the investigative process by providing additional identifiers to identify
suspects involved in a crime.  In addition, officers no longer need to
travel to multiple booking stations to capture fingerprints and mug
shots.  All booking information including images will be located at a
central designation and can be routed to the State AFIS or the FBI criminal
history record repository.





9


INVESTIGATIVE





This
software module allows users to search the database created with IWS Law
Enforcement. Officers can conduct text searches in many fields, including file
number, name, alias, distinctive features, and other information such as gang
membership and criminal history. The Investigative module creates a catalogue of
possible matches, allowing officers or witnesses to save time by looking only at
mugshots that closely resemble the description of the suspect. This module can
also be used to create a line-up of similar facial images from which a witness
may identify the suspect.





FACIAL
RECOGNITION





This
software module uses biometric facial recognition and retrieval technology to
help authorities identify possible suspects. Images taken from surveillance
videos, digital sketches or photographs can be searched against a digital
database of facial images to retrieve any desired number of faces with similar
characteristics. This module can also be used at the time of booking to identify
persons using multiple aliases. Using biometrics-based technology, the
application can search through thousands of facial images in a matter of
seconds, reducing the time it would otherwise take a witness to flip through a
paper book of facial images that may or may not be similar to the description of
the suspect. The Facial Recognition module then creates a selection of possible
matches ranked in order of similarity to the suspect, and a percentage
confidence level is attributed to each possible match. The application
incorporates search engine technology which we license from various facial
recognition algorithm providers.





SUSPECT
ID





This
software module allows officers and witnesses to quickly create full-color,
photo-realistic suspect composites. The digital composites are constructed from
libraries of facial features based upon actual color photographs of such
features. Suspect ID allows officers with minimal computer training and artistic
talent to create a suspect composite by pointing and clicking with a mouse. This
module can be installed on a laptop computer and taken into the field, allowing
officers to conduct interviews and create composites before witnesses’ memories
fade. For rapid identification, officers can distribute completed composites
within minutes via fax or e-mail.





WIRELESS





The
Wireless module enables authorized personnel to access and search a county’s
booking records stored in IWS Law Enforcement through a standard Web browser
from within the county’s intranet. This module allows remote access to the IWS
Law Enforcement database without requiring the user to be physically connected
to the customer’s network. This application requires only that the user have
access to the Internet and authorization to access the county’s
intranet.





PDA





The PDA
module is a powerful investigative tool that allows officers to access IWS Law
Enforcement booking photos and related data in the field on a handheld Pocket PC
compatible device.





Maintenance
and Customer Support





As part
of our installation of a system, we offer to train our customers’ employees as
to the effective use of our products. We offer training both on-site and at our
facilities. We offer on-site hardware support to our customers, generally within
24 hours of the customer request. Customers can contract with us for
technical support that enables them to use a toll-free number to speak with our
technical support center for software support and general assistance
24 hours a day, seven days a week. As many of our government customers
operate around the clock and perceive our systems as critical to their
day-to-day operations, a very high percentage contract for technical support.
Customer support services typically provide us with annual revenue of 12% to 18%
of the initial sales price of the hardware and software purchased by our
customers.  For the twelve months ended December 31, 2008 and 2007,
maintenance revenues accounted for approximately 43% and 33% of our total
revenues.





Software
Customization and Fulfillment





We
directly employ computer programmers and also retain independent programmers to
develop our software and perform quality control. We provide customers with
software that we specifically customize to operate on their existing computer
system. We work directly with purchasers of our system to ensure that the system
they purchase will meet their unique needs. We configure and test the system
either at our facilities or on-site and conduct any customized programming
necessary to connect the system with any legacy systems already in
place.  We can also provide customers with a complete computer
hardware system with our software already installed and configured. In either
case, the customer is provided with a complete turnkey solution which can be
used immediately. When we provide our customers with a complete solution
including hardware, we use off-the-shelf computers, cameras and other components
purchased from other companies such as Dell or Hewlett Packard. Systems are
assembled and configured either at our facilities or at the customer’s
location.





10


OUR
STRATEGY





Our
strategy is to provide open-architected identity management solutions including
multi-biometric, secure credential and law enforcement technologies that are
stand alone, integrated and/or bundled with key partners including channel
relationships and large systems integrators such as Honeywell, Boeing, GE
Security, CSC, Unisys, HP, IBM, Oracle, Motorola, among others. Key elements of
our strategy for growth include the following:





Fully
Exploit the Biometrics, Access Control and Identification Markets





The
establishment of the Department of Homeland Security coupled with the movement
by governments around the world to authenticate the identity of their citizens,
employees and contractors has accelerated the adoption of biometric
identification systems that can provide secure credentials and instant access to
centrally maintained records for real-time verification of identity and access
(physical and logical) privileges. Using our products, an organization can
create secure credentials that correspond to records including images and
biographic data in a digital database. A border guard or customs agent can stop
an individual to quickly and accurately verify his identity against a database
of authorized persons, and either allow or deny access as required. Our
technology is also standards based and applied to facilitate activities such as
federal identification mandates while complying with personal identification
verification standards (HSPD-12), International Civil Aviation Organization
(ICAO) standards, American Association of Motor Vehicle Administrators (AAMVA)
driver licenses, voter registration, immigration control and welfare fraud
identification.





With the
identity management market growing at a rapid pace, biometric identifiers are
becoming recognized and accepted as integral components to the identification
process in the public and private sectors.  As biometric technologies
(facial recognition, fingerprint, iris, etc) are adopted, identification systems
must be updated to enable their use in the field.  We have built our
solutions to enable the incorporation of one or multiple biometrics, which can
be associated with a record and stored both in a database and on a card for
later retrieval and verification without regard to the specific hardware
employed.  We believe the increasing demand for biometric technology
will drive demand for our solutions.  Our identity management products
are built to accommodate the use of biometrics and meet the demanding
requirements across the entire identity life cycle.





Expand
Law Enforcement and Public Safety Markets





We intend
to use our successful installations with customers such as the Arizona
Department of Public Safety, New South Wales Police, and the Los Angeles County
Sheriff’s Department as reference accounts and to market IWS Law Enforcement as
a superior technological solution. Our recent addition of the Livescan module
and support for local AFIS to our IWS Law Enforcement will enhance its
functionality and value to the law enforcement customer as well as increase the
potential revenue the Company can generate from a system sale.  We
primarily sell directly to the law enforcement community. Our sales strategy is
to increase sales to new and existing customers including renewing supporting
maintenance agreements. We have also established relationships with large
systems integrators such as Sagem Morpho to OEM our law enforcement solution
utilizing their worldwide sales force. We will focus our sales efforts in the
near term to establish IWS Law Enforcement as the integrated mug shot and
Livescan system adopted in as many countries, states, large counties and
municipalities as possible. Once we have a system installed in a region, we
intend to then sell additional systems or retrieval seats to other agencies
within the primary customer’s region and in neighboring regions. In addition, we
plan to market our integrated investigative modules to the customer, including
the Facial Recognition and Wireless modules, Suspect ID, WitnessView, Wireless
module, and PDA module. As customer databases of digital mug shots grow, we
expect that the perceived value of our investigative modules, and corresponding
revenues from sales of those modules, will also grow.





SALES
AND MARKETING





We market
and sell our products through our direct sales force and through indirect
distribution channels, including systems integrators. As of December 31, 2008 we
had sales and account representatives based domestically in Virginia, Maryland,
Arizona, and California. Geographically, our sales and marketing force
consisted of 10 persons in the United States.  As of January 28, 2010
we have sales and account representatives based domestically in Virginia,
Maryland and California. Geographically, our sales and marketing force consists
of 9 persons in the United States, one person in Canada and one person in
Mexico.





11


We sell
through a direct sales organization which is supported by the marketing
organization.  Our sales professionals are supported by our technical
experts who are available by telephone and conduct on-site customer
presentations.





The
typical sales cycle for IWS Biometric Engine and IWS Law Enforcement includes a
pre-sale process to define the potential customer’s needs and budget, an on-site
demonstration and conversations between the potential customer and existing
customers. Government agencies are typically required to purchase large 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 the project by
responding to the RFP. If our response is selected, we enter into negotiations
for the contract and, if successful, ultimately receive a purchase order from
the customer. This process can take anywhere from a few months to over a
year.





Our
Biometric and ID products are also sold to large integrators, direct via our
sales force and to end users through distributors. Depending on the customer’s
requirements, there may be instances that require an RFP. The sales cycle can
vary from a few weeks to a year.





In
addition to our direct sales force, we have developed relationships with a
number of systems integrators who contract with government agencies for the
installation and integration of large computer and communication systems. By
acting as a subcontractor to these systems integrators, we are able to avoid the
time consuming and often-expensive task of submitting proposals to government
agencies, and we also gain access to large clients.





We also
work with companies that offer complementary products, where value is created
through product integration. Through teaming arrangements we are able to enhance
our products and to expand our customer base through the relationships and
contracts of our strategic partners.





We
promote our products through trade journal advertisements, direct mail and
attendance at industry trade shows, including those sponsored by
the Biometric Consortium, International Association for Biometrics,
American Association of Motor Vehicle Administrators, International
Association for Identification, American Society of Industrial Security and
the International Association of Chiefs of Police. We also target other media
through public relations efforts, including non-industry publications, daily
newspapers, local and national news programs, and television programs related to
law enforcement. Articles regarding our products have appeared in Business Week,
Los Angeles Times, Chicago Tribune, The Wall Street Journal and a number of
other publications.





We plan
to continue to market and sell our products internationally. Some of the
challenges and risks associated with international sales include the difficulty
in protecting our intellectual property rights, difficulty in enforcing
agreements through foreign legal systems and volatility and unpredictability in
the political and economic conditions of foreign countries. We believe we can
work to successfully overcome these challenges.





CUSTOMERS





We have a
wide variety of domestic and international customers. Most of our IWS Law
Enforcement customers are government agencies at the federal, state and local
levels in the United States. Our products are also being used in Australia,
Canada, the United Arab Emirates, Kuwait, Mexico, Colombia, Costa Rica,
Venezuela, Singapore, Indonesia and the Philippines. The customer base for our
digital identification systems includes domestic and foreign government
agencies, universities, airports, and private sector companies, many of which
are Fortune 500 or Fortune 1000 companies.  In 2008, the US Government
accounted for approximately 17% of our revenues. In 2007, Unisys Corporation
accounted for approximately 18% of our revenues.


COMPETITION





The
Law Enforcement and Public Safety Markets





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





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





·
            our reputation as a reliable
      systems supplier;





12


·
            the usability and functionality
      of our products; and





·
            the responsiveness, availability
      and reliability of our customer
support.





Our law
enforcement product line faces competition from other companies such as
DataWorks Plus and Cogent Systems, Inc.  Internationally, there are
often a number of local companies offering solutions in most
countries.





Identification
Markets





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





·
            our strong brand reputation with
      a customer base which includes small and medium-sized businesses, Fortune
      500 corporations and large government
  agencies;





·
            the ease of integrating our
      technology into other complex applications;
  and





·
            the leveraged strength that comes
      from offering customers software tools, packaged solutions and Web-based
      service applications that support a wide range of hardware
      peripherals.





Our
software faces competition from Datacard Corporation, a privately held
manufacturer of hardware, software and consumables for the ID market. There are
also a considerable number of smaller software competitors such as Number Five
Software Ltd., Loronix Information Systems, Inc. and Fox Technology
Pty Ltd. who compete in differing geographical markets, primarily in the
packaged product segment.





Biometric
Market





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





·
            our ability to provide a system
      which enables the enrollment, management and authentication of multiple
      biometrics managing population databases of unlimited
      sizes;





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





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





Our
multi-biometric product faces competition from L-1 Identity
Solutions, Inc., Ireland-based Daon, and French-based Sagem none of which
have offerings with the scope and flexibility of our IWS Biometric
Engine.





INTELLECTUAL
PROPERTY





We rely
on trademark, patent, trade secret and copyright laws and confidentiality and
license agreements to protect our intellectual property. We have several
unregistered and federally registered trademarks including the trademark
ImageWare, as well as trademarks for which there are pending trademark
registrations with the United States, Canadian and other International
Patent & Trademark Offices.  We hold several issued patents
and have several other patent applications pending for elements of our
products.  We license and depend on intellectual property from third
parties for our biometric products and modules which utilize third party
biometric encoding and matching technologies.





We regard
our software as proprietary and retain title to and ownership of the software we
develop.  We attempt to protect our rights in the software primarily
through trade secrets.  We have not published the source code of most
of our software products and require employees and other third-parties who have
access to the source code and other trade secret information to sign
confidentiality agreements acknowledging our ownership and the nature of these
materials as our trade secrets.





Despite
these precautions, it may be possible for unauthorized parties to copy or
reverse-engineer portions of our products.  While our competitive
position could be threatened by disclosure or reverse engineering of this
proprietary information, we believe that copyright and trademark protection are
less important than other factors such as the knowledge, ability, and experience
of our personnel, name recognition and ongoing product development and
support.





13


Our
software products are licensed to end users under a perpetual, nontransferable,
nonexclusive license that stipulates which modules can be used and how many
concurrent users may use them.  These forms of licenses are typically
not signed by the licensee and may be more difficult to enforce than signed
agreements in some jurisdictions.





Although
our products have never been the subject of an infringement claim, we cannot
assure that third parties will not assert infringement claims against us in the
future or that any such assertion will not require us to enter into royalty
arrangements or result in costly litigation.





RESEARCH
AND DEVELOPMENT





Our
research and development team was made up of 29 and 25 programmers, engineers
and other employees as of December 31, 2008 and January 28, 2010 respectively.
We also contract with outside programmers for specific projects as needed. We
spent approximately $3.0 million and$3.7 million on research and development in
2008 and 2007, respectively. We continually work to increase the speed,
accuracy, and functionality of our existing products. We anticipate that our
research and development efforts will continue to focus on new technology and
products for the identity management markets.





EMPLOYEES





We had a
total of 65 and 58 full-time employees as of December 31, 2008 and January 28,
2010 respectively. Our employees are not covered by any collective bargaining
agreement, and we have never experienced a work stoppage. We believe that our
relations with our employees are good.





Item
1A.  Risk Factors





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





14


RISKS
RELATED TO OUR BUSINESS





Risks
Related to Our Business





We have a history of significant
recurring losses totaling approximately $87.2million, and these losses may
continue in the future.





As of
December 31, 2008, we had an accumulated deficit of $87.2 million, and
these losses may continue in the future. We will need to raise capital to fund
our continuing operations, and financing may not be available to us on favorable
terms or at all. In the event financing is not available in the time frame
required, we will be forced to sell certain of our assets or license our
technologies to others. 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 we may never achieve profitability.





Our
operating results have fluctuated in the past and are likely to fluctuate
significantly in the future. We may experience fluctuations in our quarterly
results of operations as a result of:





·
            varying demand for and market
      acceptance of our technology and
  products;





·
            changes in our product or
      customer mix;





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





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





·
            the announcement or introduction
      of products and technologies by our
  competitors;





·
            competitive pressures on selling
      prices;





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





·
            our
      ability to successfully integrate acquired companies, products and
      technologies;





·
            our accounting and legal
      expenses; and





·
            general economic
      conditions.





These
factors, some of which are not within our control, may cause the price of our
stock to fluctuate substantially. To respond to these and other factors, we may
need to make business decisions that could result in failure to meet financial
expectations. If our quarterly operating results fail to meet or exceed the
expectations of securities analysts or investors, our stock price could drop
suddenly and significantly. Most of our expenses, such as employee compensation,
inventory and debt repayment obligations, are relatively fixed in the short
term. Moreover, our expense levels are based, in part, on our expectations
regarding future revenue levels. As a result, if our revenue for a particular
period were below our expectations, we would not be able to proportionately
reduce our operating expenses for that period. Any revenue shortfall would have
a disproportionately negative effect on our operating results for the
period.





We
received a “going concern” opinion from our independent registered public
accounting firm for the fiscal years ended December 31, 2008 and 2007,
which may negatively impact our business.





We
received a report from Stonefield Josephson, Inc., our independent
registered public accounting firm (“Stonefield Josephson”), regarding our
consolidated financial statements for the fiscal years ended December 31,
2008 and 2007, which included an explanatory paragraph stating that the
consolidated financial statements were prepared assuming we will continue as a
going concern. The report also stated that our substantial net losses and
monetary liabilities have raised substantial doubt about our ability to continue
as a going concern.  The “going concern” opinion for the fiscal year ended
December 31, 2008, may fail to dispel any continuing doubts about our
ability to continue as a going concern and could adversely affect our ability to
enter into collaborative relationships with business partners, to raise
additional capital and to sell our products, and could have a material adverse
effect on our business, financial condition and results of
operations.





15


We currently have limited cash
resources and we will require additional funding to finance our working capital
requirements for at least the next twelve months.





We
currently have limited cash resources and we will require financing to fund our
anticipated working capital requirements for at least the next twelve months. If
we are not able to generate positive cash flows from operations in the near
future, we will be required to seek additional funding through public or private
equity or debt financing. There can be no assurance that additional financing
will be available on acceptable terms, or at all. If we are required to sell
equity to raise additional funds, our existing stockholders may incur
substantial dilution and any shares so issued may have rights, preferences and
privileges superior to the rights, preferences and privileges of our outstanding
common stock. If we seek debt financing, the terms of the financing may require
us to agree to restrictive covenants or impose other obligations that limit our
ability to grow our business, acquire necessary assets or take other actions
that we consider necessary or desirable.  Also, we may be required to
obtain funds through arrangements with third parties that require us to
relinquish rights to certain of our technologies or products that we would seek
to develop or commercialize ourselves.





Our current ineligibility to use the
Registration Statement on Form S-3 may affect our ability to finance our
working capital requirements for the next twelve months.





As a
result of the fact that we have not been able to remain current with our
periodic filings with the SEC we have been ineligible to register shares of our
common stock on Form S-3 Registration Statement. Certain investors, for
whom the ability to resell their shares relatively soon after they acquire them
is important, may only be willing to participate in private financings by us if
we can register their shares using a Form S-3 Registration Statement. 
Therefore, our ineligibility to use Form S-3 could limit our ability to
raise additional capital for at least the next 12 months or such longer period
that we are ineligible to use the Form S-3 Registration
Statement.





We depend upon a small number of
large system sales ranging from $500,000 to in excess of $2,000,000, and we may
fail to achieve one or more large system sales in the
future.





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





Our lengthy sales cycle may cause us
to expend significant resources for as long as one year in anticipation of a
sale to certain customers, yet we still may fail to complete the
sale.





When
considering the purchase of a large computerized identity management system,
potential customers of ours may take as long as one year to evaluate different
systems and obtain approval for the purchase. Under these circumstances, if we
fail to complete a sale, we will have expended significant resources and
received no revenue in return. Generally, customers consider a wide range of
issues before committing to purchase our products, including product benefits,
ability to operate with their current systems, product reliability and their own
budgetary constraints. While potential customers are evaluating our products, we
may incur substantial selling costs and expend significant management resources
in an effort to accomplish potential sales that may never occur. In times of
economic recession, our potential customers may be unwilling or unable to commit
resources to the purchase of new and costly systems.





A significant number of our
customers and potential customers are government agencies that are subject to
unique political and budgetary constraints and have special contracting
requirements which may affect our ability to obtain new and retain current
government customers.





A
significant number of our customers are government agencies. These agencies
often do not set their own budgets and therefore have little control over the
amount of money they can spend from quarter-to-quarter or year-to-year. In
addition, these agencies experience political pressure that may dictate the
manner in which they spend money. Due to political and budgetary processes and
other scheduling delays that may frequently occur relating to the contract or
bidding process, some government agency orders may be canceled or substantially
delayed, and the receipt of revenues or payments from these agencies may be
substantially delayed. In addition, future sales to government agencies will
depend on our ability to meet government contracting requirements, certain of
which may be onerous or impossible 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 the contract without penalty, and provisions permitting the
agency to perform investigations or audits of our business practices, any of
which may limit our ability to enter into new contracts or maintain our current
contracts.





16


We occasionally rely on systems
integrators to manage our large projects, and if these companies do not perform
adequately, we may lose business.





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





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





Our
success depends significantly on our ability to protect our rights to the
technologies used in our products. We rely on patent protection, trade secrets,
as well as a combination of copyright and trademark laws and nondisclosure,
confidentiality and other contractual arrangements to protect our technology.
However, these legal means afford only limited protection and may not adequately
protect our rights or permit us to gain or keep any competitive advantage. In
addition, we cannot be assured that any of our current and future pending patent
applications will result in the issuance of a patent to us. The U.S. Patent and
Trademark Office (“PTO”) may deny or require significant narrowing of claims in
our pending patent applications, and patents issued as a result of the pending
patent applications, if any, may not provide us with significant commercial
protection or be issued in a form that is advantageous to us. We could also
incur substantial costs in proceedings before the PTO. These proceedings could
result in adverse decisions as to the claims included in our
patents.





Our
issued and licensed patents and those that may be issued or licensed in the
future may be challenged, invalidated or circumvented, which could limit our
ability to stop competitors from marketing related products. Additionally, upon
expiration of our issued or licensed patents, we may lose some of our rights to
exclude others from making, using, selling or importing products using the
technology based on the expired patents. We also must rely on contractual rights
with the third parties that license technology to us to protect our rights in
the technology licensed to us. Although we have taken steps to protect our
intellectual property and technology, there is no assurance that competitors
will not be able to design around our patents. We also rely on unpatented
proprietary technology. We cannot assure you that we can meaningfully protect
all our rights in our unpatented proprietary technology or that others will not
independently develop substantially equivalent proprietary products or processes
or otherwise gain access to our unpatented proprietary technology. We seek to
protect our know-how and other unpatented proprietary technology with
confidentiality agreements and intellectual property assignment agreements with
our employees. However, such agreements may not provide meaningful protection
for our proprietary information in the event of unauthorized use or disclosure
or other breaches of the agreements or in the event that our competitors
discover or independently develop similar or identical designs or other
proprietary information. In addition, we rely on the use of registered and
common law trademarks with respect to the brand names of some of our products.
Our common law trademarks provide less protection than our registered
trademarks. Loss of rights in our trademarks could adversely affect our
business, financial condition and results of operations.





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





If third parties claim that we
infringe their intellectual property rights, we may incur liabilities and costs
and may have to redesign or discontinue selling certain
products.





Whether a
product infringes a patent involves complex legal and factual issues, the
determination of which is often uncertain. We face the risk of claims that we
have infringed on third parties’ intellectual property rights. Searching for
existing intellectual property rights may not reveal important intellectual
property and our competitors may also have filed for patent protection, which is
not as yet a matter of public knowledge, or claimed trademark rights that have
not been revealed through our availability searches. Our efforts to identify and
avoid infringing on third parties’ intellectual property rights may not always
be successful. Any claims of patent or other intellectual property infringement,
even those without merit, could:





·
            increase the cost of our
      products;





·
            be expensive and time consuming
      to defend;





·
            result in us being required to
      pay significant damages to third
parties;




17


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





·
            require us to redesign,
      reengineer or rebrand our
products;





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





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





·
            divert the attention of our
      management; and





·
            result in our customers or
      potential customers deferring or limiting their purchase or use of the
      affected products until the litigation is
  resolved.





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








We operate in foreign countries and
are exposed to risks associated with foreign political, economic and legal
environments and with foreign currency exchange rates.





With our
acquisition of G&A Imaging Ltd. in 2001, we have significant foreign
operations. As a result, we are exposed to risks, including among others, risks
associated with foreign political, economic and legal environments and with
foreign currency exchange rates. Our results may be adversely affected by, among
other things, changes in government policies with respect to laws and
regulations, anti-inflation measures, currency conversions, collection of
receivables abroad and rates and methods of taxation.





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





Our
success will depend to a significant extent upon the efforts and abilities of
our executive officers and other key personnel. The loss of the services of one
or more of these key employees and any negative market or industry perception
arising from the loss of such services could have a material adverse effect on
us and the trading price of our common stock.  Our business will also be
dependent upon our ability to attract and retain qualified personnel. Acquiring
and keeping these personnel could prove more difficult or cost substantially
more than estimated and we cannot be certain that we will be able to retain such
personnel or attract a high caliber of personnel in the future.





Compliance with
Section 404 of the Sarbanes-Oxley Act of 2002 may result in substantial
costs to us and a diversion of management attention and resources, and failure
to maintain adequate internal controls over financial reporting could result in
our business being harmed and our stock price declining.




Section 404
of the Sarbanes-Oxley Act of 2002 requires us to document and test the
effectiveness of our internal controls over financial reporting in accordance
with an established control framework and to report on our management’s
conclusion as to the effectiveness of these internal controls over financial
reporting beginning with the fiscal year ending December 31, 2007. 
This section also requires that our independent registered public accounting
firm provide an attestation report on our internal control over financial
reporting beginning with the fiscal year ending December 31, 2010. Our
management completed its evaluation of the effectiveness of our disclosure
controls and procedures as of December 31, 2008 and concluded that our internal
controls over financial reporting were effective as of that date. As of the end
of the third quarter of 2008, we were faced with limited funds for operations
and were compelled to suspend SEC filings. Management has determined that this
late filing situation was due to shortages in capital resources and is not
related to internal controls over financial reporting.




The
standards that must be met for management to continue to assess the internal
control over financial reporting are complex and will require significant
documentation, testing and possible remediation to meet the detailed
standards.  In addition, the attestation process that must be performed by
our independent registered public accounting firm is new and complex. We may
encounter problems or delays in completing the activities necessary to continue
to make assessments of our internal control over financial reporting, completing
the implementation of any requested improvements, or receiving an unqualified
attestation of our assessment by our independent registered public
accountants.  Ensuring that we have adequate internal financial and
accounting controls and procedures in place is a costly and time-consuming
effort that needs to be evaluated frequently, so compliance with these new
rules could require us to incur substantial costs and may require a
significant amount of time and attention of management, which could seriously
harm our business, financial condition and results of operations. If we are
unable to continue to our internal control over financial reporting as
effective, or if our independent registered public accounting firm is unable to
provide an unqualified attestation report on our assessment, investors may lose
confidence in us and our stock price may be negatively impacted.





18


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





We face
competition from other established companies. A number of our competitors have
longer operating histories, larger customer bases, significantly greater
financial, technological, sales, marketing and other resources than we do. 
As a result, our competitors may be able to respond more quickly than we can to
new or changing opportunities, technologies, standards or client requirements,
more quickly develop new products or devote greater resources to the promotion
and sale of their products and services than we can.  Likewise, their
greater capabilities in these areas may enable them to better withstand periodic
downturns in the identity management solutions industry and compete more
effectively on the basis of price and production.  In addition, new
companies may enter the markets in which we compete, further increasing
competition in the identity management solutions industry.





We
believe that our ability to compete successfully depends on a number of factors,
including the type and quality of our products and the strength of our brand
names, as well as many factors beyond our control. We may not be able to compete
successfully against current or future competitors, and increased competition
may result in price reductions, reduced profit margins, loss of market share and
an inability to generate cash flows that are sufficient to maintain or expand
the development and marketing of new products, any of which would adversely
impact our results of operations and financial condition.





Risks
Related to Our Securities





Our
common stock is no longer listed on the AMEX or the Over-the-Counter Bulletin
Board and is now traded on the Pink Sheets.





In May
of 2008 the AMEX removed ImageWare’s common stock from being listed on
their exchange as we failed to comply with AMEX’s continued listing
standards.  In December of 2008 our common stock was removed from
being quoted on the Over-the-Counter Bulletin Board as we failed to make the
required filings with the SEC in the required timeframe.  As of the
end of the third quarter of 2008 we were faced with limited funds for operations
and were compelled to suspend SEC filings and the associated costs until such
time as we had sufficient resources to cover ongoing operations and the expenses
of maintaining compliance with SEC filing requirements.   There
is no assurance that we will be able to attain compliance with SEC filing
requirements in the future, and if we are able to attain compliance, there is no
assurance we will be able to maintain compliance.  If we are not able
to attain and maintain compliance with SEC reporting requirements for the
minimum required periods, we will not be eligible for re-listing on the
Over-the-Counter Bulletin Board or other exchanges.





The holders of our preferred stock
have certain rights and privileges that are senior to our common stock, and we
may issue additional shares of preferred stock without stockholder approval that
could have a material 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 stock and to fix the rights, preferences, privileges, and
restrictions, including voting rights, of the preferred stock, which typically
are senior to the rights of the common stockholders, without any further vote or
action by the common stockholders. The rights of our common stockholders will be
subject to, and may be adversely affected by, the rights of the holders of the
preferred stock that have been issued, or might be issued in the future.
Preferred stock also could have the effect of making it more difficult for a
third party to acquire a majority of our outstanding voting stock. This could
delay, defer, or prevent a change in control. Furthermore, holders of preferred
stock may have other rights, including economic rights, senior to the common
stock. As a result, their existence and issuance could have a material adverse
effect on the market value of the common stock. We have in the past issued and
may from time to time in the future issue, preferred stock for financing or
other purposes with rights, preferences, or privileges senior to the common
stock. As of December 31, 2008, we had three series of preferred stock
outstanding, Series B preferred stock, Series C 8% convertible
preferred stock and Series D 8% convertible preferred stock.





The
provisions of our Series B Preferred Stock prohibit the payment of
dividends on the common stock unless the dividends on those preferred shares are
first paid. In addition, upon a liquidation, dissolution or sale of our
business, the holders of the Series B Preferred Stock will be entitled to
receive, in preference to any distribution to the holders of common stock,
initial distributions of $2.50 per share, plus all accrued but unpaid
dividends.  Pursuant to the terms of our Series B Preferred Stock we
are obligated to pay cumulative cash dividends on shares of Series B
Preferred Stock from legally available funds at the annual rate of $0.2125 per
share, payable in two semi-annual installments of $0.10625 each, which
cumulative dividends must be paid prior to payment of any dividend on our common
stock. As of December 31, 2008, we had cumulative undeclared dividends on
the Series B Preferred Stock of approximately $34,000.





19
 
 The
Series C Preferred Stock has a liquidation preference equal to its stated
value, plus any accrued and unpaid dividends thereon and any other fees or
liquidated damages owing thereon. The Series C Preferred Stock accrues
cumulative dividends at the rate of 8.0% of the stated value per share per
annum.  At the option of the Company, the dividend payment may be made in
the form of cash, after the payment of cash dividends to the holders of
Series B Preferred Stock, or common stock issuable upon conversion of the
Series C Preferred Stock.  Each share of Series C Preferred Stock
is convertible at any time at the option of the holder into a number of shares
of common stock equal to the stated value (initially $1,000 per share, subject
to adjustment), plus any accrued and unpaid dividends, divided by the conversion
price (initially $1.50 per share, subsequently adjusted to $0.50 per share and
subject to further adjustment). Subject to certain limitations, the conversion
price per share shall be adjusted in the event of certain subsequent stock
dividends, splits, reclassifications, dilutive issuances, rights offerings, and
reclassifications.  Certain activities may not be undertaken by the Company
without the affirmative vote of a majority of the holders of the outstanding
shares of Series C Preferred Stock. As of December 31, 2008, we had
cumulative undeclared dividends on the Series C Preferred Stock of
approximately $404,000.
 
 The
Series D Preferred Stock has a liquidation preference equal to its stated
value, plus any accrued and unpaid dividends thereon and any other fees or
liquidated damages owing thereon. The Series D Preferred Stock accrues
cumulative dividends at the rate of 8.0% of the stated value per share per
annum.  At the option of the Company, the dividend payment may be made in
the form of cash, after the payment of cash dividends to the holders of
Series B and Series C Preferred Stock, or common stock issuable upon
conversion of the Series D Preferred Stock.  Each share of
Series D Preferred Stock is convertible at any time at the option of the
holder into a number of shares of common stock equal to the stated value
(initially $1,000 per share, subject to adjustment), plus any accrued and unpaid
dividends, divided by the conversion price (initially $1.90 per share,
subsequently adjusted to 0.50 per share and subject to further adjustment).
Subject to certain limitations, the conversion price per share shall be adjusted
in the event of certain subsequent stock dividends, splits, reclassifications,
dilutive issuances, rights offerings, and reclassifications.  Certain
activities may not be undertaken by the Company without the affirmative vote of
a majority of the holders of the outstanding shares of Series D Preferred
Stock. As of December 31, 2008, we had cumulative undeclared dividends on
the Series D Preferred Stock of approximately $230,000.


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





There has
been significant volatility in the market price and trading volume of equity
securities, which is unrelated to the financial performance of the companies
issuing the securities. These broad market fluctuations may negatively affect
the market price of our common stock. You may not be able to resell your shares
at or above the price you pay for those shares due to fluctuations in the market
price of our common stock caused by changes in our operating performance or
prospects and other factors.





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





·
            actual or anticipated
      fluctuations in our operating results or future
      prospects;





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





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





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





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





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





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





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





·
            our inability to raise additional
      capital as needed;





·
            substantial sales of common stock
      underlying warrants and preferred
stock;





·
            concern as to the efficacy of our
      products;





·
            changes in financial markets or
      general economic conditions;





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





·
            changes in stock market analyst
      recommendations or earnings estimates regarding our common stock, other
      comparable companies or our industry
  generally.





20


Our future sales of our common stock
could adversely affect its price and our future capital-raising activities could
involve the issuance of equity securities, which would dilute shareholders’
investments and could result in a decline in the trading price of our common
stock.





We may
sell securities in the public or private equity markets if and when conditions
are favorable, even if we do not have an immediate need for additional capital
at that time. Sales of substantial amounts of our common stock, or the
perception that such sales could occur, could adversely affect the prevailing
market price of our common stock and our ability to raise capital. We may issue
additional common stock in future financing transactions or as incentive
compensation for our executive management and other key personnel, consultants
and advisors. Issuing any equity securities would be dilutive to the equity
interests represented by our then-outstanding shares of common stock. The market
price for our common stock could decrease as the market takes into account the
dilutive effect of any of these issuances. Furthermore, we may enter into
financing transactions at prices that represent a substantial discount to the
market price of our common stock. A negative reaction by investors and
securities analysts to any discounted sale of our equity securities could result
in a decline in the trading price of our common stock.





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





We have
agreed to register with the SEC certain shares of our common stock which we
issued in unregistered offerings.  In the event these securities are
registered with the SEC, they may be freely sold in the open market provided the
registration statement relating to such shares becomes effective and subject to
trading restrictions to which our affiliates holding the shares may be subject
from time to time. We expect that we also will be required to register any
securities sold in future private financings. Additionally, the number of shares
of our common stock underlying issued and outstanding warrants and preferred
stock registered under prior registration statements, many of which are now
available for resale under Rule 144 of the Securities Act, is substantial
and sales of such underlying stock could cause significant dilution.  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 of our common stock to
decline or become highly volatile.





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





Provisions
in our certificate of incorporation and bylaws may discourage, delay or prevent
a merger or acquisition involving us that our stockholders may consider
favorable. For example, our certificate of incorporation authorizes preferred
stock, which carries special rights, including voting and dividend rights. With
these rights, preferred stockholders could make it more difficult for a third
party to acquire us.





We are
also subject to the anti-takeover provisions of Section 203 of the Delaware
General Corporation Law. Under these provisions, if anyone becomes an
“interested stockholder,” we may not enter into a “business combination” with
that person for three years without special approval, which could discourage a
third party from 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 of ours that owned 15% or more of our outstanding voting stock during
the past three years, subject to certain exceptions as described in
Section 203.





We do not expect to pay cash
dividends on our common stock for the foreseeable future.





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





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





There is
no guarantee that securities analysts will continue to cover our common stock.
If securities analysts do not cover our common stock, the lack of research
coverage may adversely affect our common stock’s market price. The trading
market for our common stock relies in part on the research and reports that
industry or financial analysts publish about our business or us. If one or more
of the analysts who cover us downgrades our stock, our stock price may decline
rapidly. 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 stock
price to decline. In addition, rules mandated by the Sarbanes-Oxley Act of
2002, and a global settlement reached between the SEC, other regulatory analysts
and a number of investment banks in April 2003, may lead to a number of
fundamental changes in how analysts are reviewed and compensated. In particular,
many investment banking firms will now be required to contract with independent
financial analysts for their stock research. It may be difficult for companies
with smaller market capitalizations, such as our company, to attract independent
financial analysts that will cover our common stock, which could have a negative
effect on our market price.





21


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





Our stock
is held in a large number of individual accounts. As a result, it may be
difficult for us to reach a quorum or obtain an affirmative vote of a majority
of our stockholders where either of those thresholds are measured based on the
total number of shares of our common stock outstanding. Difficulty in obtaining
a stockholder vote could impact our ability to complete any financing or
strategic transaction requiring stockholder approval or effect basic corporate
governance changes, such as an increase in the authorized number of shares of
our preferred stock and our common stock.





Item
1B. Unresolved Staff Comments





Not
applicable.





Item 2. Properties.




As of
December 31, 2008 our corporate headquarters were located in San Diego,
California where we occupied approximately 16,000 square feet of office space
and approximately 1,000 square feet of warehouse space. Our lease for this
facility was for an indefinite term subject to termination on a 60 day notice at
a cost of approximately $13,000 per month.  As of January 28, 2010 the
monthly rate for our corporate headquarters was reduced to a cost of
approximately $10,000 per month.  We occupy 6,768 square feet in
Ottawa, Province of Ontario, Canada. These premises are leased until
September 2013, at a cost of approximately $14,000 per month. As of
December 31, 2008 we occupied 3,470 square feet of office space in Portland,
Oregon at a cost of approximately $7,300 per month.  Our lease for
this facility expired in October 2009.  As of January 28, 2010 we
occupy 6,024 square feet of office space in Portland, Oregon at a cost of
approximately $11,044 per month and continues through
October 2012.  As of January 28, 2010 we occupy approximately 500
square feet of office space in Mexico City, Mexico.  Our lease for
this facility is for an indefinite term at a cost of approximately $800 per
month.




Item
3. Legal Proceedings.





We are
periodically engaged in litigation in the ordinary course of business and do not
believe that any of such 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.





Market
Information.





Our
Common Stock is quoted under the symbol “IWSY” on the Pink Sheets.





The
following table sets forth the high and low sales prices per share for our
Common Stock  for each quarter in 2008 and 2007:





2008 Fiscal Quarters
            
            High
            
            
            LowFirst
      Quarter
            
            $
            1.610
            
            
            $
            0.950Second
      Quarter
            
            $
            1.150
            
            
            $
            0.250Third
      Quarter
            
            $
            0.800
            
            
            $
            0.340Fourth
      Quarter
            
            $
            0.480
            
            
            $
            0.050





2007 Fiscal Quarters
            
            High
            
            
            LowFirst
      Quarter
            
            $
            2.810
            
            
            $
            1.450Second
      Quarter
            
            $
            2.740
            
            
            $
            1.450Third
      Quarter
            
            $
            2.180
            
            
            $
            1.400Fourth
      Quarter
            
            $
            2.000
            
            
            $
            1.400





There is
no public trading market for our preferred stock.





22


Holders.





As of
January 28, 2010, there were approximately 600 holders of record of our Common
Stock.





Dividends.





We have
never declared or paid dividends on our Common Stock and do not anticipate
paying any cash dividends on our shares of Common Stock in the foreseeable
future. We are obligated to pay cumulative cash dividends on shares of
Series B Preferred Stock from legally available funds at the annual rate of
$0.2125 per share, payable in two semi-annual installments of $0.10625 each,
which cumulative dividends must be paid prior to payment of any dividend on our
Common Stock.  The holders of our Series C Preferred Stock are
entitled to receive cumulative dividends, at the option of the Company, payable
(i) in common stock upon conversion of the Series C Preferred Stock,
or (ii) in cash after the payment of cash dividends to the 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 receive cumulative dividends, at the option of the
Company, payable (i) in common stock upon conversion of the Series D
Preferred Stock, or (ii) in cash after the payment of cash dividends to the
holders of our Series B Preferred Stock at the rate of 8% per annum (as a
percentage of stated value per share).





As of
December 31, 2008, the Company had cumulative undeclared dividends of
approximately $34,000 relating to our Series B Preferred Stock,
approximately $404,000 relating to our Series C Preferred Stock, and
approximately $230,000 relating to our Series D Preferred
Stock.





Repurchases.





We did
not repurchase any shares of our common stock during fiscal 2008.





23
 Item
7.                      Management’s
Discussion and Analysis of Financial Condition and Results of Operations.





FORWARD-LOOKING
STATEMENTS





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





24


OVERVIEW





ImageWare
Systems, Inc. is a leader in the emerging market for software-based
identity management solutions, providing biometric, secure credential and law
enforcement technologies.  Our “flagship” product is the IWS Biometric
EngineTM.  Scalable for small city, enterprise or worldwide deployment,
our biometric engine is a multi-biometric platform that is hardware and
algorithm independent, enabling the enrollment and management of unlimited
population sizes.  Our identification products are used to manage and
issue secure credentials including national IDs, passports, driver licenses,
smart cards and access control credentials. Our law enforcement products provide
law enforcement with integrated mug shot, fingerprint Livescan and investigative
capabilities.  Biometric technology is now an integral part of all
markets we address, and all of our products are integrated into the Biometric
Engine Platform.  Elements of the biometric engine can be used as
investigative tools to law enforcement potentially utilizing multiple biometrics
and forensic data elements, and to enhance security and authenticity of public
and private sector credentials.





CRITICAL
ACCOUNTING ESTIMATES





The
discussion and analysis of our consolidated financial condition and results of
operations are based on our consolidated financial statements, which have been
prepared in accordance with accounting principals generally accepted in the
United States of America, or U.S. GAAP. The preparation of these consolidated
financial statements in accordance with U.S. GAAP requires us to utilize
accounting policies and make certain estimates and assumptions that affect the
reported amounts of assets and liabilities, the disclosure of contingencies as
of the date of the consolidated financial statements and the reported amounts of
revenue and expenses during a fiscal period. The SEC considers an accounting
policy to be critical if it is important to a company’s financial condition and
results of operations, and if it requires significant judgment and estimates on
the part of management in its application. Although we believe that our
judgments and estimates are appropriate and correct, actual results
may differ from those estimates.




The following are our critical
accounting policies because we believe they are both important to the portrayal
of our financial condition and results of operations and require critical
management judgments and estimates about matters that are uncertain. If actual
results or events differ materially from those contemplated by us in making
these estimates, our reported financial condition and results of operations for
future periods could be materially affected.  For a detailed
discussion on the application of these and other accounting policies, see
Note 2 in the Notes to the Consolidated Financial Statements in Item 8 of
this Annual Report on Form 10-K, beginning on page 68.





Revenue
Recognition





Our
revenue recognition policy is significant because our revenue is a key component
of our consolidated results of operations. We recognize revenue from the
following major revenue sources:





·
            Long-term fixed-price contracts
      involving significant
customization





·
            Fixed-price contracts involving
      minimal customization





·
            Software
      licensing





·
            Sales of computer hardware and
      identification media





·
            Postcontract customer support
      (PCS)




The
Company’s revenue recognition policies are consistent with U. S. GAAP including
Statements of Position 97-2 “Software Revenue Recognition” and 98-9
“Modification of SOP 97-2, Software Revenue Recognition With Respect to Certain
Transactions”, Statement of Position 81-1 “Accounting for Performance of
Construction-Type and Certain Production-Type Contracts “Securities and Exchange
Commission Staff Accounting Bulletin 104 , Emerging Issues Task Force Issue
00-21 “Revenue Arrangements with Multiple Deliverables”, and Emerging Issues
Task Force Issue 03-05 “Applicability of AICPA Statement of Position 97-2 to
Non-Software Deliverables in an Arrangement Containing More-Than-Incidental
Software”. Accordingly, the Company recognizes revenue when all of the following
criteria are met: persuasive evidence of an arrangement exists, delivery has
occurred or services have been rendered, the fee is fixed or determinable, and
collectability is reasonably assured.





25
 
 We
recognize revenue and profit as work progresses on long-term, fixed-price
contracts involving significant amount of hardware and software customization
using the percentage of completion method based on costs incurred to date
compared to total estimated costs at completion. Revenue from contracts for
which we cannot reliably estimate total costs or there are not significant
amounts of customization are recognized upon completion. Determining when a
contract should be accounted for using the percentage of completion method
involves judgment. Critical items that are considered in this process are the
degree of customization and related labor hours necessary to complete the
required work as well as ongoing estimates of the future labor hours needed to
complete the contract. We also generate non-recurring revenue from the licensing
of our software. Software license revenue is recognized upon the execution of a
license agreement, upon deliverance, fees are fixed and determinable,
collectability is probable and when all other significant obligations have been
fulfilled. We also generate revenue from the sale of computer hardware and
identification media. Revenue for these items is recognized upon delivery of
these products to the customer. Our revenue from periodic maintenance agreements
is generally recognized ratably over the respective maintenance periods provided
no significant obligations remain and collectability of the related receivable
is probable.





For a
detailed discussion on the application of these and other accounting policies,
see Note 1 in the Notes to the Consolidated Financial Statements in Item 8
of this Annual Report on Form 10-K, beginning on page 67.





Allowance
for Doubtful Accounts





We
provide an allowance for our accounts receivable for estimated losses that may
result 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 customer payment terms when evaluating the adequacy
of the allowance for doubtful accounts. Our accounts receivables balance was
$503,000, net of allowance for doubtful accounts of $28,000 for the year ended
December 31, 2008.





Valuation
of Goodwill, Other Intangible and Long-Lived Assets





We assess
impairment of goodwill and identifiable intangible assets whenever events or
changes in circumstances indicate that the carrying value may not be
recoverable. Factors we consider important which could trigger an impairment
review include the following:





·
              Significant underperformance
      relative to historical or expected future operating
      results;





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





·
            Significant negative industry or
      economic trends;




When we
determine that the carrying value of goodwill and other intangible assets may
not be recoverable based upon the existence of one or more of the above
indicators of impairment, we measure any impairment based upon fair value
methodologies. Goodwill and other net intangible assets amounted to
approximately $3,416,000 for the year ended December 31,
2008.  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 of
approximately $1,036,000 after the allocation of purchase price as determined by
employing fair value methodologies. In March2008, we amended the purchase
agreement for the acquisition of substantially all the assets of Sol
Logic, Inc. originally consummated December 19, 2007. As a result of
this amendment, which reduced the purchase price of the Sol Logic assets, we
reversed previously recorded goodwill from this acquisition of approximately
$1,036,000 as originally reflected in the 2007 consolidated financial
statements.
 
 In 2002,
Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and
Other Intangible Assets” became effective, and as a result we ceased to amortize
goodwill. In lieu of amortization, we performed an initial impairment review of
our goodwill in June, 2002 and will perform an annual impairment review
thereafter in the fourth quarter of our fiscal year.  Our tests were
conducted 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.





With the
sale of our Digital Photography component in 2006, we reassessed the composition
of our operating segments and determined that we no longer operate in 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’s business structure due to the consolidation
of operations, restructuring of the Company’s operations and management team,
and the integration of what where previously distinct, mutually exclusive
technologies.  This has resulted in changes in the manner by which the
Company’s chief decision maker assesses performance and makes decisions
concerning resource allocation.  As a result of our operation in one
market segment, such segment being identity management, our 2008 and 2007
goodwill impairment review consisted of the comparison of the fair value of our
identity management segment as determined by the quoted market prices of our
common stock to the carrying amount of the segment. As the fair value exceeded
the carrying value by a substantial margin, we determined that our goodwill was
not impaired.





26


There are
many management assumptions and estimates underlying the determination of an
impairment loss, and estimates using different, but reasonable, assumptions
could produce significantly different results. Significant assumptions include
estimates of future levels of revenues and operating expenses. Therefore, the
timing and recognition of impairment losses by us in the future, if any, may be
highly dependent upon our estimates and assumptions.  There can be no
assurance that goodwill impairment will not occur in the future.





We
account 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-lived assets and certain
identifiable intangible assets be reviewed for impairment whenever events or
changes in circumstances indicate that the carrying amount of an asset may not
be recoverable.  Recoverability of assets to be held and used is
measured by a comparison of the carrying amount of an asset to future net
undiscounted cash flows expected to be generated by the asset.  If
such assets are considered to be impaired, the impairment to be recognized is
measured by the amount which the carrying amount of the assets exceeds the fair
value of the assets.  Fair value is determined based on discounted
cash flows or appraised values, depending upon the nature of the
asset.  Assets to be disposed of are reported at the lower of the
carrying amount of fair value less costs to sell.  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 at
approximately $200,000, customer base valued at approximately $93,000 and
developed technology valued at approximately $2,018,000.  The
allocation of the purchase price was based on fair value
methodologies.





In 2008,
we recorded an impairment charge of approximately $742,000 related to our
intangible assets related to our acquisition of Sol Logic in
2007.  This loss reflects the amount by which the carrying value of
this asset exceeded its estimated fair value determined by the assets’ future
discounted cash flows.  The impairment loss is recorded as a component
of “Operating expenses” in the Statement of Operations for 2008.  We
recorded no impairment losses for long-lived or intangible assets during the
twelve months ended December 31, 2007. There are many management
assumptions and estimates underlying the determination of an impairment loss,
and estimates using different, but reasonable, assumptions could produce
significantly different results. Significant assumptions include estimates of
future levels of revenues and operating expenses. Therefore, the timing and
recognition of impairment losses by us in the future, if any, may be highly
dependent upon our estimates and assumptions.  There can be no
assurance that intangible asset impairment will not occur in the
future.





Stock-Based
Compensation





Upon
adoption of SFAS No. 123R “Accounting for Stock Based Compensation” on
January 1, 2006, we began estimating the value of employee stock options on
the grant date using the Black-Scholes model. Prior to the adoption of SFAS No.
123R, the value of each employee stock option was estimated on the date of grant
using the Black-Scholes model for the purpose of the pro forma financial
disclosure in accordance with SFAS No. 123R. The determination of fair value of
stock-based payment awards on the grant date using an option-pricing model is
affected by our stock price as well as assumptions regarding a number of highly
complex and subjective variables. These variables include, but are not limited
to the expected stock price volatility over the term of the awards and the
actual and projected employee stock option exercise behaviors. The expected term
of options granted is derived from historical data on employee exercises and
post-vesting employment termination behavior. We calculated our expected
volatility assumption required in the Black-Scholes model based on the
historical volatility of our stock. As of January 1, 2006 we have adopted
the modified prospective transition method and its effect is included in our
consolidated financial statements for the twelve months ended December 31,
2008.  We will update these assumptions on at least an annual basis
and on an interim basis if significant changes to the assumptions are
warranted.





27


Year
Ended December 31, 2008 Compared to Year Ended December 31,
2007





Revenues





Product
Revenues





TWELVE MONTHS ENDEDDECEMBER 31,($
      in thousands)
            
            2008
            
            
            Change
            
            
            2007Product revenues:Software
      and Royalties
            
            $
            2,362
            
            
            -52
            %
            
            $
            4,966Percentage
      of total net product revenue
            
            64
            %
            
            -24
            %
            
            88
            %Hardware
      and consumables
            
            $
            171
            
            
            -51
            %
            
            $
            350Percentage
      of total net product revenue
            
            5
            %
            
            -2
            %
            
            6
            %Services
            
            $
            1,174
            
            
            250
            %
            
            $
            336Percentage
      of total net product revenue
            
            31
            %
            
            25
            %
            
            6
            %Total
      net product revenues
            
            $
            3,707
            
            
            -34
            %
            
            $
            5,652





Identity
management software and royalty revenues decreased 52% or approximately
$2,605,000 during the twelve months ended December 31, 2008 as compared to the
corresponding period in 2007.  The decrease is due primarily to lower
project-oriented revenues of our Personal Identity Verification (“PIV”) and
Biometric Engine software solutions of approximately $1,706,000, lower
identification software royalties and license revenues of approximately $520,000
relating  primarily to our Desktop Security product, lower sales of
our boxed identity management software through our distribution channel of
approximately $248,000 and lower Law Enforcement project-oriented revenues of
approximately $131,000.




Revenues
from the sale of hardware and consumables decreased 51% or $179,000 during the
twelve months ended December 31, 2008 as compared to the corresponding period in
2007.  The decrease reflects lower revenues from project solutions
containing hardware and consumable components.




Services
revenues are comprised primarily of software integration services, system
installation services and customer training.  Such revenues increased
approximately $838,000 during the twelve months ended December 31, 2008 as
compared to the corresponding period in 2007 due primarily to higher service
revenues being generated from software integration of our biometric engine and
PIV products into project solutions offset by a decrease in our installation of
hardware products.
 
 We expect
service revenues to continue to be a significant component of our
revenues  through our implementation of large-scale high-end
installations.
 
 We
believe that the period-to-period fluctuations of identity management software
revenue in project-oriented solutions are largely due to the timing of
government procurement with respect to the various programs we are
pursuing.  Based on management’s current visibility into the timing of
potential government procurements, we believe that we will see a significant
increase in government procurement and implementations with respect to identity
management initiatives however we cannot predict the timing of such
initiatives.




Our
backlog of product orders as of December 31, 2008, was approximately
$1,839,000.  At December 31, 2008, we also had maintenance and
support backlog of approximately $872,000 under existing maintenance
agreements.  Product revenue is typically recognized within a three to
six month period for projects not requiring significant customization. Projects
that require significant customization can range from six months to two years
depending upon the required degree of customization and customer implementation
schedules. Historically, we have experienced a very minimal risk of order
cancellation and do not anticipate order cancellations in excess of
5%.  Our revenue from maintenance agreements is generally recognized
ratably over the respective maintenance periods provided no significant
obligations remain and collectability of the related receivable is
probable.





28


Maintenance
Revenues





TWELVE MONTHS ENDEDDECEMBER 31,($
      in thousands)
            
            2008
            
            
            Change
            
            
            2007Maintenance
      revenues
            
            $
            2,808
            
            
            -1
            %
            
            $
            2,836





Maintenance
revenues decreased 1% or approximately $28,000.  The decrease in
maintenance revenues reflects lower revenues generated due to the expiration of
maintenance contracts on certain identification software solutions combined with
lower maintenance revenues generated from our Desktop Security product due to
the expiration of certain maintenance contracts related to this
product.





We
anticipate continued growth of our installed base through the retention of
existing customers combined with the completion of project-oriented work;
however we cannot predict the timing of this anticipated growth.





Cost of Product
Revenues





TWELVE MONTHS ENDED($
      in thousands)
            
            DECEMBER 31,2008
            
            
            Change
            
            
            2007Cost of Product Revenues:Software
      and Royalties
            
            $
            419
            
            
            
            -58
            %
            
            $
            1,008Percentage
      of software and royalty net product revenue
            
            
            18
            %
            
            
            -2
            %
            
            
            20
            %Hardware
      and consumables
            
            $
            157
            
            
            
            -47
            %
            
            $
            295Percentage
      of hardware and consumables net product revenue
            
            
            92
            %
            
            
            8
            %
            
            
            84
            %Services
            
            $
            486
            
            
            
            531
            %
            
            $
            77Percentage
      of services net product revenue
            
            
            41
            %
            
            
            18
            %
            
            
            23
            %Total
      net product revenues
            
            $
            1,062
            
            
            
            -23
            %
            
            $
            1,380Percentage
      of total net product revenues
            
            
            29
            %
            
            
            5
            %
            
            
            24
            %





The cost
of software and royalty product revenue decreased 58% or $589,000 during the
twelve months ended December 31, 2008 as compared to the corresponding period in
2007 due to lower software and royalty revenues generated during the twelve
months ended December 31, 2008.  In addition to changes in costs of
software and royalties product revenues caused by revenue level fluctuations,
costs of products can also vary as a percentage of product revenue from period
to period depending upon the level of software customization and third party
software license content included in product sales during a given
period.





Costs of
product revenues of our hardware and consumables revenues decreased
approximately 47% or $138,000 for the twelve months ended December 31, 2008 as
compared to the corresponding period of 2007 due to lower sales of hardware and
consumables.  Sales of hardware decreased approximately $140,000 and
sales of consumables decreased approximately $40,000 for the twelve months ended
December 31, 2008 as compared to the corresponding period in 2007. These revenue
decreases resulted in lower cost of sales of approximately $60,000 related to
hardware and lower cost of sales of approximately $78,000 related
consumables.





Costs of
service revenues increased approximately 531% or $409,000 for the twelve months
ended December 31, 2008 as compared to the corresponding period of 2007 due to
an increase in integration services and system installation services generated
from project work





29


Costs of
products also can vary as a percentage of product revenue from period to period
depending upon product mix and the third party software license content,
hardware content, and print media consumable content included in systems
installed during a given period.





Maintenance Cost of
Revenues





TWELVE MONTHS ENDED($
      in thousands)
            
            DECEMBER 31,2008
            
            
            Change
            
            
            2007Total
      maintenance cost of revenues
            
            $
            1,146
            
            
            
            -2
            %
            
            $
            1,166Percentage
      of total maintenance revenues
            
            
            41
            %
            
            
            0
            %
            
            
            41
            %





Costs of
maintenance revenues decreased 2% or $20,000 during the twelve months ended
December 31, 2008 as compared to the corresponding period in 2007 due to lower
maintenance costs for replacement hardware and a greater percentage of
maintenance revenues being derived from software maintenance which typically has
lower costs than hardware maintenance.







Product Gross
Profit





TWELVE MONTHS ENDED($
      in thousands)
            
            DECEMBER 31,2008
            
            
            Change
            
            
            2007Product gross
      profitSoftware
      and royalties
            
            $
            1,944
            
            
            
            -51
            %
            
            $
            3,959Percentage
      of software and royalty product revenue
            
            
            82
            %
            
            
            2
            %
            
            
            80
            %Hardware
      and consumables
            
            $
            13
            
            
            
            -75
            %
            
            $
            54Percentage
      of hardware and consumables product revenue
            
            
            8
            %
            
            
            -8
            %
            
            
            16
            %Services
            
            $
            688
            
            
            
            166
            %
            
            $
            259Percentage
      of services product revenue
            
            
            59
            %
            
            
            -18
            %
            
            
            77
            %Total
      product gross profit
            
            $
            2,645
            
            
            
            -37
            %
            
            $
            4,272Percentage
      of total product revenues
            
            
            71
            %
            
            
            -5
            %
            
            
            76
            %





Total
product gross profit as a percentage of product revenues decreased approximately
5%.  The dollar decrease of $1,627,000 reflects lower product revenues
generated in the twelve months ended December 31, 2008 as compared to the
corresponding period in 2008.  In addition to changes in costs of
software and royalties product revenues caused by revenue level fluctuations,
costs of products can also vary as a percentage of product revenue from period
to period depending upon the level of software customization and third party
software license content included in product sales during a given
period.
 
 The
dollar decrease in gross profit of software and royalties of approximately 51%
or $2,015,000 for the twelve months ended December 31, 2008 as compared to the
corresponding period in 2007 reflects lower sales of software and royalties into
project-oriented work of approximately $2,605,000 in the twelve month period
ending December 31, 2008.




Hardware
and consumable gross profit as a percentage of hardware and consumable product
revenue decreased approximately $41,000 for the twelve months ended
December 31, 2008 as compared to the corresponding period in 2007 due to
lower sales of hardware and consumables of approximately $180,000 in the twelve
month period ending December 31, 2008.





30


Services
gross profit increased approximately $429,000 for the twelve months ended
December 31, 2008 as compared to the corresponding period of 2007 due to higher
project revenues for the integration and customization of our Biometric Engine
and PIV products into project solutions.








Maintenance Gross
Profit





TWELVE MONTHS ENDED($
      in thousands)
            
            DECEMBER 31,2008
            
            
            Change
            
            
            2007Maintenance
      gross profitTotal
      maintenance gross profit
            
            $
            1,662
            
            
            
            2
            %
            
            $
            1,670Percentage
      of total maintenance revenues
            
            
            59
            %
            
            
            0
            %
            
            
            59
            %





Total
gross profit dollars related to maintenance revenues decreased approximately
$8,000 during the twelve months ended December 31, 2008 as compared to the
corresponding period in 2007 and reflect lower maintenance revenues of
approximately $28,000 offset by lower maintenance costs of
$20,000.  Our decrease in maintenance revenues reflects lower revenues
generated due to the expiration of maintenance contracts on certain
identification software solutions combined with lower maintenance revenues
generated from our Desktop Security product due to the expiration of certain
maintenance contracts related to this product.  Our decrease in the
cost of maintenance revenues reflects lower maintenance costs for replacement
hardware and a greater percentage of maintenance revenues being derived from
software maintenance which typically has lower costs than hardware
maintenance.





Operating
Expenses





TWELVE MONTHS ENDEDDECEMBER 31,($
      in thousands)
            
            2008
            
            
            Change
            
            
            2007Operating
      expenses:General &
      administrative
            
            $
            3,553
            
            
            
            -8
            %
            
            $
            3,865Percentage
      of total net revenue
            
            
            55
            %
            
            
            9
            %
            
            
            46
            %Sales
      and marketing
            
            $
            2,111
            
            
            
            -20
            %
            
            $
            2,647Percentage
      of total net revenue
            
            
            32
            %
            
            
            1
            %
            
            
            31
            %Research &
      development
            
            $
            2,956
            
            
            
            -19
            %
            
            $
            3,669Percentage
      of total net revenue
            
            
            45
            %
            
            
            2
            %
            
            
            43
            %Impairment
      loss
            
            $
            742
            
            
            
            100
            %
            
            $
            0Percentage
      of total net revenue
            
            
            11
            %
            
            
            11
            %
            
            
            0
            %Depreciation
      and amortization
            
            $
            772
            
            
            
            200
            %
            
            $
            258Percentage
      of total net revenue
            
            
            12
            %
            
            
            9
            %
            
            
            3
            %





General
and Administrative Expenses





General
and administrative expenses are comprised primarily of salaries and other
employee-related costs for executive, financial, and other infrastructure
personnel. General legal, accounting and consulting services, insurance,
occupancy and communication costs are also included with general and
administrative expenses.





General
and administrative expenses decreased during the twelve months ended
December 31, 2008 as compared to the corresponding period in 2007 by
approximately $312,000.  Major components of this change
are:





·
            Decrease in stock-based
      compensation expense of approximately $111,000 due the vesting of certain
      restricted stock grants combined with lower expenses recorded pursuant to
      SFAS 123(R) due to the expiration of vesting periods for certain
      prior year share-based payment
issuances.





·
            Decrease in consulting and
      professional fees expense of approximately $229,000 due to the termination
      of various consulting
agreements.





·
            Decrease
      in insurance expense of approximately $24,000; decrease in facilities
      related expense of approximately $32,000 and decrease in bad debt expense
      of approximately $25,000.





·
            Increase in salaries and related
      personnel costs of approximately $22,000 and increases in royalty and
      license expense of approximately
$87,000.





31


The
percentage increase is reflective of lower total net revenues during the year
ended December 31, 2008 as compared to the corresponding period in
2007.




We are
continuing to focus our efforts on achieving additional future operating
efficiencies by reviewing and improving upon existing business processes and
evaluating our cost structure. We believe these efforts will allow us to
continue to gradually decrease our level of general and administrative expenses
expressed as a percentage of total revenues.





Sales
and Marketing Expenses





Sales and
marketing expenses consist primarily of the salaries, commissions, other
incentive compensation, employee benefits and travel expenses of our sales
force.





Selling
and marketing expenses decreased in 2008 by approximately
$536,000.  Major components of this change are:





·
            Decrease in salaries and
      personnel costs of approximately $242,000 due to reductions in
      headcount.





·
            Decrease in advertising and trade
      show expenses of approximately
$109,000.





·
            Decrease in travel related
      expenses $91,000.





·
            Decrease
      in equipment and supplies of approximately
  $36,000.





·
            Decrease
      in professional services of approximately
  $58,000.





We
anticipate that the level of expenses incurred for sales and marketing during
the twelve months ended December 31, 2009 will increase as we pursue large
project solution opportunities.





Research
and Development Expenses





Research
and development costs consist primarily of salaries, employee benefits and
outside contractors for new product development, product enhancements and custom
integration work.





Research
and development expenses were approximately $2,956,000 and $3,669,000 during the
twelve months ended December 31, 2008 and 2007,
respectively.  Such expenses decreased 19% or approximately $713,000
for the twelve months ended December 31, 2008 as compared to the corresponding
period in 2007.  The decrease reflects reductions in contract
programming expenditures of approximately $656,000 combined with reductions in
salaries and employee benefits of approximately $73,000 due to reductions in
headcount.  These reductions were offset by increases in facilities
related expenses of $32,000.  Travel expenditures decreased by
$16,000.





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





Impairment
Losses





Impairment
losses represent the amount by which the carrying amount of long-lived
assets exceeds their fair value.  Fair value is determined based on
the best information available in the circumstances, including present value
techniques.  During the twelve months ended December 31, 2008, we
recorded impairment losses of $742,000 for long-lived intangible assets acquired
in the Company’s December 2007 purchase of certain assets of Sol Logic,
Inc.




Depreciation
and Amortization




Depreciation
and amortization increased during the twelve months ended December 31, 2008
as compared to the corresponding period in 2007.  This increase
reflects higher amortization expense of approximately $509,000 for certain
definite long-lived intangible assets acquired in the Company’s December 2007
purchase of certain assets of Sol Logic, Inc.  Depreciation expense
increased approximately $4,000 due to the depreciation of fixed assets acquired
in the Company’s December 2007 purchase of certain assets of Sol Logic,
Inc.





32


Interest
Expense, Net





For the
year ended December 31, 2008, we recognized interest income of $11,000 and
interest expense of $30,000. For the year ended December 31, 2007, we
recognized interest income of $48,000 and interest expense of
$263,000.





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




Liquidity
and Capital Resources




As of
December 31, 2008, we had total current assets of $884,000 and total
current liabilities of $5,069,000, or negative working capital of $4,185,000. At
December 31, 2008 and 2007, we had available cash of $171,000 and
$1,044,000, respectively. In 2009, we secured a line of credit facility through
the issuance of a secured promissory note whereby we borrowed an aggregate
amount of approximately $2,325,000 and subsequently repaid $350,000. In 2009, we
also undertook a series of warrant financings whereby we raised approximately
$1,371,000 in cash.  Despite securing these financing arrangements, we
still have negative working capital and will need to secure additional new
financing to fund working capital and operations should we be unable to generate
positive cash flow from operation in the near future.




Net cash
used in operating activities was $2,192,000 for the year ended December 31,
2008, as compared to $2,875,000 for the corresponding period in 2007. We used
cash to fund net losses of $3,421,000, excluding non-cash expenses
(depreciation, amortization, debt issuance costs, debt discount, stock-based
compensation, and provision for losses on accounts receivable, reductions in
inventory valuation allowance, and write-down of investments in equity
securities) of $2,297,000 for the year ended December 31,
2008.  We used cash to fund net losses of $3,568,000, excluding
non-cash expenses (depreciation, amortization, accretion of beneficial
conversion feature on convertible debt, debt discount, stock-based compensation,
increases in inventory valuation allowance, impairment losses recorded on
intangible assets and write-down of prepaid royalties) of $1,117,000 for the
year ended December 31, 2007.  For the year ended
December 31, 2008, we used cash of $53,000 to fund increases in current
assets and generated cash of $1,282,000 through increases in current liabilities
(excluding debt). For the year ended December 31, 2007, we generated cash
of $913,000 through reductions in current assets and used cash of $220,000 from
decreases in current liabilities (excluding debt).





Net cash
used by investing activities was $122,000 for the year ended December 31,
2008.  Net cash used by investing activities was $522,000 for the year
ended December 31, 2007. For the year ended December 31, 2008, we used
cash to fund capital expenditures of computer equipment and software, furniture
and fixtures and leasehold improvements of approximately $67,000. The level of
equipment purchases resulted primarily from continued growth of the business and
replacement of older equipment.  For the year ended December 31, 2008,
we generated cash of $132,000 from the expiration of certain letters of credit
securing our performance on software implementation contracts. For the year
ended December 31, 2008 we used cash of $187,000 for our acquisition of Sol
Logic, Inc. For the year ended December 31, 2007, we used cash to fund
capital expenditures of computer equipment and software, furniture and fixtures
and leasehold improvements of approximately $86,000. The level of equipment
purchases resulted primarily from continued growth of the business and
replacement of older equipment. For the year ended December 31, 2007, we
also used cash of $410,000 for our acquisition of Sol Logic, Inc. and used
cash of $26,000 to fund increases in restricted cash securing our performance of
certain software implementation contracts.





Net cash
provided by financing activities was $1,404,000 for the year ended
December 31, 2008. We generated cash of $810,000 from our issuance of
preferred stock in a private placement net of transaction costs of
$33,000.  We also generated cash of $542,000 from our issuance of
common stock pursuant to warrant exercises.  We also generated cash of
$110,000 for our issuance of convertible notes payable.  In 2008, we
used cash of $25,000 for the payment of dividends on our Series B Preferred
Stock In 2007, we used cash of $1,310,000 to repay notes payable and used cash
of $51,000 for the payment of dividends on our Series B Preferred Stock and
incurred financing related expenses of $54,000.  Net cash provided by
financing 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 private
placement and generated cash of $1,233,000 from our issuance of preferred stock
in a private placement.  We also generated cash of $1,121,000 from our
issuance of common stock pursuant to warrant exercises.  In 2007, we
used cash of $1,310,000 to repay notes payable and used cash of $51,000 for the
payment of dividends on our Series B Preferred Stock and incurred financing
related expenses of $54,000.





33


Contractual
Obligations and Commercial Commitments





We conduct operations in leased
facilities under operating leases expiring at various dates through
2013.  We also
have various short-term notes payable and capital lease obligations due at
various times during 2009.




The
report of the Company’s independent accountants included with this Annual Report
contains an explanatory paragraph regarding our ability to continue as a going
concern.  We are seeking additional financing that we believe is
necessary to fund our working capital requirements for at least the next twelve
months in conjunction with the successful implementation of our business plan.
Our business plan includes, among other things, the monitoring and controlling
of operating expenses, collection of significant trade and other accounts
receivables, and controlling of capital expenditures.  If we are
unable to secure additional financing or successfully implement our business
plan, we will be required to seek funding from alternate sources and/or
institute cost reduction measures.  We may seek to sell equity or debt
securities, secure a bank line of credit, or consider strategic
alliances.  The sale of equity or equity-related securities could
result in additional dilution to our shareholders.  There can be no
assurance that additional financing, in any form, will be available at all or,
if available, will be on terms acceptable to us.  In addition, our
ability to raise additional capital may be impacted by the markets on which our
common stock is quoted and our ability to maintain compliance with SEC filing
requirements.  In May of 2008 the AMEX removed ImageWare’s common
stock from being listed on their exchange as we failed to comply with AMEX’s
continued listing standards.  In December of 2008 our common stock was
removed from being quoted on the Over-the-Counter Bulletin Board as we failed to
make the required filings with the SEC in the required timeframe.  As
of the end of the third quarter of 2008 we were faced with limited funds for
operations and were compelled to suspend SEC filings and the associated costs
until such time as we had sufficient resources to cover ongoing operations and
the expenses of maintaining compliance with SEC filing
requirements.   There is no assurance that we will be able to
attain compliance with SEC filing requirements in the future, and if we are able
to attain compliance, there is no assurance we will be able to maintain
compliance.  If we are not able to attain and maintain compliance for
minimum required periods, we will not be eligible for re-listing on the
Over-the-Counter Bulletin board or other exchanges.




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





Item 8.
Consolidated Financial Statements and Supplementary Data.





The index
to our Consolidated Financial Statements and the Report of Independent
Registered Public Accounting Firm appears in Part IV of this
Form 10-K.





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





Not
applicable





Item
9A. Controls and Procedures.





Management
is responsible for establishing and maintaining adequate internal control over
financial reporting of the Company.




Evaluation of disclosure controls
and procedures.  Our chief executive officer and our chief
financial officer, after evaluating the effectiveness of our disclosure controls
and procedures (as defined in Exchange Act Rule 13a-15(e)) as of
December 31, 2008 (the “Evaluation Date”), have concluded that our
disclosure controls and procedures were adequate and effective as of December
31, 2008. As of the end of the third quarter of 2008, we were faced with limited
funds for operations and were compelled to suspend SEC filings. Management has
determined that this late filing situation was due to shortages in capital
resources and is not related to internal controls over financial
reporting.




The
Company’s management assessed the effectiveness of the Company’s internal
control over financial reporting as of December 31, 2008 in accordance with
the standards set forth by the Public Company Accounting Oversight Board
(“PCAOB”).  In accordance with these standards, management assessed
and tested, on a sample basis, the Company’s internal control over financial
reporting according to a comprehensive risk analysis using the Internal Control
– Integrated Framework issued by the Committee of Sponsoring Organizations of
the Treadway Commission, (“COSO”).  It is management’s opinion that
the testing methodology of the internal control framework is appropriate and
provides reasonable assurance as to the integrity and reliability of our
internal controls over financial reporting. Based on the results of its
evaluation, the Company’s management has concluded that the Company’s internal
control over financial reporting was effective as of December 31,
2008.  .This annual report does not include an attestation report of
the Company’s registered public accounting firm regarding internal control over
financial reporting.  Management’s report was not subject to
attestation by the Company’s registered public accounting firm pursuant to the
temporary rules of the Securities and Exchange Commission that permit the
Company to provide only management’s report in this annual
report





34


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





Item
9B. Other Information.





Not
applicable.





35


PART III





Item 10.
            Directors, Executive Officers and
      Corporate Governance





DIRECTORS
AND EXECUTIVE OFFICERS





DIRECTORS





The
following table sets forth information regarding our directors as of January 28,
2010:





Name
            
            Age
            
            Principal Occupation/Position
              Held With the CompanyMr. S.
      James Miller, Jr.
            
            56
            
            Chief
      Executive Officer and Chairman of the Board of
DirectorsMr. John
      Callan
            
            63
            
            DirectorMr. David
      Carey
            
            65
            
            DirectorMr. Guy
      Steven Hamm
            
            62
            
            DirectorMr. John
      Holleran
            
            83
            
            DirectorMr. David
      Loesch
            
            65
            
            Director





On
March 16, 2008, Mr. Patrick Downs, a member of our board of directors,
passed away.  We have not yet filled the vacancy resulting from
Mr. Downs’ untimely passing.





S. James Miller, Jr. has
served as our Chief Executive Officer since 1990 and Chairman of the Board since
1996. He also served as our President from 1990 until 2003. From 1980 to 1990,
Mr. Miller was an executive with Oak Industries, Inc., a manufacturer
of components for the telecommunications industry. While at Oak Industries,
Mr. Miller served as a director and as Senior Vice President, General
Counsel, Corporate Secretary and Chairman/President of Oak Industries’ Pacific
Rim subsidiaries. He has a J.D. from the University of San Diego School of Law
and a B.A. from the University of California, San Diego.




John Callan was appointed to
the Board in September 2000.  Since July 2008, Mr. Callan
returned to Ursa Major Associates, the consulting firm he co-founded in
2001.  He now serves as Managing Director.From
February 2007 to July 2008, Mr. Callan served as Vice President, Strategy
and Business Development at DHL Global Mail, Americas. From March 2006 to
February 2007, Mr. Callan served DHL Global Mail as Vice President -
Domestic Product Management. From 2001 to 2006, Mr. Callan served as
Principal of Ursa Major Associates, LLC, the logistics strategy consulting firm
he co-founded. From 1997 to 2002, he was an independent business strategy
consultant in the imaging and logistics fields. From 1995 to 1997,
Mr. Callan served as Chief Operating Officer for Milestone Systems, a
shipping systems software company. From 1987 to 1995, he served as Director of
Entertainment Imaging at Polaroid Corporation. Mr. Callan is a graduate of
the University of North Carolina.
 
 David Carey was appointed to
the Board in February 2007. Mr. Carey is a former Executive Director of the
Central Intelligence Agency. Since April 2005, Mr. Carey has served as
Executive Director for Blackbird Technologies, which provides state-of-the-art
IT security expertise, where he assists the company with business development
and strategic planning. Prior to joining Blackbird Technologies, Mr. Carey
was Vice President, Information Assurance for Oracle Corporation from
September 2001 to April 2005. In addition, Mr. Carey worked for
the CIA for 32 years until 2001. During his career at the CIA, Mr. Carey
held several senior positions including that of Executive Director, often
referred to as the Chief Operating Officer, or No. 3 person in the agency,
from 1997 to 2001. Before assuming that position, Mr. Carey was Director of
the DCI Crime and Narcotics Center, the Director of the Office of Near Eastern
and South Asian Analysis, and Deputy Director of the Office of Global Issues.
Mr. Carey is a graduate of Cornell University and the University of
Delaware.
 
 Guy Steven Hamm was appointed
to the Board in October 2004. Mr. Hamm served Aspen Holding, a
privately held insurance provider, as CFO from December 2005 to February
2007. In 2002, Mr. Hamm retired from PricewaterhouseCoopers, where he was a
national partner-in-charge of middle market. Mr. Hamm was instrumental in
growing the Audit Business Advisory Services (ABAS) Middle Market practice at
PricewaterhouseCoopers, where he was responsible for $300 million in revenue and
more than 100 partners. Mr. Hamm is a graduate of San Diego State
University.





36


John Holleran was appointed
to the Board in May 1996. Since 1974, Mr. Holleran has been a
management and investment consultant. Prior to consulting, Mr. Holleran
served as the Chief Financial Officer, Executive Vice President and Chief
Operating Officer of Southwest Gas Corporation. He served as Executive Vice
President of the Hawaii Corporation, a diversified holding company, and as
President and Chairman of Property Research Financial Corporation, a real estate
investment and syndication firm, from 1972 to 1974. Mr. Holleran has also
served as a director of Kilroy Industries, a national office building and office
park developer, as a director of Walker & Lee, a national full service
real estate firm, and as a director of NTN Communications, Inc., a company
engaged in the interactive television business. Mr. Holleran is a graduate
of Woodbury University.





David Loesch was appointed to
the Board in September 2001 after 29 years of service as a Special
Agent with the Federal Bureau of Investigations (“FBI”). At the time of his
retirement from the FBI, Mr. Loesch was the Assistant Director in Charge of
the Criminal Justice Information Services Division of the FBI. Mr. Loesch
was awarded the Presidential Rank Award for Meritorious Executive in 1998 and
has served on the board of directors of the Special Agents Mutual Benefit
Association since 1996. He is also a member of the International Association of
Chiefs of Police and the Society of Former Special Agents of the FBI, Inc.
Mr. Loesch served in the United States Army as an Officer with the 101st
Airborne Division in Vietnam. He holds a Bachelor’s degree from Canisius College
and a Master’s degree in Criminal Justice from George Washington University.
Mr. Loesch is currently a private consultant on public safety and criminal
justice solutions.





EXECUTIVE
OFFICERS





The
following table sets forth the names, ages and positions for our executive
officers and certain significant employees not discussed above as of January 28,
2010:





Name
            
            Age
            
            Principal Position(s) Held With the CompanyMr. Wayne
      Wetherell
            
            57
            
            Sr.
      Vice President, Administration, Chief Financial Officer, Secretary and
      TreasurerMr. Charles
      AuBuchon
            
            66
            
            Vice
      President, Business DevelopmentMr. David
      Harding
            
            40
            
            Vice
      President and Chief Technical Officer





Wayne Wetherell has served as
our Senior Vice President, Administration and Chief Financial Officer since
May 2001 and additionally as our Secretary and Treasurer since
October 2005. From 1996 to May 2001, he served as Vice








President
of Finance and Chief Financial Officer. From 1991 to 1996, Mr. Wetherell
was the Vice President and Chief Financial Officer of Bilstein Corporation of
America, a manufacturer and distributor of automotive parts. Mr. Wetherell
holds a B.S. degree in Management and an M.S. degree in Finance from San Diego
State University.





SIGINIFICANT
EMPLOYEES





Chuck AuBuchon has served as
our Vice President, Business Development since January 2007. From 2004 to
2007 he served as Vice President, Sales. From 2003 to 2004, he served as
Director of North American Sales. From 2000 to 2003, Mr. AuBuchon was Vice
President Sales & Marketing at Card Technology Corporation, a
manufacturer of Card Personalization Systems, where he was responsible for
distribution within the Americas, Asia Pacific and EMEA (Europe, Middle East and
Africa) regions. From 1992 to 2000, Mr. AuBuchon held various sales
management positions, including Vice President Sales and Marketing, for Gemplus
and Datacard. Mr. AuBuchon is a graduate of Pennsylvania State
University.





David Harding has served as
our Vice President and Chief Technology Officer since January 2006. Before
joining us, Mr. Harding was the Chief Technology Officer at IC
Solutions, Inc., where he was responsible for all technology departments
including the development and management of software development, IT and quality
assurance as well as their respective hardware, software and human resource
budgets from 2001 to 2003. He was the Chief Technology Officer at Thirsty.com
from 1999 to 2000, the Chief Technology Officer at Fulcrum Point
Technologies, Inc., from 1996 to 1999, and consultant to Access360, which
is now part of IBM/Tivoli, from 1995 to 1996.





37


COMPLIANCE
WITH FEDERAL SECURITIES LAWS





Section 16(a)
of the Exchange Act of 1934, as amended (the “Exchange Act”), requires our
directors and executive officers, and persons who own more than 10% of a
registered class of our equity securities, to file with the SEC initial reports
of ownership and reports of changes in ownership of common stock and other
equity securities of the company. Executive officers, directors and greater than
10% stockholders are required by SEC regulations to furnish us copies of all
Section 16(a) forms they file.





To
our knowledge, based solely upon review of the copies of such reports furnished
to us during the fiscal year ended December 31, 2008, no director, officer
or beneficial holder of more than 10% of any class of our equity securities
failed to file on a timely basis reports required by Section 16(a) of the
Exchange Act during the most recent fiscal year.





CODE
OF ETHICS





The
Company has adopted aCode of
Business Conduct and Ethics policy that applies to our directors and
employees (including the Company’s principal executive officer, principal
financial officer, principal accounting officer or controller, or persons
performing similar functions).  The Company intends to promptly
disclose (i) the nature of any amendment to this code of ethics that applies to
our principal executive officer, principal financial officer, principal
accounting officer or controller, or persons performing similar functions and
(ii) the nature of any waiver, including an implicit waiver, from a provision of
this code of ethics that is granted to one of these specified individuals, the
name of such person who is granted the waiver and the date of the waiver on our
website in the future.  A copy of our Code of Business Conduct and
Ethics can be obtained from our website at http://www.iwsinc.com.





THE
AUDIT COMMITTEE





The
Company’s Audit Committee of the Board of Directors consists of Guy Steven Hamm,
David Loesch and John Holleran. The Audit Committee operates pursuant to a
written charter.  The charter addresses the purpose, duties and
responsibilities of the Audit Committee.





The Audit
Committee is directly responsible for the appointment, compensation, retention
and oversight of our independent registered public accountants. The Audit
Committee also monitors the integrity of the company’s financial statements and
the independence and performance of the independent registered public
accountants and reviews our financial reporting processes. The Audit Committee
reviews and reports to the Board of Directors the scope and results of audits by
the company’s independent registered public accountants and reviews other
professional services rendered by the company’s independent registered public
accountants. It reviews transactions between the company and our directors and
officers, the company’s policies regarding those transactions and compliance
with our Ethics Code and conflict of interest policies.





The Board
has determined that all members of the Audit Committee meet the SEC’s
requirements with respect to independence of listed company audit committee
members.  The Board has determined that at least one member of the
Audit Committee, Guy Steven Hamm, meets the SEC’s definition of an “audit
committee financial expert”.





The Audit
Committee met four times during 2008.





Item 11.
            Executive
      Compensation





SUMMARY
COMPENSATION TABLE





The
following table sets forth information regarding the compensation of our Chief
Executive Officer, our Chief Financial Officer and two of our significant
employees who were not serving as executive officers at December 31, 2008,
collectively referred to as our named executive officers.





38


Stock
            
            
            Option
            
            
            All OtherName and Principal Position
            
            
            Year
            
            
            Salary
            
            
            Awards
            
            
            Awards(1)(2)
            
            
            Compensation
            
            
            TotalS.
      James Miller, Jr.
              Chairman of the Board
              and Chief Executive
              Officer
            
            
            2008
            
            
            $
            308,988
            
            
            $
            64,718
            (3)
            
            $
            109,026
            (5)
            
            $
            12,448
            (4)
            
            $
            495,1802007
            
            
            
            314,791
            
            
            
            126,119
            (3)
            
            
            52,325
            (5)
            
            
            12,244
            (6)
            
            
            505,479Wayne
      G. Wetherell
              Senior Vice President
              Administration, Chief
              Financial Officer,
              Secretary, and
              Treasurer
            
            
            2008
            
            
            
            183,160
            
            
            
            31,032
            (7)
            
            
            62,966
            (5)
            
            
            10,324
            (8)
            
            
            287,4822007
            
            
            
            186,631
            
            
            
            67,136
            (7)
            
            
            35,588
            (5)
            
            
            10,019
            (9)
            
            
            299,374Charles
      AuBuchon
              Vice President Business
              Development
            
            
            2008
            
            
            
            152,600
            
            
            
            —
            
            
            
            89,603
            (5)
            
            
            —
            
            
            
            242,2032007
            
            
            
            155,581
            
            
            
            —
            
            
            
            62,439
            (5)
            
            
            —
            
            
            
            218,020David
      Harding
              Vice President and Chief
              Technical Officer
            
            
            2008
            
            
            
            185,029
            
            
            
            —
            
            
            
            62,482
            (5)
            
            
            —
            
            
            
            248,5112007
            
            
            
            182,132
            
            
            
            —
            
            
            
            48,251
            (5)
            
            
            —
            
            
            
            230,383





(1)
            
            All
      option awards were granted under the 1999 Plan.(2)
            
            The
      amounts reflect the dollar amount recognized for financial statement
      reporting purposes for the fiscal year ended December 31, 2008, in
      accordance with the provisions of SFAS 123R and thus may include
      amounts from awards granted prior to 2008. We have elected to use the
      Black-Scholes option-pricing model, which incorporates various assumptions
      including volatility, expected life, and interest rates. We are required
      to make various assumptions in the application of the Black-Scholes option
      pricing model and have determined that the best measure of expected
      volatility is based on the historical weekly volatility of our common
      stock. Historical volatility factors utilized in our Black-Scholes
      computations range from 64.4% to 98.5%. We have elected to estimate the
      expected life of an award based upon the SEC approved “simplified method”
      noted under the provisions of Staff Accounting Bulletin No. 107.
      Under this formula, the expected term is equal to: ((weighted-average
      vesting term + original contractual term)/2). The expected term used by us
      as computed by this method ranges from 3.5 years to 6.1 years. The
      interest rate used is the risk free interest rate and is based upon U.S.
      Treasury rates appropriate for the expected term. Interest rates used in
      our Black-Scholes calculations range from 2.7% to 4.6%. Dividend yield is
      zero as we do not expect to declare any dividends on our common shares in
      the foreseeable future. In addition to the key assumptions used in the
      Black-Scholes model, the estimated forfeiture rate at the time of
      valuation is a critical assumption. We have estimated an annualized
      forfeiture rate of 10% for corporate officers, 4% for members of the Board
      of Directors and 24% for all other employees. We review the expected
      forfeiture rate annually to determine if that percent is still reasonable
      based on historical experience.(3)
            
            Represents
      the quarterly vesting of 124,162 restricted shares granted on
      March 30, 2004, and the vesting of 109,700 restricted shares granted
      on September 27, 2005 for Mr. Miller. The restricted shares
      granted in September 2005 vest one-third after one year with the
      remainder vesting ratably on a quarterly basis over two years ending
      September 27, 2008.(4)
            
            Consists
      of $9,200 in 401(K) matching contributions, $1,248 in life insurance
      premiums and $2,000 in club membership.  39
 (5)
            
            The
      amounts reflect the dollar amount recognized for financial statement
      reporting purposes for the fiscal year ended December 31, 2007, in
      accordance with the provisions of SFAS 123R and thus may include
      amounts from awards granted prior to 2007. Assumptions used in the
      calculation of these amounts are included in Notes to the Consolidated
      Financial Statements for the fiscal year ended December 31, 2007,
      included in our annual report on Form 10-K filed with the SEC on
      April 15, 2008.(6)
            
            Consists
      of $9,000 in 401(K) matching contributions, $1,244 in life insurance
      premiums and $2,000 in club membership.(7)
            
            Represents
      the quarterly vesting of 80,281 restricted shares granted on
      March 30, 2004 and the vesting of 52,600 restricted shares granted on
      September 27, 2005. The restricted shares granted in
      September 2005 vest one-third after one year with the remainder
      vesting ratably on a quarterly basis over two years ending
      September 27, 2008.(8)
            
            Consists
      of $7,466 in 401(K) matching contributions, $858 in life insurance
      premiums and $2,000 in club membership.(9)
            
            Consists
      of $7,221 in 401(K) matching contributions, $798 in life insurance
      premiums and $2,000 in club
membership.








2008
GRANTS OF PLAN-BASED AWARDS





The
following table sets forth certain information with respect to each grant of an
award made to a named executive officer in 2008 under our plans.





All OtherStockAwards:
            
            
            Exercise or
            
            
            Grant DateNumber of
            
            
            Base
            
            
            Fair ValueSecurities
            
            
            Price of
            
            
            of StockGrant
            
            Underlying
            
            
            Option
            
            
            and OptionName
            
            Date
            
            Options(1)
            
            
            Awards
      ($/Sh)(2)
            
            
            Awards(3)S.
      James Miller, Jr.
            
            1/2/2008
            
            
            100,000
            
            
            $
            1.45
            
            
            $
            94,000Wayne
      Wetherell
            
            1/2/2008
            
            
            60,000
            
            
            $
            1.45
            
            
            
            56,400Charles
      AuBuchon
            
            1/2/2008
            
            
            50,000
            
            
            $
            1.45
            
            
            
            47,000David
      Harding
            
            1/2/2008
            
            
            50,000
            
            
            $
            1.45
            
            
            
            47,000





(1) The
shares subject to each option vest over a three year period, with 33 1/3% of the
shares subject to each option vesting on the first anniversary of the grant date
and then 8.33% vesting on  each subsequent quarterly anniversary of
the grant date. The options expire ten years from the date of
grant.


(2) The
exercise price is the closing price of our common stock on the date of
grant.


(3) The
fair value of our stock options is computed using the Black-Scholes valuation
model.





40


OUTSTANDING
EQUITY AWARDS AT FISCAL YEAR-END





The
following table sets forth information regarding unexercised options, stock that
has not vested and equity incentive awards held by each of the named executive
officers outstanding as of December 31, 2008.





Option AwardsNumber of
            
            
            Number ofSecurities
            
            
            SecuritiesUnderlying
            
            
            UnderlyingUnexercised
            
            
            UnexercisedUnearned
            
            
            Unearned
            
            
            OptionOptions:
            
            
            Options:
            
            
            Exercise
            
            
            Option#
            
            
            #
            
            
            Price
            
            
            ExpirationName
            
            Exercisable
            
            
            Unexercisable
            
            
            ($)
            
            
            DateS.
      James Miller, Jr.
            
            
            75,000
            
            
            
            —
            
            
            $
            3.00
            
            
            9/12/201125,000
            
            
            
            —
            
            
            $
            1.97
            
            
            5/28/2013100,000
            
            
            
            —
            
            
            $
            2.40
            
            
            10/28/2014100,000
            
            
            
            —
            
            
            $
            2.62
            
            
            8/16/2015109,700
            
            
            
            —
            
            
            $
            2.36
            
            
            9/27/20159,000
            (1)
            
            
            9,000
            
            
            $
            2.49
            
            
            4/3/2017—
            (4)
            
            
            100,000
            
            
            $
            1.45
            
            
            1/2/2018Wayne
      G. Wetherell
            
            
            25,000
            
            
            
            —
            
            
            $
            3.00
            
            
            9/12/201110,000
            
            
            
            —
            
            
            $
            1.97
            
            
            5/28/201350,000
            
            
            
            —
            
            
            $
            2.40
            
            
            10/28/201460,000
            
            
            
            —
            
            
            $
            2.62
            
            
            8/16/201552,600
            
            
            
            —
            
            
            $
            2.36
            
            
            9/27/20157,500
            (1)
            
            
            7,500
            
            
            $
            2.49
            
            
            4/3/2017—
            (4)
            
            
            60,000
            
            
            $
            1.45
            
            
            1/2/2018Charles
      AuBuchon
            
            
            10,000
            
            
            
            —
            
            
            $
            3.00
            
            
            9/12/201140,000
            
            
            
            —
            
            
            $
            2.30
            
            
            10/15/201430,000
            
            
            
            —
            
            
            $
            3.19
            
            
            4/1/201560,000
            
            
            
            —
            
            
            $
            2.62
            
            
            8/16/201555,000
            (2)
            
            
            5,000
            
            
            $
            1.99
            
            
            1/13/20165,002
            (1)
            
            
            4,998
            
            
            $
            2.49
            
            
            4/3/2017—
            (4)
            
            
            50,000
            
            
            $
            1.45
            
            
            1/2/2018David
      Harding
            
            
            91,675
            (3)
            
            
            8,325
            
            
            $
            1.65
            
            
            1/31/201612,550
            (1)
            
            
            12,450
            
            
            $
            2.49
            
            
            4/3/2017—
            (4)
            
            
            50,000
            
            
            $
            1.45
            
            
            1/2/2018





(1)
            
            These
      options vest over three years with one third vesting 4/2/2008 and the
      remainder vesting in equal quarterly installments
    thereafter.(2)
            
            These
      options vest over three years with one third vesting 1/13/2007 and the
      remainder vesting in equal quarterly installments
    thereafter.(3)
            
            These
      options vest over three years with one third vesting 1/31/2007 and the
      remainder vesting in equal quarterly installments
    thereafter.(4)
            
            These
      options vest over three years with one third vesting 1/02/2009 and the
      remainder vesting in equal quarterly installments
    thereafter.





41


OPTION
EXERCISES AND STOCK VESTED





The
following table sets forth information regarding exercises of stock options and
vesting of stock for each of the named executive officers during
2008.





Stock AwardsNumber ofShares
            
            
            ValueAcquired on
            
            
            RealizedName
            
            Vesting
            
            
            on VestingS.
      James Miller, Jr.(1)
            
            
            27,423
            
            
            $
            21,299Wayne
      G. Wetherell(2)
            
            
            13,149
            
            
            
            10,212





(1)
            
            Represents
      the quarterly vesting of 109,700 restricted shares granted on
      September 27, 2005. The restricted shares granted in
      September 2005 vest one-third after one year with the remainder
      vesting ratably on a quarterly basis over two years ending
      September 27, 2008.(2)
            
            Represents
      the quarterly vesting of 52,600 restricted shares granted on
      September 27, 2005. The restricted shares granted in
      September 2005 vest one-third after one year with the remainder
      vesting ratably on a quarterly basis over two years ending
      September 27, 2008.





EMPLOYMENT
CONTRACTS





Employment
Agreement with S. James Miller, Jr.On
October 1, 2005, we entered into an employment agreement with
Mr. Miller pursuant to which Mr. Miller serves as President and Chief
Executive Officer. This agreement was  for a three-year term ending
September 30, 2008.  On September 27, 2008 this agreement was
amended to change the expiration from September 30, 2008 to June 30,
2009.   On April 6, 2009 this agreement was amended to change the
expiration to December 31, 2009.   On December 10, 2009 this
agreement was amended to change the expiration to December 31, 2011. This
agreement provides for annual base compensation in the amount of $291,048, which
amount will be increased based on cost-of-living increases. Under this
agreement, we will reimburse Mr. Miller for reasonable expenses incurred in
connection with our business. Under the terms of the agreement, Mr. Miller
will be entitled to the following severance benefits if we terminate his
employment without cause or in the event of an involuntary termination:
(i) a lump sum cash payment equal to twenty-four months’ base salary;
(ii) continuation of Mr. Miller’s fringe benefits and medical
insurance for a period of three years; and (iii) immediate vesting of 50%
of Mr. Miller’s outstanding stock options and restricted stock awards. In
the event that Mr. Miller’s employment is terminated within six months
prior to or thirteen months following a change of control (defined below),
Mr. Miller is entitled to the severance benefits described above, except
that 100% of Mr. Miller’s outstanding stock options and restricted stock
awards will immediately vest.





Employment
Agreement with Wayne Wetherell.On October 1,
2005, we entered into an amended employment agreement with Mr. Wetherell
pursuant to which Mr. Wetherell will serve as our Chief Financial Officer.
This agreement is for a three-year term ending September 30, 2008. On
September 27, 2008 this agreement was amended to change the expiration from
September 30, 2008 to June 30, 2009.   On April 6, 2009 this
agreement was amended to change the expiration to December 31,
2009.   On December 10, 2009 this agreement was amended to change
the expiration to December 31, 2010.   This agreement provides
for annual base compensation in the amount of $174,100, which amount will be
increased based on cost-of-living increases and may also be increased based on
performance reviews. Under this agreement, we will reimburse Mr. Wetherell
for reasonable expenses incurred in connection with our business. Under the
terms of the agreement, Mr. Wetherell will be entitled to the following
severance benefits if we terminate his employment without cause or in the event
of an involuntary termination: (i) a lump sum cash payment equal to twelve
months; (ii) continuation of Mr. Wetherell’s fringe benefits and
medical insurance for a period of three years; (iii) immediate vesting of
50% of Mr. Wetherell’s outstanding stock options and restricted stock
awards. In the event that Mr. Wetherell’s employment is terminated within
six months prior to or thirteen months following a change of control (defined
below),





42


Mr. Wetherell
is entitled to the severance benefits described above, except that 100% of
Mr. Wetherell’s outstanding stock options and restricted stock awards will
immediately vest.





Change of Control
and Severance Benefits Agreement with Charles AuBuchon. On
October 31, 2005, we entered into a Change of Control and Severance
Benefits Agreement with Mr. Charles AuBuchon, our Vice President of
Sales. This agreement has a three-year term, commencing on October 31,
2005. On September 27, 2008 this agreement was amended to change the expiration
from October 31, 2008 to June 30, 2009.   On April 6, 2009 this
agreement was amended to change the expiration to December 31,
2009.   On December 10, 2009 this agreement was amended to change
the expiration to December 31, 2010. Subject to the conditions and other
limitations set forth therein, Mr. AuBuchon will be entitled to the
following severance benefits if we terminate his employment without cause prior
to the closing of any change of control transaction: (i) a lump sum cash
payment equal to six months of base salary; and (ii) continuation of
Mr. AuBuchon’s health insurance benefits until the earlier of
six (6) months following the date of termination, the date on which he
is no longer entitled to continuation coverage pursuant to COBRA or the date
that he obtains comparable health insurance coverage. In the event that
Mr. AuBuchon’s employment is terminated within the twelve months following
a change of control, he is entitled to the severance benefits described above,
plus his stock options will immediately vest and become exercisable.
Mr. AuBuchon’s eligibility to receive severance payments or other benefits
upon his termination is conditioned upon him executing a general release of
liability.





Change of Control
and Severance Benefits Agreement with David Harding. On May 21,
2007, we entered into a Change of Control and Severance Benefits Agreement with
Mr. David Harding, our Vice President and Chief Technical
Officer. This agreement has a two-year term, commencing on May 21,
2007. On September 27, 2008 this agreement was amended to change the expiration
from May 21, 2009 to June 30, 2009.  On April 6, 2009 this agreement
was amended to change the expiration to December 31, 2009.   On
December 10, 2009 this agreement was amended to change the expiration to
December 31, 2010.  Subject to the conditions and other limitations
set forth therein, Mr. Harding will be entitled to the following severance
benefits if we terminate his employment without cause prior to the closing of
any change of control transaction: (i) a lump sum cash payment equal to six
months of base salary; and (ii) continuation of Mr. Harding’s health
insurance benefits until the earlier of six (6) months following the
date of termination, the date on which he is no longer entitled to continuation
coverage pursuant to COBRA or the date that he obtains comparable health
insurance coverage. In the event that Mr. Harding’s employment is
terminated within the twelve months following a change of control, he is
entitled to the severance benefits described above, plus his stock options will
immediately vest and become exercisable. Mr. Harding’s eligibility to
receive severance payments or other benefits upon his termination is conditioned
upon him executing a general release of liability.





For
purposes of each of the above-referenced agreements, termination for “cause”
generally means the executive’s commission of an act of fraud or similar conduct
which is intended to result in substantial personal enrichment of the executive,
conviction or plea ofnolo
contendere  to a felony, gross negligence or breach of
fiduciary duty that results in material injury to us, material breach of the
executive’s proprietary information agreement that is materially injurious to
us, willful and material failure to perform his duties as an officer or employee
of ours or material breach of his employment agreement and the failure to cure
such breach in a specified period of time or a violation of a material policy of
ours that is materially injurious to us. A “change in control” as used in these
agreements generally means the occurrence of any of the following events:
(i) the acquisition by any person or group of 50% or more of our
outstanding voting stock, (ii) the consummation of a merger, consolidation,
reorganization, or similar transaction other than a transaction: (1) in
which substantially all of the holders of our voting stock hold or receive
directly or indirectly 50% or more of the voting stock of the resulting entity
or a parent company thereof, in substantially the same proportions as their
ownership of the Company immediately prior to the transaction; or (2) in
which the holders of our capital stock immediately before such transaction will,
immediately after such transaction, hold as a group on a fully diluted basis the
ability to elect at least a majority of the directors of the surviving
corporation (or a parent company); (iii)  there is consummated a sale,
lease, exclusive license, or other disposition of all or substantially all of
the consolidated assets of us and our Subsidiaries, other than a sale, lease,
license, or other disposition of all or substantially all of the consolidated
assets of us and our Subsidiaries to an entity, 50% or more of the combined
voting power of the voting securities of which are owned by our stockholders in
substantially the same proportions as their ownership of the Company immediately
prior to such sale, lease, license, or other disposition; or (iv) 
individuals who, on the date the applicable agreement was adopted by the Board,
are Directors (the “Incumbent Board”) cease for any reason to constitute at
least a majority of the Directors; provided, however, that if the appointment or
election (or nomination for election) of any new Director was approved or
recommended by a majority vote of the members of the Incumbent Board then still
in office, such new member shall, for purposes of the applicable agreement, be
considered as a member of the Incumbent Board.





43


POTENTIAL
PAYMENTS UPON TERMINATION OR CHANGE IN CONTROL





The
following tables summarize the potential payments to certain of our named
executive officers upon a termination of employment or a change in control. The
amounts shown in the tables are only estimates and apply the assumption that
employment terminated on December 31, 2008. The calculations of payments
related to equity reflect the closing price of our common stock on
December 31, 2008. The amounts set forth below do not include accrued
obligations such as salary and other amounts payable with respect to days
previously worked, accrued vacation time and other accrued amounts that were
fully earned and vested as of December 31, 2008, and would be payable in
connection with the executive’s employment.





S. James
Miller, Jr. The following table describes the potential payments
upon termination or a change in control for Mr. Miller, our Chief Executive
Officer.





InvoluntaryExecutive Benefits and Payments
            
            
            Voluntary
            
            
            Not for Cause
            
            
            Change inUpon Termination(1)
            
            
            Termination
            
            
            Termination
            
            
            ControlCash
            
            
            $
            —
            
            
            $
            662,856
            (2)
            
            $
            662,856
            (2)Equity
            
            
            $
            —
            
            
            $
            —
            (3)(4)
            
            $
            —
            (3)(4)Fringe
      Benefits
            
            
            $
            —
            
            
            $
            72,634
            (5)
            
            $
            72,634
            (5)





(1)
            
            For
      purposes of this analysis, we assumed Mr. Miller’s compensation is
      based on his current base salary of $331,428.(2)
            
            Mr. Miller’s
      cash severance benefit under an involuntary, good reason termination or a
      termination due to a change in control is equal to two times annual
      compensation.(3)
            
            Mr. Miller’s
      equity severance benefit under an involuntary or good reason termination
      is the immediate vesting of 50% of Mr. Miller’s outstanding stock
      options and restricted stock awards. In the event that Mr. Miller’s
      employment is terminated within six months prior to or thirteen months
      following a change in control, Mr. Miller is entitled to the
      immediate vesting of 100% of Mr. Miller’s outstanding stock options
      and restricted stock awards.(4)
            
            This
      amount was calculated from the unexercisable stock options and unvested
      stock awards held by Mr. Miller on December 31, 2008. The stock
      option award amount was calculated by multiplying the number of securities
      underlying the unexercisable options by the difference between the option
      price and the price per share of common stock on the date of termination.
      The unvested stock award amount was calculated by multiplying the number
      of unvested shares of stock by the price per share on the date of
      termination.(5)
            
            Mr. Miller’s
      fringe benefits consist of medical and life insurance for a period of
      three years.





44


Wayne G.
Wetherell. The following table describes the potential payments upon
termination or a change in control for Mr. Wetherell, our Sr. Vice
President Administration, Chief Financial Officer, Secretary and
Treasurer.





InvoluntaryExecutive Benefits and Payments
            
            
            Voluntary
            
            
            Not for Cause
            
            
            Change inUpon Termination(1)
            
            
            Termination
            
            
            Termination
            
            
            ControlCash
            
            
            $
            —
            
            
            $
            198,291
            (2)
            
            $
            198,291
            (2)Equity
            
            
            $
            —
            
            
            $
            —
            (3)(4)
            
            $
            —
            (3)(4)Fringe
      Benefits
            
            
            $
            —
            
            
            $
            73,120
            (5)
            
            $
            73,120
            (5)





(1)
            
            For
      purposes of this analysis, we assumed Mr. Wetherell’s compensation is
      based on his current base salary of $198,291.(2)
            
            Mr. Wetherell’s
      cash severance benefit under an involuntary, good reason termination or a
      termination due to a change in control is equal to the amount of his
      annual compensation.(3)
            
            Mr. Wetherell’s
      equity severance benefit under an involuntary or good reason termination
      is the immediate vesting of 50% of Mr. Wetherell’s outstanding stock
      options and restricted stock awards. In the event that
      Mr. Wetherell’s employment is terminated within six months prior to
      or thirteen months following a change in control, Mr. Wetherell is
      entitled to the immediate vesting of 100% of Mr. Wetherell’s
      outstanding stock options and restricted stock awards.(4)
            
            This
      amount was calculated from the unexercisable stock options and unvested
      stock awards held by Mr. Wetherell on December 31, 2008. The
      stock option award amount was calculated by multiplying the number of
      securities underlying the unexercisable options by the difference between
      the option price and the price per share of common stock on the date of
      termination.  The unvested stock award amount was calculated by
      multiplying the number of unvested shares of stock by the price per share
      on the date of termination.(5)
            
            Mr. Wetherell’s
      fringe benefits consist of medical and life insurance for a period of
      three years.








Charles
AuBuchon. The following table describes the potential payments upon
termination or a change in control for Mr. AuBuchon, our Vice President
Business Development.





InvoluntaryExecutive Benefits and Payments
            
            
            Voluntary
            
            
            Not for Cause
            
            
            Change inUpon Termination(1)
            
            
            Termination
            
            
            Termination
            
            
            ControlCash
            
            
            $
            —
            
            
            $
            82,500
            (2)
            
            $
            77,500
            (2)Equity
            
            
            $
            —
            
            
            $
            —
            
            
            $
            —Fringe
      Benefits
            
            
            $
            —
            
            
            $
            19,264
            (3)
            
            $
            19,264
            (3)





(1)
            
            For
      purposes of this analysis, we assumed Mr. AuBuchon’s compensation is
      based on his current base salary of $165,000.(2)
            
            Mr. AuBuchon’s
      cash severance benefit under an involuntary, good reason termination or a
      termination due to a change in control is equal to six months of annual
      compensation.(3)
            
            Mr. AuBuchon’s
      fringe benefits consist of medical and life insurance for a period of six
      months.





45


David
Harding. The following table describes the potential payments upon
termination or a change in control for Mr. Harding, our Vice President and
Chief Technical Officer.





InvoluntaryExecutive Benefits and Payments
            
            
            Voluntary
            
            
            Not for Cause
            
            
            Change inUpon Termination(1)
            
            
            Termination
            
            
            Termination
            
            
            ControlCash
            
            
            $
            —
            
            
            $
            95,500
            (2)
            
            $
            92,500
            (2)Equity
            
            
            $
            —
            
            
            $
            —
            
            
            $
            —Fringe
      Benefits
            
            
            $
            —
            
            
            $
            7,030
            (3)
            
            $
            7,030
            (3)





(1)
            
            For
      purposes of this analysis, we assumed Mr. Harding’s compensation is
      based on his current base salary of $191,000.(2)
            
            Mr. Harding’s
      cash severance benefit under an involuntary, good reason termination or a
      termination due to a change in control is equal to six months of annual
      compensation.(3)
            
            Mr. Harding’s
      fringe benefits consist of medical and life insurance for a period of six
      months.





DIRECTOR
COMPENSATION





Each of
our non-employee directors receives a monthly retainer of $3,000 for serving on
the Board. Board members who also serve on the Audit Committee receive
additional monthly compensation of $458.33 for the Chairman and $208.33 for the
remaining members of the Audit Committee.   Board members who
also serve on the Compensation Committee receive additional monthly compensation
of $416.67 for the Chairman and $208.33 for the remaining members of the
Compensation  Committee.  The members of the Board of
Directors are also eligible for reimbursement for their expenses incurred in
attending Board meetings in accordance with our policies. For the fiscal year
ended December 31, 2008, the Board held the payment of fees for the period
from April 1, 2008 till December 31, 2008 in light of the limited cash resources
of the company.  For the fiscal year ended December 31, 2008 the total
amounts paid to non-employee directors as compensation (excluding reimbursable
expenses) was $36,625.  During that same period a total of $115,375
was accrued as board fees but not paid.
 
 Each of
our non-employee directors is also eligible to receive stock option grants under
the 1999 Plan. Options granted under the 1999 Plan are intended by us not to
qualify as incentive stock options under the Code.





The term
of options granted under the 1999 Plan is 10 years. In the event of a
merger of us with or into another corporation or a consolidation, acquisition of
assets or other change-in-control transaction involving us, an equivalent option
will be substituted by the successor corporation, provided, however, that we may
cancel outstanding options upon consummation of the transaction by giving at
least thirty (30) days notice.




During
the last fiscal year, we granted 25,000 options under the 1999 Plan to our
non-employee directors. The fair market value of the common stock underlying
such options on the date of grant is based on the closing sales price reported
on AMEX for the date of each such grant, as detailed in the following
table:





Name (1)
            
            Option
              Awards
              (number of
              shares)
            
            
            Exercise Price
              Per Share
            
            Fair Market Value
              on Option Grant
              Date (2)John
      Callan
            
            
            5,000
            
            
            $
            1.45
            
            $
            1.45John
      Holleran
            
            
            5,000
            
            
            
            1.45
            
            
            1.45David
      Loesch
            
            
            5,000
            
            
            
            1.45
            
            
            1.45Guy
      Steve Hamm
            
            
            5,000
            
            
            
            1.45
            
            
            1.45David
      Carey
            
            
            5,000
            
            
            
            1.45
            
            
            1.45





46


(1)
            
            As
      of December 31, 2008, no options had been exercised by non-employee
      directors under any plans maintained by us.(2)
            
            The
      fair market value of the common stock underlying such options on the date
      of grant is based on the closing sales price reported for the date of each
      such grant.







The
following table sets forth the compensation of our directors for the 2008 fiscal
year.





Name and Principal Position
            
            Fees
              Earned or
              Paid in
              Cash
            
            
            Option
              Awards(1)(2)(3)
            
            
            TotalJohn
      Callan
            
            $
            28,250
            
            
            $
            11,749
            
            
            $
            39,999John
      Holleran
            
            
            29,450
            
            
            
            11,749
            
            
            
            41,199David
      Loesch
            
            
            28,875
            
            
            
            12,882
            
            
            
            41,757Guy
      Steven Hamm
            
            
            31,125
            
            
            
            6,609
            
            
            
            37,734David
      Carey
            
            
            27,625
            
            
            
            13,044
            
            
            
            40,669





(1)
            
            The
      grant date per share fair value of options issued to Messrs. Callan,
      Downs, Holleran, Loesch, Hamm and Carey in 2008 was
  $.94.(2)
            
            The
      amounts reflect the dollar amount recognized for financial statement
      reporting purposes for the fiscal year ended December 31, 2008, in
      accordance with the provisions of SFAS 123R and thus may include
      amounts from awards granted prior to 2008. We have elected to use the
      Black-Scholes option-pricing model, which incorporates various assumptions
      including volatility, expected life, and interest rates. We are required
      to make various assumptions in the application of the Black-Scholes option
      pricing model and have determined that the best measure of expected
      volatility is based on the historical weekly volatility of our common
      stock. Historical volatility factors utilized in our Black-Scholes
      computations range from 64.4% to 98.5%. We have elected to estimate the
      expected life of an award based upon the SEC approved “simplified method”
      noted under the provisions of Staff Accounting Bulletin No. 107.
      Under this formula, the expected term is equal to: ((weighted-average
      vesting term + original contractual term)/2). The expected term used by us
      as computed by this method ranges from 3.5 years to 6.1 years. The
      interest rate used is the risk free interest rate and is based upon U.S.
      Treasury rates appropriate for the expected term. Interest rates used in
      our Black-Scholes calculations range from 2.7% to 4.6%. Dividend yield is
      zero as we do not expect to declare any dividends on our common shares in
      the foreseeable future. In addition to the key assumptions used in the
      Black-Scholes model, the estimated forfeiture rate at the time of
      valuation is a critical assumption. We have estimated an annualized
      forfeiture rate of 10% for corporate officers, 4% for members of the Board
      of Directors and 24% for all other employees. We review the expected
      forfeiture rate annually to determine if that percent is still reasonable
      based on historical experience.(3)
            
            The
      aggregate number of stock option awards outstanding at the end of fiscal
      2008 for each director was as follows: John Callan (42,535); John Holleran
      (40,261); David Loesch (47,000); Guy Steven Hamm (27,000); and David Carey
      (20,000).







47


Item 12.
            Security Ownership of Certain
      Beneficial Owners and Management and Related Stockholder
      Matters





SECURITY
OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT




The
following table sets forth information as of January 28, 2010 with respect to
the beneficial ownership of shares of our common stock by (i) each person
known by us to be the beneficial owner of more than five percent of our common
stock, (ii) each director, (iii) each named executive officer and
(iv) all directors and executive officers as a group.





Beneficial
      Ownership(1)Name and Address of Beneficial Owner
            
            Number of
              Shares
            
            
            Percent of
              Class (2)Directors and Named Executive Officers:S.
      James Miller, Jr.(3)
            
            
            913,150
            
            
            
            4.1John
      Callan(4)
            
            
            77,193
            
            
            
            *David
      Carey(5)
            
            
            33,672
            
            
            
            *G.
      Steve Hamm(6)
            
            
            65,072
            
            
            
            *John
      Holleran(7)
            
            
            26,491
            
            
            
            *David
      Loesch(8)
            
            
            93,072
            
            
            
            *Wayne
      Wetherell(9)
            
            
            346,200
            
            
            
            1.6Charles
      AuBuchon(10)
            
            
            440,078
            
            
            
            2.8David
      Harding (11)
            
            
            121,672
            
            
            
            **Total
      Shares Held By Directors and Executive Officers
            
            
            2,116,600
            
            
            
            9.35%
      Stockholders:Gruber &
      McBaine Capital Management LLC 50
              Osgood
      Place San Francisco, CA(12)
            
            
            10,941,260
            
            
            
            36.5Bruce
      Toll (13)
            
            
            8,539,851
            
            
            
            27.9Goldman
      Capital (14)
            
            
            3,400,121
            
            
            
            14.2





*
            Less
      than one percent.




(1)
            This
      table is based our records and Schedules 13D and 13G filed with the
      SEC. Unless otherwise indicated in the footnotes to this table and subject
      to community property laws where applicable, we believe that each of the
      stockholders named in this table has sole voting and investment power with
      respect to the shares indicated as beneficially owned. Unless otherwise
      indicated, the address for each listed stockholder is c/o ImageWare
      Systems, Inc., 10883 Thornmint Road, San Diego, CA
    92127.




(2)
            The
      percentages set forth below are based on 22,104,483 shares of common stock
      outstanding as of January 28, 2010.




(3)
            Mr. Miller
      serves as the Chairman of our Board of Directors and our Chief Executive
      Officer. Includes 75,201 shares held jointly with spouse and 33,400
      options exercisable within 60 days of January 28, 2010.  Also
      includes  122,727 warrants and a convertible notes convertible
      into 89,679 shares of common stock.




48


(4)
            Includes
      1,672 options exercisable within 60 days of January 28,
    2010.




(5)
            Includes
      1,672 options exercisable within 60 days of January 28,
    2010.




(6)
            Includes
      1,672 options exercisable within 60 days of January 28,
      2010.  Also includes 27,271 warrants and a convertible notes
      convertible into 19,929 shares of common
stock.




(7)
            Includes
      1,672 options exercisable within 60 days of January 28,
      2010.




(8)
            Includes
      1,672 options exercisable within 60 days of January 28,
      2010.   Also includes 27,271 warrants and a convertible
      notes convertible into 19,929 shares of common
  stock.




(9)
            Includes
      20,000 options exercisable within 60 days of January 28,
    2010.




(10)
            Includes
      41,672 options exercisable within 60 days of January 28,
      2010.  Also includes 122,727 warrants and a convertible
      notes convertible into 89,679 shares of common
  stock.




(11)
            Includes
      16,672 options exercisable within 60 days of January 28,
    2010.




(12)
            Based
      on certain of our records and Schedule 13G filed with the SEC as of
      February 12, 2010.   Includes 1,096,081 shares issuable
      upon exercise of warrants.  Also included are 6,760,619 shares
      of common stock issuable upon the conversion of Series C and Series D
      Convertible Preferred Stock.




(13)
            Based
      on Schedule 13D filed with the SEC on October 5, 2009. Includes
      6,710,000 shares issuable upon exercise of warrants.  Also
      included are 845,556 shares of common stock issuable upon the conversion
      of Series C and Series D Convertible Preferred
  Stock.




(14)
            Includes
      1,000,000 shares issuable upon exercise of warrants.  Also
      included are 900,121 shares of common stock issuable upon the conversion
      of Series D Convertible Preferred
Stock.




The
following table sets forth additional information as of December 31, 2008,
with respect to the shares of common stock that may be issued upon the exercise
of options and other rights under our existing equity compensation plans and
arrangements. The information includes the number of shares covered by and the
weighted average exercise price of, outstanding options and other rights and the
number of shares remaining available for future grants, excluding the shares to
be issued upon exercise of outstanding options and other rights.





49


Equity
Compensation Plan Information





Plan category
            
            Number of securities
              to be issued
              upon exercise of
              outstanding
              options, warrants
              and rights
            
            
            Weighted-
              average exercise
              price of
              outstanding
              options, warrants
              and rights
            
            
            Number of securities
              remaining available
              for future issuance
              under equity
              compensation plans
              (excluding securities
              reflected in
              column (a))(a)
            
            
            (b)
            
            
            (c)Equitycompensationplans
      approved by security holders:1994
      Employee Stock Option
              Plan
            
            
            24,250
            
            
            $
            2.15
            
            
            
            —1999
      Stock Award Plan amended
              and
      restated as of June 7, 2005
            
            
            1,378,495
            
            
            $
            2.19
            
            
            
            1,035,208Equitycompensationplans
      notapproved
      by security holders:2001
      Equity Incentive Plan
            
            
            345,654
            
            
            $
            2.89
            
            
            
            —Total
            
            
            1,748,399
            
            
            $
            2.33
            
            
            
            1,035,208








DESCRIPTION
OF EQUITY COMPENSATION PLANS NOT APPROVED BY SECURITY HOLDERS.





2001
Equity Incentive Plan.




On
September 12, 2001, our Board of Directors adopted the 2001 Equity
Incentive Plan (the “2001 Plan”). Under the terms of the 2001 Plan, we
may issue stock awards to our employees, directors and consultants, and
such stock awards may be given as non-statutory stock options (options not
intended to qualify as an “incentive stock option” within the meaning of
Section 422 of the Code), stock bonuses, and rights to acquire restricted
stock. The number of options issued and outstanding and the number of options
remaining available for future issuance are shown in the table
above.
 
 The 2001
Plan is administered by the Board of Directors or a Committee of the Board as
provided in the 2001 Plan. The exercise price of options  granted
under the 2001 Plan shall not be less than 85% of the market value of our 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 is determined by the Board and to date, options have
been granted with a ten-year term and vesting over a three-year period. While
the Board may suspend or terminate the 2001 Plan at any time, if not
terminated earlier, it will terminate on the day before its tenth anniversary of
the date of adoption. The Board has determined not to issue any future awards
under the 2001 Plan.




Item 13.
            Certain Relationships and Related
      Transactions





TRANSACTIONS
WITH RELATED PERSONS





On
November 14, 2006, we entered into a Securities Purchase Agreement with
certain accredited investors (the “Series C Investors”) pursuant to which
we issued an aggregate of 2,300 shares of our Series C 8% Convertible
Preferred Stock (the “Series C Preferred Stock”) and issued to the
Series C Investors warrants to purchase up to an aggregate of 115,000
shares of the Company’s common stock, for aggregate gross proceeds of $2,300,000
(the “Series C Financing”).





On
March 9, 2007, we entered into a Securities Purchase Agreement with certain
accredited investors (the “Series D Investors”) pursuant to which we issued
an aggregate of 1,500 shares of our Series D 8% Convertible Preferred Stock
(the “Series D Preferred Stock”) and issued to the Series D Investors
warrants to purchase up to an aggregate of 59,207 shares of our common stock,
for aggregate gross proceeds of $1,500,000 (the “Series D
Financing”).





50


On
September 25, 2007, we entered into a Securities Purchase Agreement with
certain accredited investors (the “Investors”) pursuant to which we sold to the
Investors an aggregate of 2,016,666 shares of our common stock, and issued to
the Investors warrants (the “September 2007 Investor Warrants”) to purchase
up to an aggregate of 1,008,333 shares of our common stock, for aggregate gross
proceeds of approximately $3,000,000 (the “September 2007 Private
Placement”).





On
March 12, 2008, we agreed to reduce the price of the September 2007
Investor Warrants, which initially had an exercise price of $1.67 per share, to
an exercise price of $1.00 per share, in consideration for their immediate
exercise (the “Warrant Repricing”) by the Investors who participated in the
Warrant Repricing (the “Participating Investors”).  In addition, we
also issued to the Participating Investors new warrants to purchase up to an
aggregate of 270,833 shares of our common stock.  We received
aggregate gross proceeds of $541,666 from the Warrant Repricing.





Gruber &
McBaine Capital Management, LLC and its affiliates, which include Lagunitas
Partners, LP and Gruber & McBaine International, beneficially own more
than 10% of our issued and outstanding common stock. J. Patterson McBaine,
together with Jon D. Gruber, exercises voting and investment control over the
shares held by Gruber & McBaine Capital Management, LLC, Lagunitas
Partners, LP, and Gruber & McBaine International.





Gruber &
McBaine International purchased 400 shares of Series C Preferred Stock and
warrants to purchase 20,000 shares of common stock in the Series C
Financing; 135 shares of Series D Preferred Stock and warrants to purchase
5,328 shares of common stock in the Series D Financing; and 60,000 shares
of common stock and warrants to purchase 30,000 shares of common stock in the
September 2007 Private Placement.





Lagunitas
Partners LP purchased 1,200 shares of Series C Preferred Stock and warrants
to purchase 60,000 shares of common stock in the Series C Financing; 440
shares of Series D Preferred Stock and warrants to purchase 17,368 shares
of common stock in the Series D Financing; and 240,000 shares of common
stock and warrants to purchase 120,000 shares of common stock in the
September 2007 Private Placement.





J.
Patterson McBaine purchased 400 shares of Series C Preferred Stock and
warrants to purchase 20,000 shares of common stock in the Series C
Financing; 100 shares of Series D Preferred Stock and warrants to purchase
3,947 shares of common stock in the Series D Financing; and 50,000 shares
of common stock and warrants to purchase 25,000 shares of common stock in the
September 2007 Private Placement.





In
addition to the employment agreements with Messrs. Miller and Wetherell and
the Change of Control and Severance Benefits Agreements with
Messrs. AuBuchon and Harding, we have entered into indemnity agreements
with certain officers and directors that provide, among other things, that we
will indemnify such officer or director, under the circumstances and to the
extent provided for therein, for expenses, damages, judgments, fines and
settlements he or she may be required to pay in actions or proceedings which he
or she is or may be made a party by reason of his or her position as a director,
officer or other agent of ours, and otherwise to the fullest extent permitted
under Delaware law and our Bylaws.





REVIEW,
APPROVAL OR RATIFICATION OF TRANSACTIONS WITH RELATED PERSONS





As
provided in the charter of our Audit Committee, it is our policy that we will
not enter into any transactions required to be disclosed under Item 404 of the
SEC’s Regulation S-K unless the Audit Committee or another independent body of
our Board of Directors first reviews and approves the transactions.





In
addition, pursuant to our Code of Ethical Conduct and Business Practices, all
employees, officers and directors of ours and our subsidiaries are prohibited
from engaging in any relationship or financial interest that is an actual or
potential conflict of interest with us without approval. Employees, officers and
directors are required to provide written disclosure to the Chief Executive
Officer as soon as they have any knowledge of a transaction or proposed
transaction with an outside individual, business or other organization that
would create a conflict of interest or the appearance of one.








DIRECTOR
INDEPENDENCE





Our Board
of Directors has the responsibility for establishing corporate policies and for
our overall performance, although it is not involved in day-to-day operations.
As required under the listing standards of AMEX, a majority of the members of a
listed company’s board of directors must qualify as “independent,” as
affirmatively determined by the Board. Consistent with these considerations,
after review of all relevant transactions or relationships between each
director, or any of his family members, and ImageWare, our senior management and
our independent auditors, our Board of Directors has affirmatively determined
that all of our directors are independent directors within the meaning of the
applicable AMEXlisting standards,
except for Mr. Miller, our Chairman of the Board and Chief Executive
Officer.





51


Item 14.
            Principal Accountant Fees and
      Services





The
following table represents aggregate fees billed to the Company for the fiscal
years ended December 31, 2008 and 2007 by Stonefield Josephson, Inc., the
Company’s principal accountant for the fiscal years ended December 31, 2008 and
2007:





Fiscal
      Year Ended2008
            
            
            2007Audit
      Fees
            
            $
            195,642
            
            
            $
            150,892Audit-Related
      Fees
            
            
            11,422
            
            
            
            28,682Tax
      Fees
            
            
            —
            
            
            
            —All
      Other Fees
            
            
            26,224
            
            
            
            22,821Total
      Fees
            
            $
            233,288
            
            
            $
            202,395




All
      fees described above were approved by the Audit Committee of the Company’s
      Board of Directors.





Pre-Approval
Policies and Procedures.





The Audit
Committee has adopted a policy and procedures for the pre-approval of audit and
non-audit services rendered by our independent auditor, Stonefield Josephson,
Inc. The policy generally pre-approves specified services in the defined
categories of audit services, audit-related services, and tax services up to
specified amounts. Pre-approval may also be given as part of the Audit
Committee’s approval of the scope of the engagement of the independent auditor
or on an individual explicit case-by-case basis before the independent auditor
is engaged to provide each service. The pre-approval of services may be
delegated to one or more of the Audit Committee’s members, but the decision must
be reported to the full Audit Committee at its next scheduled
meeting.





52


PART IV





Item 15.
            Exhibits and Financial Statement
      Schedules





(a)1. Index to
Consolidated Financial Statements





See Index
to Consolidated Financial Statements.





53


(b)Exhibits





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





Item 16.
            Exhibits and Financial Statement
      Schedules





(a)  Exhibits




Exhibit
                Number
              
              Description2.1
              
              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).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).  54
  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).4.19
              
              Form of Warrant to Purchase Common Stock dated
      September 5, 2008.4.20
              
              Form
      of Warrant to Purchase Common Stock dated November 14,
    2008.4.21
              
              Registration
      Rights Agreement, dated February 12, 2009, between the Registrant and BET
      Funding, LLC.4.22
              
              Warrant
      to Purchase Common Stock, dated February 12, 2009, issued by the
      Registrant to BET Funding, LLC.4.23
              
              Warrant
      to Purchase Common Stock, dated June 9, 2009, issued by the Registrant to
      BET Funding, LLC.4.24
              
              Warrant
      to Purchase Common Stock, dated June 22 2009, issued by the Registrant to
      BET Funding, LLC.4.25
              
              Warrant
      to Purchase Common Stock, dated October 5 2009, issued by the Registrant
      to BET Funding, LLC.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 onForm 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 onForm 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
              
              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).10.20
              
              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).10.21
              
              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).10.22
              
              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).  55
  10.23
              
              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).10.24
              
              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).10.25
              
              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).10.26
              
              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).10.27
              
              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).10.38
              
              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).10.39
              
              Office
      Space Lease between I.W. Systems Canada Registrant and GE Canada Real
      Estate Equity dated July 25, 2008).10.40
              
              Form of Securities Purchase Agreement, dated
      August 29, 2008 by and among the Registrant and certain
      accredited investors.10.41
              
              Change
      of Control and Severance Benefits Agreement, dated September 27, 2008,
      between Registrant and Charles Aubuchon.10.42
              
              Change
      of Control and Severance Benefits Agreement, dated September 27, 2008,
      between Registrant and David Harding.10.43
              
              First
      Amendment to Employment Agreement, dated September 27, 2008, between the
      Registrant and S. James Miller.10.44
              
              First
      Amendment to Employment Agreement, dated September 27, 2008, between the
      Registrant and Wayne Wetherell.10.45
              
              Form
      of Convertible Note dated November 14, 2008.10.46
              
              Secured
      Note Agreement, dated February 12, 2009, by and between the Registrant and
      BET Funding, LLC.10.47
              
              Security
      Agreement, dated February 12, 2009, by and between the Registrant and BET
      Funding, LLC10.48
              
              Second
      Amendment to Change of Control and Severance Benefits Agreement, dated
      April 6, 2009, between Registrant and Charles Aubuchon.10.49
              
              Second
      Amendment to Change of Control and Severance Benefits Agreement, dated
      April 6, 2009, between Registrant and David Harding.10.50
              
              Second
      Amendment to Employment Agreement, dated April 6, 2009, between the
      Registrant and S. James Miller.10.51
              
              Second
      Amendment to Employment Agreement, dated April 6, 2009, between the
      Registrant and Wayne Wetherell.10.52
              
              Waiver
      and Amendment Agreement to Secured Note Agreement, dated June 9, 2009
      between the Registrant and BET Funding, LLC10.53
              
              Second
      Amendment to Secured Note Agreement, dated June 22, 2009 between the
      Registrant and BET Funding, LLC.10.54
              
              Office
      Space Lease between the Registrant and Allen W. Wooddell, dated
      July 25, 2008.10.55
              
              Third
      Amendment to Secured Note Agreement, dated October 5, 2009 between the
      Registrant and BET Funding, LLC.10.56
              
              Fourth
      Amendment to Secured Note Agreement, dated November 11, 2009 between the
      Registrant and BET Funding, LLC.10.57
              
              Assignment
      of Receivable dated November 11, 2009 between the Registrant and BET
      Funding, LLC.10.58
              
              Third Amendment to Change of Control and Severance
      Benefits Agreement, dated December 10, 2009, between Registrant and
      Charles Aubuchon.10.59
              
              Third Amendment to Change of Control and Severance
      Benefits Agreement, dated December 10, 2009, between Registrant and David
      Harding.10.60
              
              Third Amendment to Employment Agreement, dated
      December 10, 2009, between the Registrant and S. James
    Miller.10.61
              
              Third Amendment to Employment Agreement, dated
      December 10, 2009, between the Registrant and Wayne
    Wetherell.21.1
              
              Subsidiaries
      of the Registrant31.1
              
              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





56


SIGNATURES





In
accordance with Section 13 or 15(d) of the Exchange Act, the
registrant caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.





IMAGEWARE
      SYSTEMS, INC.February
      23, 2010
            By:
            /s/
      S. JAMES MILLER,
      JR.S.
      James Miller, Jr.Chief
      Executive Officer and
              Chairman
      of the Board of Directors





In
accordance with the Exchange Act, this report has been signed below by the
following persons on behalf 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
            
            February
      24, 2010S.
      James Miller, Jr.
            
            (Principal
      Executive Officer)/s/
      WAYNE G. WETHERELL
            
            Senior
      Vice President of Administration and Chief Financial
    Officer
            
            February
      24, 2010Wayne
      G. Wetherell
            
            (Principal
      Financial and Accounting Officer)/s/
      JOHN CALLAN
            
            Director
            
            February
      24, 2010John
      Callan/s/
      JOHN L. HOLLERAN
            
            Director
            
            February
      24, 2010John
      L. Holleran/s/
      DAVID LOESCH
            
            Director
            
            February
      24, 2010David
      Loesch/s/
      STEVE HAMM
            
            Director
            
            February
      24, 2010Steve
      Hamm/s/
      DAVID CAREY
            
            Director
            
            February
      24, 2010David
      Carey





57


IMAGEWARE
SYSTEMS, INC.





INDEX
TO CONSOLIDATED FINANCIAL STATEMENTS





REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
            59CONSOLIDATED
      FINANCIAL STATEMENTS:CONSOLIDATED
      BALANCE SHEETS
            60CONSOLIDATED
      STATEMENTS OF OPERATIONS
            61CONSOLIDATED
      STATEMENTS OF CASH FLOW
            62CONSOLIDATED
      STATEMENTS OF COMPREHENSIVE LOSS
            64CONSOLIDATED
      STATEMENTS OF SHAREHOLDERS’ EQUITY (DEFICIT)
            65NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS
            67





58


REPORT
OF INDEPENDENT REGISTERED PUBLIC 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, 2008 and 2007, and the related consolidated statements
of operations, comprehensive loss, shareholders’ equity (deficit), and cash
flows for each of the two years in the period ended December 31, 2008.
 These consolidated financial statements are the responsibility of the
Company’s management. Our responsibility is to express an opinion on these
consolidated financial statements based on our audits.
 
 We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement.  We were not engaged to
perform an audit of the Company’s internal control over financial
reporting.  Our audit included consideration of internal control over
financial reporting as a basis for designing audit procedures that are
appropriate in the circumstances, but not for the purpose of expressing an
opinion on the effectiveness of the Company’s internal control over financial
reporting.  Accordingly, we express no such opinion.  An audit also
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements, assessing the accounting principles
used and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
 
 In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of ImageWare Systems, Inc. as
of December 31, 2008 and 2007, and the results of its operations and its cash
flows for each of the two years in the period ended December 31, 2008 in
conformity with accounting principles generally accepted in the United States of
America.
 
 The
accompanying consolidated financial statements have been prepared assuming the
Company will continue as a going concern.  As discussed in Note 1 to
the consolidated financial statements, the Company has incurred substantial
losses since inception, experienced negative cash flows from operations, and has
negative working capital as of December 31, 2008.  These matters,
among others, raise  substantial doubt about the Company’s ability to
continue as a going concern.  Management’s plans concerning these
matters are described in Note 1.  These consolidated financial
statements do not include any adjustments relating to the recoverability and
classifications of recorded assets, or the amounts and classification of
liabilities that might be necessary in the event the Company cannot continue in
existence.


/s/
Stonefield Josephson, Inc.
 Irvine,
California
 February 23,
2010




59


IMAGEWARE
SYSTEMS, INC.


CONSOLIDATED
BALANCE SHEETS


(in
thousands, except share amounts)





December 31,
              2008
            
            
            December 31,
              2007ASSETSCurrent
      Assets:Cash
      and cash equivalents
            
            $
            171
            
            
            $
            1,044Accounts receivable, net of allowance for doubtful accounts of $28 and
      $0at December 31, 2008 and 2007, respectively
            
            
            503
            
            
            
            425Inventories,
      net
            
            
            19
            
            
            
            130Other
      current assets
            
            
            191
            
            
            
            441Total
      Current Assets
            
            
            884
            
            
            
            2,040Property
      and equipment, net
            
            
            108
            
            
            
            288Other
      assets
            
            
            37
            
            
            
            24Pension
      assets
            
            
            682
            
            
            
            694Intangible
      assets, net
            
            
            110
            
            
            
            2,437Goodwill
            
            
            3,416
            
            
            
            4,452Total
      Assets
            
            $
            5,237
            
            
            $
            9,935LIABILITIES
      AND SHAREHOLDERS’ (DEFICIT) EQUITYCurrent
      Liabilities:Accounts
      payable
            
            $
            2,388
            
            
            $
            1,415Deferred
      revenue
            
            
            872
            
            
            
            1,011Billings
      in excess of costs and estimated earnings on uncompleted
      contracts
            
            
            279
            
            
            
            —Accrued
      expenses
            
            
            1,530
            
            
            
            1,341Acquisition
      related obligation
            
            
            —
            
            
            
            1,502Total
      Current Liabilities
            
            
            5,069
            
            
            
            5,269Notes
      payable to related parties
            
            
            98
            
            
            
            —Pension
      obligation
            
            
            1,102
            
            
            
            1,139Total
      Liabilities
            
            
            6,269
            
            
            
            6,408Commitments
      and contingencies
            
            
            —
            
            
            
            —Shareholders’
      equityPreferred
      stock, authorized 4,000,000 shares:Series B convertible preferred stock, designated 750,000 shares,389,400 shares issued, and 239,400 shares outstanding at December 31,
      2008and 2007, liquidation preference $632 at December 31, 2008 and $607
      at December 31, 2007
            
            
            2
            
            
            
            2Series C convertible preferred stock, designated 3,500
    shares,2,500 shares issued, and 2,200 shares outstanding at December 31,
      2008and 2007, liquidation preference of $2,604 at December 31, 2008 and
      $2,434 at December 31, 2007
            
            
            —
            
            
            
            —Series D convertible preferred stock, designated 3,000
      shares,2,310 and 1,500 shares issued at December 31, 2008 and 2007, respectively,
      and2,198 and 1,388 shares outstanding at December 31, 2008 and 2007,
      respectively,liquidation preference $2,428 and $1,486 at December 31, 2008 and
      2007, respectively
            
            
            —
            
            
            
            —Common stock, $.01 par value, 50,000,000 shares authorized, 18,163,487 and17,797,826 shares issued at December 31, 2008 and 2007,
      respectively,18,156,783
      and 17,791,122 shares outstanding at December 31, 2008and
      2007, respectively
            
            
            180
            
            
            
            177Additional
      paid in capital
            
            
            86,007
            
            
            
            79,294Treasury
      stock, at cost - 6,704 shares
            
            
            (64
            )
            
            
            (64
            )Accumulated
      other comprehensive income
            
            
            44
            
            
            
            7Accumulated
      deficit
            
            
            (87,201
            )
            
            
            (75,889
            )Total
      shareholders’ (deficit) equity
            
            
            (1,032
            )
            
            
            3,527Total
      Liabilities and Shareholders’ (Deficit)Equity
            
            $
            5,237
            
            
            $
            9,935





The
accompanying notes are an integral part of these consolidated financial
statements.




60


IMAGEWARE
SYSTEMS, INC.


CONSOLIDATED
STATEMENTS OF OPERATIONS


(In
Thousands, except share and per share amounts)





Twelve
      Months Ended December 31,
            
            
            Twelve
      Months Ended December 31,2008
            
            
            2007Revenues:Product
            
            $
            3,707
            
            
            $
            5,652Maintenance
            
            
            2,808
            
            
            
            2,8366,515
            
            
            
            8,488Cost
      of revenues:Product
            
            
            1,062
            
            
            
            1,380Maintenance
            
            
            1,146
            
            
            
            1,166Gross
      profit
            
            
            4,307
            
            
            
            5,942Operating
      expenses:General and
      administrative
            
            
            3,553
            
            
            
            3,865Sales
      and marketing
            
            
            2,111
            
            
            
            2,647Research and
      development
            
            
            2,956
            
            
            
            3,669Impairment
      of intangible assets
            
            
            742
            
            
            
            —Depreciation
      and amortization
            
            
            772
            
            
            
            25810,134
            
            
            
            10,439Loss
      from operations
            
            
            (5,827
            )
            
            
            (4,497
            )Interest
      (income) expense, net
            
            
            19
            
            
            
            215Other
      (income) expense, net
            
            
            (110
            )
            
            
            23Loss
      from continuing operations before income taxes
            
            
            (5,736
            )
            
            
            (4,735
            )Income
      tax benefit (expense)
            
            
            —
            
            
            
            —Loss
      from continuing operations
            
            
            (5,736
            )
            
            
            (4,735
            )Discontinued
      operations:Gain
      from operations of discontinued Digital Photography
    Component
            
            $
            18
            
            
            $
            50Income
      tax benefit (expense)
            
            
            —
            
            
            
            —Gain
      (loss) on discontinued operations
            
            
            18
            
            
            
            50Net
      loss
            
            
            (5,718
            )
            
            
            (4,685
            )Preferred
      dividends
            
            
            (5,928
            )
            
            
            (1,171
            )Net
      loss available to common shareholders
            
            $
            (11,646
            )
            
            $
            (5,856
            )Basic
      and diluted loss per common share - see Note 2Continuing
      operations
            
            $
            (0.32
            )
            
            $
            (0.31
            )Discontinued
      operations
            
            
            —
            
            
            
            —Preferred
      dividends
            
            
            (0.33
            )
            
            
            (0.08
            )Basic
      and diluted loss per common available to common
    shareholders
            
            $
            (0.65
            )
            
            $
            (0.39
            )Weighted-average
      shares outstanding (basic and diluted)
            
            
            18,056,026
            
            
            
            15,070,308





The
accompanying notes are an integral part of these consolidated financial
statements.




61


IMAGEWARE
SYSTEMS, INC.


CONSOLIDATED
STATEMENTS OF CASH FLOWS


(In
Thousands)





Twelve
      Months Ended December 31,
                
                
                Twelve
      Months Ended December 31,2008
                
                
                2007
 Cash
      flows from operating activitiesNet
      loss
                
                
                (5,718
                )
                
                $
                (4,685
                )Adjustments to reconcile net loss to net cash used by operating
      activities:Depreciation and amortization
                
                
                772
                
                
                
                258Amortization
      of debt discount and debt issuance costs
                
                
                6
                
                
                
                229Stock
      based compensation
                
                
                596
                
                
                
                556Accretion
      of beneficial conversion feature of convertible debt....
                
                
                6
                
                
                
                —Prepaid
      royalty impairment
                
                
                100
                
                
                
                —Allowance
      for doubtful accounts
                
                
                —
                
                
                
                25Impairment
      of certain long-lived intangible assets
                
                
                742
                
                
                
                —Impairment
      of investment in equity securities
                
                
                —
                
                
                
                85Increase
      (decreases) in inventory obsolescence reserve
                
                
                75
                
                
                
                (36
                )Change
      in assets and liabilitiesAccounts
      receivable
                
                
                (106
                )
                
                
                1,222Inventories
                
                
                37
                
                
                
                (37
                )Other
      assets
                
                
                4
                
                
                
                (187
                )Pension
      assets
                
                
                12
                
                
                
                (85
                )Accounts
      payable
                
                
                972
                
                
                
                (303
                )Accrued
      expenses
                
                
                180
                
                
                
                207Deferred
      revenue
                
                
                (111
                )
                
                
                (248
                )Contract
      costs
                
                
                279
                
                
                
                —Pension
      obligation
                
                
                (38
                )
                
                
                123Total
      adjustments
                
                
                3,526
                
                
                
                1,809Net
      cash used by operating activities
                
                
                (2,192
                )
                
                
                (2,876
                )Cash
      flows from investing activitiesPurchase
      of property and equipment
                
                
                (67
                )
                
                
                (86
                )Restricted
      cash and cash equivalents
                
                
                132
                
                
                
                (26
                )Acquisition
      of businesses, net of cash acquired of $0
                
                
                (187
                )
                
                
                (410
                )Net
      cash used by investing activities
                
                
                (122
                )
                
                
                (522
                )Cash
      flows from financing activitiesProceeds
      from issuance of preferred stock, net of issuance costs of $33 and $267,
      respectively
                
                
                777
                
                
                
                1,233Proceeds
      from issuance of common stock, net of issuance costs of $0 and $404,
      respectively
                
                
                —
                
                
                
                2,621Proceeds
      from issuance of notes payable with warrants
                
                
                110
                
                
                
                —Other
      financing issuance costs
                
                
                —
                
                
                
                (54
                )Repayment
      of notes payable
                
                
                —
                
                
                
                (1,310
                )Dividends
      paid
                
                
                (25
                )
                
                
                (51
                )Proceeds
      from exercise of stock purchase warrants
                
                
                542
                
                
                
                1,121Net
      cash provided by financing activities
                
                
                1,404
                
                
                
                3,560Effect
      of exchange rate changes on cash and cash equivalents
                
                
                37
                
                
                
                (57
                )Net
      increase (decrease) in cash and cash equivalents
                
                
                (873
                )
                
                
                105
  62
  Twelve
      Months Ended December 31,
                  
                  
                  Twelve
      Months Ended December 31,2008
                  
                  
                  2007
 Cash
      and cash equivalents at beginning of period
              
              
              1,044
              
              
              
              939Cash
      and cash equivalents at end of period
              
              $
              171
              
              
              $
              1,044Supplemental
      disclosure of cash flow information:Cash
      paid for interest
              
              $
              —
              
              
              $
              46Cash
      paid for income taxes
              
              $
              —
              
              
              $
              —Summary
      of non-cash investing and financing activities:Beneficial
      conversion feature of preferred stock
              
              $
              5,568
              
              
              $
              814Resolution
      of purchase accounting contingency
              
              $
              1060
              
              
              $
              —Changes
      in minimum pension liability
              
              $
              (48
              )
              
              $
              (37
              )Allowance
      for doubtful accounts
              
              $
              28
              
              
              $
              —Warrants
      issued with notes payable
              
              $
              13
              
              
              $
              —Equipment
      received in lieu of cash on accounts receivable
              
              $
              —
              
              
              $
              50





The
accompanying notes are an integral part of these consolidated financial
statements.





63


IMAGEWARE
SYSTEMS, INC.


CONSOLIDATED
STATEMENTS OF COMPREHENSIVE LOSS


(In
Thousands)





Twelve
      Months Ended December 31,
            
            
            Twelve
      Months Ended December 31,2008
            
            
            2007Net
      loss
            
            $
            (5,718
            )
            
            $
            (4,685
            )Other
      comprehensive income (loss):Unrealized
      losses on available-for-sale securities arising during
    period
            
            
            —
            
            
            
            39Additional
      minimum pension liability
            
            
            48
            
            
            
            37Foreign
      currency translation adjustment
            
            
            (11
            )
            
            
            (94
            )Comprehensive
      loss
            
            $
            (5,681
            )
            
            $
            (4,703
            )





The
accompanying notes are an integral part of these consolidated financial
statements.




64
 
 ImageWare
Systems, Inc.
 Consolidated
Statements of Shareholders' Equity (Deficit)
 for
the Years Ended December 31, 2007 and 2008
 (In
thousands, except share amounts)
  Series
      B
                    Convertible,
                  
                  Series
      C
                  
                  Series
      D
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  Addit-
                    ional
                  
                  Accum-
                    ulated
                    OtherRedeemable
                  
                  Convertible,
                  
                  Convertible,
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  Paid-
                  
                  Compre-
                  
                  Accum-Preferred
                  
                  Preferred
                  
                  Preferred
                  
                  Common
      Stock
                  
                  Treasury
      Stock
                  
                  In
                  
                  hensive
                  
                  ulatedShares
                  
                  Amount
                  
                  Shares
                  
                  Amount
                  
                  Shares
                  
                  Amount
                  
                  Shares
                  
                  Amount
                  
                  Shares
                  
                  Amount
                  
                  Capital
                  
                  Loss
                  
                  Deficit
                  
                  TotalBalance
      at December 31, 2006
                  
                  239,400
                  
                  2
                  
                  2,500
                  
                  -
                  
                  -
                  
                  -
                  
                  13,700,849
                  
                  136
                  
                  (6,704
                  )
                  (64
                  )
                  71,553
                  
                  25
                  
                  (70,333
                  )
                  1,320Issuance
      of common stock pursuant to warrant exercises
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  795,956
                  
                  8
                  
                  
                  
                  
                  
                  1,113
                  
                  
                  
                  
                  
                  1,121Issuance
      of common stock as compensation
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  63,240
                  
                  1
                  
                  
                  
                  
                  
                  203
                  
                  
                  
                  
                  
                  204Issuance
      of common stock for cash, net
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  2,016,666
                  
                  20
                  
                  
                  
                  
                  
                  2,601
                  
                  
                  
                  
                  
                  2,621Issuance
      of common stock for asset purchase
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  935,089
                  
                  9
                  
                  
                  
                  
                  
                  1,468
                  
                  
                  
                  
                  
                  1,477Issuance
      of preferred stock for cash, net of financing commissions
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  1,500
                  
                  -
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  1,233
                  
                  
                  
                  
                  
                  1,233finanincing
      related expenses
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (54
                  )
                  
                  
                  
                  
                  (54
                  )Beneficial
      conversion feature of series D preferred stock
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  814
                  
                  
                  
                  (814
                  )
                  -Stock-based
      compensation option expense
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  359
                  
                  
                  
                  
                  
                  359Foreign
      currency translation adjustment
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (94
                  )
                  
                  
                  (94
                  )Unrealized
      holding losses on securities
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  39
                  
                  
                  
                  39Additional
      minumum pension liability
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  37
                  
                  
                  
                  37Conversion
      of preferred stock to common
                  
                  
                  
                  
                  
                  (300
                  )
                  -
                  
                  
                  
                  
                  
                  206,778
                  
                  2
                  
                  
                  
                  
                  
                  (2
                  )
                  
                  
                  
                  
                  -Conversion
      of preferred stock to common
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (112
                  )
                  -
                  
                  74,666
                  
                  1
                  
                  
                  
                  
                  
                  (1
                  )
                  
                  
                  
                  
                  -Dividends
      on Series B Preferred stock
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (51
                  )
                  (51
                  )Conversion
      of Accrued Dividends on Series D Preferredstock
      to common
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  4,582
                  
                  -
                  
                  
                  
                  
                  
                  7
                  
                  
                  
                  (7
                  )
                  -Net
      loss
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (4,685
                  )
                  (4,685
                  )Balance
      at December 31, 2007
                  
                  239,400
                  
                  2
                  
                  2,200
                  
                  -
                  
                  1,388
                  
                  -
                  
                  17,797,826
                  
                  177
                  
                  (6,704
                  )
                  (64
                  )
                  79,294
                  
                  7
                  
                  (75,889
                  )
                  3,527
  The accompanying notes are
an integral part of these consolidated financial statements.
  65
  ImageWare
Systems, Inc.
 Consolidated
Statements of Shareholders' Equity (Deficit)
 for
the Years Ended December 31, 2007 and 2008
 (In
thousands, except share amounts)
 (continued)
 
 Series
      B
                  Convertible,
                
                Series
      C
                
                Series
      D
                
                
                
                
                
                
                
                
                
                Addit
                  -ional
                
                Accum-ulated
                  OtherRedeemable
                
                Convertible,
                
                Convertible,
                
                
                
                
                
                
                
                
                
                Paid-
                
                Compre-
                
                Accum-Preferred
                
                Preferred
                
                Preferred
                
                Common
      Stock
                
                Treasury
      Stock
                
                In
                
                hensive
                
                ulatedShares
                
                Amount
                
                Shares
                
                Amount
                
                Shares
                
                Amount
                
                Shares
                
                Amount
                
                Shares
                
                Amount
                
                Capital
                
                Loss
                
                Deficit
                
                TotalIssuance
      of common stock pursuant to warrant exercises
                
                
                
                
                
                
                
                
                
                
                
                
                
                541,666
                
                5
                
                
                
                
                
                536
                
                
                
                
                
                541Issuance
      of preferred stock for cash, net of financing commissions
                
                
                
                
                
                
                
                
                
                810
                
                -
                
                
                
                
                
                
                
                
                
                777
                
                
                
                
                
                777Issuance
      of common stock as compensation
                
                
                
                
                
                
                
                
                
                
                
                
                
                81,144
                
                1
                
                
                
                
                
                191
                
                
                
                
                
                192Issuance
      of restricted stock grants to consultants inlieu
      of cash
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                54
                
                
                
                
                
                54Warrants
      issued in conjunction with debt to related parties
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                13
                
                
                
                
                
                13Beneficial
      conversion feature of debt
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                12
                
                
                
                
                
                12Stock-based
      compensation option expense
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                341
                
                
                
                
                
                341Beneficial
      conversion feature of series C and D preferred stock
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                5,568
                
                
                
                (5,568
                )
                -Recission
      of shares previously issued to Sol Logic
                
                
                
                
                
                
                
                
                
                
                
                
                
                (257,149
                )
                (3
                )
                
                
                
                
                (648
                )
                
                
                
                
                (651
                )Registration
      costs for shares issued in connection with Sol Logic
      acquisition
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                (131
                )
                
                
                
                
                (131
                )Dividends
      on Series B Preferred stock
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                (26
                )
                (26
                )Foreign
      currency translation adjustment
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                (11
                )
                
                
                (11
                )Additional
      minimum pension liability
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                48
                
                
                
                48Net
      loss
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                (5,718
                )
                (5,718
                )Balance
      at December 31, 2008
                
                239,400
                
                2
                
                2,200
                
                -
                
                2,198
                
                -
                
                18,163,487
                
                180
                
                (6,704
                )
                (64
                )
                86,007
                
                44
                
                (87,201
                )
                (1,032
                )
 
 The
accompanying notes are an integral part of these consolidated financial
statements.


66


IMAGEWARE
SYSTEMS, INC.





NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER 31,
2008 AND 2007





1.
            DESCRIPTION OF BUSINESS AND
      OPERATIONS





Overview





ImageWare
Systems, Inc. (the “Company”) is a leader in the emerging market for
software-based identity management solutions, providing biometric, secure
credential, law enforcement and enterprise authorization.  Our “flagship”
product is the IWS Biometric Engine.  Scalable for small city business or
worldwide deployment, our biometric engine is a multi-biometric platform that is
hardware and algorithm independent, enabling the enrollment and management of
unlimited population sizes.  Our identification products are used to manage
and issue secure credentials, including national IDs, passports, driver
licenses, smart cards and access control credentials. Our law enforcement
products provide law enforcement with integrated mug shot, fingerprint LiveScan
and investigative capabilities. We also provide comprehensive authentication
security software.  Biometric technology is now an integral part of all
markets we address, and all of our products are integrated into the Biometric
Engine Platform.  Elements of the IWS Biometric Engine can be used as
investigative tools for law enforcement utilizing multiple biometrics and
forensic data elements, and to enhance security and authenticity of public and
private sector credentials.





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




Our law
enforcement solutions enable agencies to quickly capture, archive, search,
retrieve, and share digital images, fingerprints and criminal history records on
a stand-alone, networked, wireless or Web-based platform. We develop, sell and
support a suite of modular software products used by law enforcement and public
safety agencies to create and manage criminal history records and to investigate
crime. Our IWS Law Enforcement solution consists of six software modules: a
Capture and Investigative module, which provides a criminal booking system and
related database; a Facial Recognition module, which uses biometric facial
recognition to identify suspects; a Suspect ID module, which facilitates the
creation of full-color, photo-realistic suspect composites; a wireless module,
which provides access to centrally stored records over the Internet in a
connected or wireless fashion; a PDA add-on module, which enables access to
centrally stored records while in the field on a handheld Pocket PC compatible
device combined with central repository services which allows for inter-agency
data sharing on a local, regional, and/or national level; and a LiveScan module,
which incorporates LiveScan capabilities into IWS Law Enforcement providing
integrated fingerprint and palm print biometric management for civil and law
enforcement use.





Our
Secure Credential ID solutions empower customers to create secure and smart
digital identification documents with complete ID systems. We develop, sell and
support software and design systems which utilize digital imaging in the
production of photo identification cards and credentials and identification
systems. Our products in this market consist of IWS EPI Suite, IWS EPI Builder
(SDK) and Identifier for Windows.  These products allow for the production
of digital identification cards and related databases and records and can be
used by, among others, schools, airports, hospitals, corporations or
governments.  We have added the ability to incorporate multiple biometrics
into the ID systems with the integration of IWS Biometric Engine to our Secure
Credential ID product line.





67


Our
enterprise authentication software includes the IWS Desktop Security product
which is a comprehensive authentication management infrastructure solution
providing added layers of security to workstations, networks and systems through
advanced encryption and authentication technologies. IWS Desktop Security is
optimized to enhance network security and usability, and uses multi-factor
authentication methods to protect access, verify identity and help secure the
computing environment without sacrificing ease-of-use features such as quick
login. Additionally, IWS Desktop Security provides an easy integration with
various smart card-based credentials including the Common Access Card (CAC),
Homeland Security 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 provides the crucial end-point component of a Logical Access Control
System (LACS), and when combined with a Physical Access Control System (PACS),
organizations benefit from a complete door to desktop access control and
security model.





Going
Concern





As
reflected in the accompanying consolidated financial statements, the Company has
continuing losses, negative working capital and negative cash flows from
operations. These matters raise substantial doubt about the Company’s ability to
continue as a going concern.





In May
2008, the AMEX removed the Company’s common stock from being listed on
their exchange as we failed to comply with AMEX’s continued listing
standards.  In December of 2008 our common stock was removed from
being quoted on the Over-the-Counter Bulletin Board as we failed to make the
required filings with the SEC in the required timeframe.  As of the
end of the third quarter of 2008, we were faced with limited funds for
operations and were compelled to suspend SEC filings and the associated costs
until such time as the Company had sufficient resources to cover ongoing
operations and the expenses of maintaining compliance with SEC filing
requirements.   There is no assurance that we will be able to
attain compliance with SEC filing requirements in the future, and if we are able
to attain compliance, there is no assurance we will be able to maintain
compliance.  If we are not able to attain and maintain compliance for
minimum required periods, we will not be eligible for re-listing on the
Over-the-Counter Bulletin Board or other exchanges.





The
delisting could adversely affect the public price of the Company’s common stock
and limit the Company’s stockholders’ ability to dispose of, or to obtain
accurate quotations as to the prices of, the Company’s common stock. Moreover,
the Company’s ability to obtain financing on favorable terms, or at all, may be
adversely affected by the delisting because certain institutional investors that
have policies against investments in companies that are not traded on a national
securities exchange and other investors may refrain from purchasing the
Company’s common stock because of the delisting.  The Company’s
ability to obtain financing may also be more limited in numerous states because
the Company will no longer benefit from state exemptions from registration which
are dependent upon the listing of the Company’s common stock on
AMEX.





Despite
securing financing arrangements in 2008 and 2009, additional new financing will
be required to fund working capital and operations should the Company be unable
to generate positive cash flow from operations in the near future. The Company
is exploring the possible sale of equity securities and/or debt financing.
However, there can be no assurance that additional financing will be
available.





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





In view
of the matters described in the preceding paragraph, recoverability of a major
portion of the recorded asset amounts shown in the accompanying consolidated
balance sheet is dependent upon continued operations of the Company, which, in
turn, is dependent upon the Company’s ability to continue to raise capital and
generate positive cash flows from operations. The consolidated financial
statements do not include any adjustments relating to the recoverability and
classification of recorded asset amounts or amounts and classifications of
liabilities that might be necessary should the Company be unable to continue its
existence.




The
Company operates in markets that are emerging and highly competitive. There is
no assurance that the Company will operate at a profit or positive cash flows in
the future.





2.           SUMMARY OF SIGNIFICANT ACCOUNTING
POLICIES





Principles
of consolidation





The
consolidated financial statements include the accounts of the Company and its
wholly-owned subsidiaries. All significant intercompany transactions and
balances have been eliminated.





68


Operating
Cycle





Assets
and liabilities related to long-term contracts are included in current assets
and current liabilities in the accompanying balance sheet, although they will be
liquidated in the normal course of contract completion which may take more than
one operating cycle.





Use
of estimates





The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States of America (“U.S. GAAP”) requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements, and the reported amounts of revenue and
expense during the reporting period. Significant estimates include the allowance
for doubtful accounts receivable, calculation of our tax provision, inventory
obsolescence reserve, the determination of other than temporary impairment on
our marketable securities, deferred tax asset valuation allowances, accounting
for loss contingencies, recoverability of goodwill and acquired intangible
assets and amortization periods, assumptions used in the Black-Scholes model to
calculate the fair value of share based payments, assumptions used in the
application of fair value methodologies to calculate the fair value of acquired
assets and revenue and cost of revenues recognized under the percentage of
completion method. Actual results could differ from estimates.





Cash
and Cash Equivalents





Cash and
cash equivalents consist primarily of cash on deposit, certificates of deposit,
money market accounts, and investment grade commercial paper that are readily
convertible into cash with original maturities of three months or less or that
are redeemable upon demand.





Accounts
Receivable




In the
normal course of business, the Company extends credit without collateral
requirements to its customers that satisfy pre-defined credit criteria. Accounts receivable are recorded net of an
allowance for doubtful accounts. The Company records its allowance for doubtful
accounts based upon its assessment of various factors. The Company considers
historical experience, the age of the accounts receivable balances, the credit
quality of its customers, current economic conditions and other factors that
may affect customers’ ability to pay to determine the level of allowance
required.  Accounts receivable are written off against the allowance
for doubtful accounts when all collection efforts by the Company have been
unsuccessful.




Fair
Value of Financial Instruments





For
certain of the Company’s financial instruments, including accounts receivable,
accounts payable, accrued expenses, deferred revenues and notes payable to
related parties, the carrying amounts approximate fair value due to their
relatively short maturities.





In
September 2006, the Financial Accounting Standards Board (“FASB”) issued FASB
Statement No. 157, “Fair Value Measurements” (“FAS 157”). FAS 157 defines
fair value, establishes a framework for measuring fair value in generally
accepted accounting principles, and expands disclosures about fair value
measurements. The provisions of FAS 157 were adopted January 1, 2008. In
February 2008, the FASB staff issued Staff Position No. 157-2 “Effective
Date of FASB Statement No. 157” (“FSP FAS 157-2”). FSP FAS 157-2 delayed
the effective date of FAS 157 for nonfinancial assets and nonfinancial
liabilities, except for items that are recognized or disclosed at fair value in
the financial statements on a recurring basis (at least annually). The
provisions of FSP FAS 157-2 are effective for the Company’s fiscal year
beginning January 1, 2009.





FAS 157
establishes a fair value hierarchy that prioritizes the inputs to valuation
techniques used to measure fair value. The hierarchy gives the highest priority
to unadjusted quoted prices in active markets for identical assets or
liabilities (Level 1 measurements) and the lowest priority to unobservable
inputs (Level 3 measurements). The three levels of the fair value hierarchy
under FAS 157 are described below:





Level 1
            Unadjusted
      quoted prices in active markets that are accessible at the measurement
      date for identical, unrestricted assets or
  liabilities;





Level 2
            Quoted
      prices in markets that are not active, or inputs that are observable,
      either directly or indirectly, for substantially the full term of the
      asset or liability;





Level 3
            Prices
      or valuation techniques that require inputs that are both significant to
      the fair value measurement and unobservable (supported by little or no
      market activity).





69


The
following table sets forth the Company’s financial assets and liabilities
measured at fair value by level within the fair value hierarchy. As required by
FAS 157, assets and liabilities are classified in their entirety based on the
lowest level of input that is significant to the fair value
measurement.





Fair
      Value at December 31, 2008($
      in thousands)
            
            Total
            
            
            Level
      1
            
            
            Level
      2
            
            
            Level
      3Assets:Pension
      assets
            
            $
            682
            
            
            $
            682
            
            
            $
            —
            
            
            $
            —Totals
            
            $
            682
            
            
            $
            682
            
            
            $
            —
            
            
            $
            —Liabilities:None
            
            $
            —
            
            
            $
            —
            
            
            $
            —
            
            
            $
            —





The
Company’s Pension assets are classified within Level 1 of the fair value
hierarchy because they are valued using market prices. The Pension assets are
valued based on market prices in active markets and are primarily comprised of
the cash surrender value of insurance contracts. All plan assets are managed in
a policyholder pool in Germany by outside investment managers.  The
investment objectives for the plan are the preservation of capital, current
income and long-term growth of capital.





The
Company had no financial assets or liabilities which were being measured at
Level 2 or 3.





In
February 2007, the FASB issued FASB Statement No. 159, “The Fair Value
Option for Financial Assets and Financial Liabilities” (“FAS 159”). FAS 159
permits entities to choose to measure many financial instruments and certain
other items at fair value, with the objective of improving financial reporting
by mitigating volatility in reported earnings caused by measuring related assets
and liabilities differently without having to apply complex hedge accounting
provisions. The provisions of FAS 159 were adopted January 1, 2008. The
Company did not elect the Fair Value Option for any of its financial assets or
liabilities, and therefore, the adoption of FAS 159 had no impact on the
Company’s consolidated financial position, results of operations or cash
flows





Property,
equipment and leasehold improvements





Property
and equipment, consisting of furniture and equipment, are stated at cost and are
being depreciated on a straight-line basis over the estimated useful lives of
the assets, which range from three to five years. Maintenance and repairs are
charged to expense as incurred. Major renewals or improvements are capitalized.
When assets are sold or abandoned, the cost and related accumulated depreciation
are removed from the accounts and the resulting gain or loss is recognized.
Expenditures for leasehold improvements are capitalized. Depreciation of
leasehold improvements is computed using the straight-line method over the
shorter of the remaining lease term or the estimated useful lives of the
improvements.




Inventories
  Inventories are stated at the lower of
cost, determined using the First-In, First-Out method or market.


Goodwill




The
Company accounts for its intangible assets under the provisions of SFAS
No. 142, “Goodwill and Other Intangible Assets”. In accordance with SFAS
No. 142, intangible assets with a definite life are accounted for
impairment under SFAS No. 144 and intangible assets with an indefinite life
are accounted for impairment under SFAS No. 142. In accordance with SFAS
No. 142, goodwill, or the excess of cost over fair value of net assets
acquired, is no longer amortized but is tested for impairment using a fair value
approach at the “reporting unit” level. A reporting unit is the operating
segment, or a business one level below that operating segment (referred to as a
component) if discrete financial information is prepared and regularly reviewed
by management at the component level. The Company’s reporting unit is at the
entity level. The Company recognizes an impairment charge for any amount by
which the carrying amount of a reporting unit’s goodwill exceeds its fair value.
The Company uses fair value methodologies to establish fair
values.




The
Company did not record any goodwill impairment charges for the twelve months
ended December 31, 2008 and 2007.





70


Intangible
and Long-lived assets





In
October 2001, the FASB issued SFAS No. 144, “Accounting for the
Impairment or Disposal of Long-Lived Assets SFAS No. 144 requires that
long-lived assets to be disposed of by sale, including those of discontinued
operations, be measured at the lower of carrying amount or fair value less cost
to sell, whether reported in continuing operations or in discontinued
operations. SFAS No. 144 broadens the reporting of discontinued operations
to include all components of an entity with operations that can be distinguished
from the rest of the entity and that will be eliminated from the ongoing
operations of the entity in a disposal transaction. SFAS No. 144 also
establishes a “primary-asset” approach to determine the cash flow estimation
period for a group of assets and liabilities that represents the unit of
accounting for a long-lived asset to be held and used. At December 31,
2008, the Company recorded impairment losses on certain long-lived
assets of approximately $742,000 related to certain acquired intangible
assets for developed technologies, customer base and non-compete
agreements.  The impairment reflects the amount by which the carrying
value of these assets exceeded their estimated fair values.  The
impairment loss is recorded as a component of “Operating expenses” in the
Consolidated Statement of Operations for 2008. At December 31, 2007 there
was no impairment of the Company’s intangible or long-lived assets.





Concentration
of credit risk





Financial
instruments which potentially subject the Company to concentrations of credit
risk consist principally of cash and trade accounts receivable. The Company
places its cash with high quality financial institutions and at times during the
years ended Dec 31, 2007 and 2008 exceeded the FDIC insurance limits of $250,000
for 2008 and $100,000 for 2007. Sales are typically made on credit and the
Company generally does not require collateral. The Company performs ongoing
credit evaluations of its customers’ financial condition and maintains an
allowance for doubtful accounts. Accounts receivable are presented net of an
allowance for doubtful accounts of $28,000 and $0 at December 31, 2008 and
2007, respectively.





For the
twelve months ended December 31, 2008 one customer accounted for
approximately 17% of total revenues. For the twelve months ended
December 31, 2007 one customer accounted for approximately 18% of total
revenues.




As of
December 31, 2008, there was one customer who accounted for approximately 37% of
total accounts receivable.  The account was in good
standing.  As of December 31, 2007, there was one customer who
accounted for approximately 27% of total accounts receivable.





Stock-based
compensation





At
December 31, 2008, the Company had three stock-based compensation plans for
employees and nonemployee directors which authorize the granting of various
equity-based incentives including stock options and restricted
stock.




On
January 1, 2006, the Company adopted the provisions of SFAS
123(R) using the modified prospective transition method.  SFAS
123(R) requires companies to measure and recognized the cost of employee
services received in exchange for awards of equity instruments based on the
grant date fair value of those awards. For share option instruments issued
subsequent to the adoption of SFAS 123(R), compensation cost is recognized
ratably using the straight-line attribution method over the expected vesting
period. For equity options issued prior to the adoption of SFAS 123(R),
compensation cost is recognized using a graded vesting attribution method. In
addition, pursuant to SFAS 123(R), the Company is required to estimate the
amount of expected forfeitures when calculating compensation costs, instead of
accounting for forfeitures as incurred, which was our previous method. Prior
periods are not restated under this transition method. Options previously
awarded and classified as equity instruments continue to maintain their equity
classification under SFAS 123(R).  Stock-based compensation expense
related to equity options was approximately $341,000 and $359,000 for the twelve
month ended December 31, 2008 and 2007, respectively.





SFAS
No. 123(R) requires cash flows resulting from excess tax benefits to
be classified as a financing activity. Excess tax benefits are realized from tax
deductions for exercised options in excess of the deferred tax asset
attributable to stock compensation costs for such options. The Company did not
record any excess tax benefits as a result of adopting SFAS 123(R) in the
twelve months ended December 31, 2006 because the Company is currently
providing a full valuation on future tax benefits realized in the United States
until it can sustain a level of profitability that demonstrates its ability to
utilize the assets.





71


SFAS
No. 123(R) requires the use of a valuation model to calculate the fair
value of stock-based awards. For the twelve months ended December 31, 2007
and 2008, the Company has elected to use the Black-Scholes option-pricing model,
which incorporates various assumptions including volatility, expected life, and
interest rates. The Company is required to make various assumptions in the
application of the Black-Scholes option pricing model. The Company has
determined that the best measure of expected volatility is based on the
historical weekly volatility of the Company’s common stock. Historical
volatility factors utilized in the Company’s Black-Scholes computations range
from 64.4% to 96.2%. The Company has elected to estimate the expected life of an
award based upon the SEC approved “simplified method” noted under the
provisions of Staff Accounting Bulletin No. 107. Under this formula, the
expected term is equal to: ((weighted-average vesting term + original
contractual term)/2). The expected term used by the Company as computed by this
method range from 3.5 years to 6.1 years. The interest rate used is the risk
free interest rate and is based upon U. S. Treasury rates appropriate for the
expected term. Interest rates 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 our common shares in the foreseeable future.





In
addition to the key assumptions used in the Black-Scholes model, the estimated
forfeiture rate at the time of valuation is a critical
assumption.  The Company has estimated an annualized forfeiture rate
of approximately 10% for corporate officers, 4% for members of the Board of
Directors and 25% for all other employees.  The Company reviews the
expected forfeiture rate annually to determine if that percent is still
reasonable based on historical experience.




A summary
of the activity under the Company’s stock option plans for the twelve months
ended December 31, 2008 and 2007are as follows:




Options
              
              
              Weighted-
                Average
                Exercise
                Price
              
              
              Weighted-
                Average
                Remaining
                Contractual
                Term (Years)Balance
      at December 31, 2006
              
              
              1,603,164
              
              
              $
              2.45
              
              
              
              7.84Granted
              
              
              165,250
              
              
              $
              2.38
              
              
              
              9.32Forfeited
              
              
              (103,206
              )
              
              $
              2.58
              
              
              
              5.69Exercised
              
              
              —
              
              
              
              —
              
              
              
              —Balance
      at December 31, 2007
              
              
              1,665,208
              
              
              $
              2.44
              
              
              
              7.74Granted
              
              
              821,221
              
              
              $
              0.89
              
              
              
              9.42Forfeited
              
              
              (437,115
              )
              
              $
              2.19
              
              
              
              6.9Exercised
              
              
              —
              
              
              $
              —
              
              
              
              —Balance
      at December 31, 2008
              
              
              2,049,314
              
              
              $
              1.87
              
              
              
              7.2




Options
exercisable at December 31, 2008 totaled 1,239,422 at a weighted-average
price of $2.42, with a remaining weighted average contractual term of
approximately 6.0 years.





The
weighted-average grant date fair value of options granted during the twelve
months ended December 31, 2008 was $0.54.




The
following table sets forth a summary of the status and changes of the Company’s
unvested shares related to its stock option plans as of and during the twelve
months ended December 31, 2008 and 2007:




Options
              
              
              Weighted-
                Average
                Grant Date
                Fair Value
                Per ShareBalance
      at December 31, 2006
              
              
              761,782
              
              
              $
              1.63Granted
              
              
              165,250
              
              
              $
              1.48Vested
              
              
              (418,529
              )
              
              $
              1.64Forfeited
              
              
              (56,048
              )
              
              $
              1.61Balance
      at December 31, 2007
              
              
              452,455
              
              
              $
              1.63Granted
              
              
              821,221
              
              
              $
              0.54Vested
              
              
              (431,848
              )
              
              $
              1.62Forfeited
              
              
              (31,966
              )
              
              $
              1.15Balance
      at December 31, 2008
              
              
              809,892
              
              
              $
              0.64


At December 31, 2008, the total
remaining unrecognized compensation cost related to unvested stock options
amounted to approximately $383,707, which will be amortized over the
weighted-average remaining requisite service period of 9.3 years.  At December 31, 2007, the
total remaining unrecognized compensation cost related to unvested stock options
amounted to approximately $308,897, amortized over the weighted-average
remaining requisite service period of 1.41 years.


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





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





72


In
conjunction with these restricted stock agreements, the Company has recognized
stock-based compensation expense of $96,000 and $197,000 for the twelve months
ended December 31, 2008 and 2007, respectively.





Income
taxes





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





Foreign
currency translation





The
financial position and results of operations of the Company’s foreign
subsidiaries are measured using the foreign subsidiary’s local currency as the
functional currency. Revenues and expenses of such subsidiaries have been
translated into U.S. dollars at average exchange rates prevailing during the
period. Assets and liabilities have been translated at the rates of exchange on
the balance sheet date. The resulting translation gain and loss adjustments are
recorded directly as a separate component of shareholders’ equity, unless there
is a sale or complete liquidation of the underlying foreign investments. The
Company translates foreign currencies of its German and Canadian subsidiaries.
The cumulative translation adjustment account, which is part of accumulated
other comprehensive income, decreased approximately $11,000 for the twelve
months ended December 31, 2008 and decreased approximately $94,000 for the
twelve months ended December 31, 2007.





Comprehensive
Income





Comprehensive
income 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 translation
adjustment, unrealized holding losses on marketable securities classified as
available-for-sale and the additional minimum liability related to the Company’s
defined benefit pension plan, recognized pursuant to Statement of Financial
Accounting Standards No. 87 (“SFAS 87”), Employers’ Accounting for Pensions
and Statement of Financial Accounting Standards No 158, “Employers’ Accounting
for Defined Benefit Pension and Other Postretirement Plans (an amendment of FASB
Statements No. 87, 88, 106, and 132R)”.





Revenue
recognition





The
Company recognizes revenue from the following major revenue
sources:





·
            Long-term fixed-price contracts
      involving significant
customization


·
            Fixed-price contracts involving
      minimal customization


·
            Software
      licensing


·
            Sales of computer hardware and
      identification media


·
            Postcontract customer support
      (PCS)




The
Company follows the provisions of Statements of Position 97-2 “Software Revenue
Recognition” and 98-9 “Modification of SOP 97-2, Software Revenue Recognition
With Respect to Certain Transactions”, Statement of Position 81-1 “Accounting
for Performance of Construction-Type and Certain Production-Type Contracts",
Securities and Exchange Commission Staff Accounting Bulletin 104 , Emerging
Issues Task Force Issue 00-21 “Revenue Arrangements with Multiple Deliverables”,
and Emerging Issues Task Force Issue 03-05 “Applicability of AICPA Statement of
Position 97-2 to Non-Software Deliverables in an Arrangement Containing
More-Than-Incidental Software”. Accordingly, the Company recognizes revenue when
all of the following criteria are met: persuasive evidence of an arrangement
exists, delivery has occurred or services have been rendered, the fee is fixed
or determinable, and collectability is reasonable assured.
 
 The
Company recognizes revenue and profit as work progresses on long-term,
fixed-price contracts involving significant amount of hardware and software
customization using the percentage of completion method based on costs incurred
to date compared to total estimated costs at completion. The primary components
of costs incurred are third party software and direct labor cost including
fringe benefits.  Revenue from contracts for which we cannot reliably
estimate total costs or there are not significant amounts of customization are
recognized upon completion. The Company also generates non-recurring revenue
from the licensing of its software. Software license revenue is recognized upon
the execution of a license agreement, upon deliverance, when fees are fixed and
determinable, when collectability is probable and when all other significant
obligations have been fulfilled. The Company also generates revenue from the
sale of computer hardware and identification media. Revenue for these items is
recognized upon delivery of these products to the customer. Our revenue from
periodic maintenance agreements is generally recognized ratably over the
respective maintenance periods provided no significant obligations remain and
collectability of the related receivable is probable. Sales tax collected from
customers is excluded from revenue.





73


Advertising
costs





The
Company expenses advertising costs as incurred. Advertising expense totaled
approximately $0 and $29,000 and for the years ended December 31, 2008 and
2007, respectively.





Loss
per share





Basic
loss per common share is calculated by dividing net income (loss) available to
common shareholders for the period by the weighted-average number of common
shares outstanding during the period. Diluted loss per common share is
calculated by dividing net loss available to common shareholders for the period
by the weighted-average number of common shares outstanding during the period,
increased to include, if dilutive, the number of additional common shares that
would have been outstanding if the potential common shares had been issued at
the date of issuance. The dilutive effect of outstanding stock options is
included in the calculation of diluted loss per common share, if dilutive, using
the treasury stock method. During the years ended December 31, 2008 and
2007, the Company has excluded the following securities from the calculation of
diluted loss per share, as their effect would have been anti-dilutive due to the
Company’s net loss:




Potential Dilutive Securities:
              
              Number of
                Common Shares
                Convertible into
                at
                December 31,
                2008
              
              
              Number of
                Common Shares
                Convertible into
                at
                December 31,
                2007Convertible
      notes payable
              
              
              199,998
              
              
              
              —Convertible
      preferred stock – Series B
              
              
              45,384
              
              
              
              45,384Convertible
      preferred stock – Series C
              
              
              5,150,290
              
              
              
              1,466,666Convertible
      preferred stock – Series D
              
              
              4,799,395
              
              
              
              925,333Stock
      options
              
              
              2,049,314
              
              
              
              1,665,208Restricted
      stock grants
              
              
              120,000
              
              
              
              —Warrants
              
              
              10,471,167
              
              
              
              5,955,830




The
following table sets forth the computation of basic and diluted loss per share
for the years ended December 31, 2008, 2007 and 2006:





(Amounts
      in thousands, except share and per share amounts)
            
            TWELVE MONTHS ENDED
              DECEMBER 31,2008
            
            
            2007Numerator
      – loss from continuing operations:Net
      loss from continuing operations
            
            $
            (5,736
            )
            
            $
            (4,735
            )Less
      preferred stock dividends
            
            
            (5,928
            )
            
            
            (1,171
            )Net
      loss from continuing operations available to common
      shareholders
            
            $
            (11,664
            )
            
            $
            (5,906
            )Numerator
      – gain (loss) from discontinued operations:Net
      loss from discontinued operations
            
            
            18
            
            
            
            50DenominatorWeighted-average
      shares outstanding
            
            
            18,056,026
            
            
            
            15,070,308Basic
      and Diluted loss per share:Continuing
      operations
            
            $
            (0.32
            )
            
            $
            (0.31
            )Discontinued
      operations
            
            $
            —
            
            
            $
            —Preferred
      dividends
            
            $
            (0.33
            )
            
            $
            (0.08
            )Net
      loss per share
            
            $
            (0.65
            )
            
            $
            (0.39
            )





74


Segment
information





Prior to
its acquisitions during 2001 of G & A, Castleworks and E-Focus, the
Company operated in one business segment. With its acquisition of G &
A, Castleworks and E-Focus, the Company determined it was comprised of three
reportable segments based on the management approach as prescribed by Statement
of Financial Accounting Standards No. 131 (As Amended), “Disclosures about
Segments of an Enterprise and Related Information”, (“SFAS
131”).  These segments were determined to be: Law Enforcement,
Identification and Digital Photography.  With the sale of its entire
Digital Photography product line in November 2006, the Company reassessed
the composition of its operating segments and determined that it no longer
operates in separate, distinct market segments but rather operates in one market
segment, that segment being identity management.  The Company’s
determination was based on fundamental changes in the Company’s business
structure due to the consolidation of operations, restructuring of the Company’s
operations and management team, and the integration of what where previously
distinct, mutually exclusive technologies.  This has resulted in
changes in the manner by which the Company’s chief decision maker assesses
performance and makes decisions concerning resource allocation.





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





New
Accounting Pronouncements





In February 2008, the FASB issued
FASB Staff Position FAS 157-2, Partial Deferral of the Effective
Date of Statement 157(“FSP FAS 157-2”). FSP
FAS 157-2 delays the effective date of SFAS No. 157 for nonfinancial assets
and nonfinancial liabilities, except for items that are recognized or disclosed
at fair value in the financial statements on a recurring basis (at least
annually) to fiscal years beginning after November 15, 2008.  The
Company does not expect the provisions of FSP FAS 157-2 to have an impact on our
results of operations or 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 standards are intended to improve, simplify, and
converge internationally the accounting for business combinations and the
reporting of non-controlling interests in consolidated financial statements.
SFAS No. 141(R) requires the acquiring entity in a business
combination to recognize all (and only) the assets acquired and liabilities
assumed in the transaction; establishes the acquisition-date fair value as the
measurement objective for all assets acquired and liabilities assumed; and
requires the acquirer to disclose to investors and other users all of the
information they need to evaluate and understand the nature and financial effect
of the business combination. SFAS No. 141(R) is effective for fiscal
years, and interim periods within those fiscal years, beginning on or after
December 15, 2008. SFAS No. 141(R) applies prospectively to
business combinations for which the acquisition date is on or after the
beginning of the first annual reporting period beginning on or after
December 15, 2008. Earlier adoption is prohibited. SFAS 141(R) will be
applied to business combinations occurring after the effective
date.





In
December 2007, the FASB issued SFAS No. 160, Non-controlling Interests in
Consolidated Financial Statements, an Amendment of ARB 51 (“SFAS
No. 160”), which requires non-controlling interests (previously
referred to as minority interests) to be treated as a separate component of
equity. SFAS No. 160 is effective for periods beginning on or after
December 15, 2008. Earlier application is prohibited. In addition, SFAS
No. 160 shall be applied prospectively as of the beginning of the fiscal
year in which it is initially applied, except for the presentation and
disclosure requirements. The presentation and disclosure requirements shall be
applied retrospectively for all periods presented. We do not have an outstanding
non-controlling interest in one or more subsidiaries and therefore, SFAS
No. 160 is not applicable to us at this time.





In
December 2007, the FASB ratified the consensus reached by the EITF on Issue
No. 07-1 (“EITF 07-1”), Accounting for Collaborative
Arrangements. EITF 07-1 is effective for the Company beginning
January 1, 2009 and will be applied retrospectively to all prior periods
presented for all collaborative arrangements existing as of the effective date.
EITF 07-1 defines collaborative arrangements and establishes reporting
requirements for transactions between participants in a collaborative
arrangement and between participants in the arrangement and third parties. The
Company does not expect the provisions of EITF 07-1 to have an impact on our
financial position and results of operations.





75


In
March 2008, the FASB issued Statement No. 161, Disclosures about Derivative
Instruments and Hedging Activities(“FAS 161”), which is effective
January 1, 2009. FAS 161 requires enhanced disclosures about derivative
instruments and hedging activities to allow for a better understanding of their
effects on an entity’s financial position, financial performance, and cash
flows. Among other things, FAS 161 requires disclosure of the fair values of
derivative instruments and associated gains and losses in a tabular format.
Since FAS 161 affects only disclosure requirements, there will be no effect on
our results of operations or financial position.





In
April 2008, the FASB issued Staff Position FSP FAS 142-3, “Determination of
the Useful Life of Intangible Assets” (“FSP FAS 142-3”). The FSP amends the
factors that should be considered in developing renewal or extension assumptions
used to determine the useful life of a recognized intangible asset under SFAS
No. 142, “Goodwill and Other Intangible Assets”. The intent of the FSP is
to improve the consistency between the useful life of a recognized intangible
asset under SFAS No. 142 and the period of expected cash flows used to
measure the fair value of the asset under other accounting principles generally
accepted in the United States of America. The FSP is effective for financial
statements issued for fiscal years beginning after December 15, 2008, and
interim periods within those fiscal years. Early adoption is prohibited. The
guidance for determining the useful life of a recognized intangible asset shall
be applied prospectively to intangible assets acquired after the effective date.
Certain disclosure requirements shall be applied prospectively to all intangible
assets recognized as of, and subsequent to, the effective date. FSP FAS 142-3
will be applied to intangible assets acquired after the effective
date.





In
May 2008, the FASB issued FASB Statement No. 162, The Hierarchy of Generally Accepted
Accounting Principles. The new standard is intended to improve financial
reporting by identifying a consistent framework, or hierarchy, for selecting
accounting principles to be used in preparing financial statements that are
presented in conformity with U.S. generally accepted accounting principles
(GAAP) for nongovernmental entities. FAS No. 162 is effective for financial
statements issued for interim and annual periods ending after September 15,
2009.  Previous references to GAAP accounting standards will no longer
be used in our disclosures for financial statements ending after the effective
date. The adoption of SFAS No. 162 will not have an impact on our consolidated
financial position or results of operations.





In
May 2008, the FASB issued FASB Staff Position (FSP) No. APB 14-1,
Accounting for Convertible
Debt Instruments That May Be Settled in Cash upon Conversion (Including
Partial Cash Settlement)(“FSP APB 14-1”).  FSP APB 14-1
clarifies that convertible debt instruments that may be settled in cash upon
conversion (including partial cash settlement) are not addressed by paragraph 12
of APB Opinion No. 14, Accounting for Convertible Debt and
Debt Issued with Stock Purchase Warrants. Additionally, this FSP
specifies that issuers of such instruments should separately account for the
liability and equity components in a manner that will reflect the entity’s
nonconvertible debt borrowing rate when interest cost is recognized in
subsequent periods. This FSP is effective for financial statements issued for
fiscal years beginning after December 15, 2008, and interim periods within
those fiscal years. Early adoption is not permitted. The Company is assessing
the impact of adoption of FSP No EITF 03-6-1 on its financial position and
results of operations.





In June
2008, the FASB issued FSP No. EITF 03-6-1, “Determining Whether Instruments
Granted in Share-Based Payment Transactions Are Participating Securities,” (FSP
EITF 03-6-1). FSP EITF 03-6-1 states that unvested share-based payment awards
that contain nonforfeitable rights to dividends or dividend equivalents (whether
paid or unpaid) are participating securities and shall be included in the
computation of earnings per share pursuant to the two-class method. FSP EITF
03-6-1 becomes effective for the Company on January 1, 2009. The Company
does not expect the provisions of FSP No. EITF 03-6-1to have a material impact
on our results of operations or financial position.





In
January 2009, the FASB issued FSP EITF 99-20-1, "Amendments to the Impairment
Guidance of EITF Issue No. 99 - Recognition of Interest Income and Impairment on
Purchased and Retained Beneficial Interests in Securitized Financial Assets".
FSP EITF 99-20-1 changes the impairment model included within EITF 99-20 to be
more consistent with the impairment model of SFAS No. 115. FSP EITF 99-20-1
achieves this by amending the impairment model in EITF 99-20 to remove its
exclusive reliance on "market participant" estimates of future cash flows used
in determining fair value. Changing the cash flows used to analyze
other-than-temporary impairment from the "market participant" view to a holder's
estimate of whether there has been a "probable" adverse change in estimated cash
flows allows companies to apply reasonable judgment in assessing whether
another-than-temporary impairment has occurred. The adoption of FSP EITF 99-20-1
is not expected to have a material impact on our results of operations,
financial position or liquidity.





In April
2009 the FASB issued FSP No. 141R-1 Accounting for Assets Acquired and
Liabilities Assumed in a Business Combination That Arise from Contingencies, or
FSP 141R-1. FSP 141R-1 amends the provisions in SFAS 141R for the initial
recognition and measurement, subsequent measurement and accounting, and
disclosures for assets and liabilities arising from contingencies in business
combinations. The FSP eliminates the distinction between contractual and
non-contractual contingencies, including the initial recognition and measurement
criteria in SFAS 141R and instead carries forward most of the provisions in SFAS
141 for acquired contingencies. FSP 141R-1 is effective for contingent assets
and contingent liabilities acquired in business combinations for which the
acquisition date is on or after the beginning of the first annual reporting
period beginning on or after December 15, 2008. The adoption of FSP No. 141R-1
is not expected to have a material impact on our results of operations,
financial position or liquidity.





76


In April 2009 the FASB issued three related Staff Positions: (i) FSP No. 157-4,
Determining Fair Value When the Volume and Level of Activity for the Asset or
Liability have Significantly Decreased and Identifying Transactions That Are Not
Orderly, or FSP 157-4, (ii) FSP 115-2 and FSP No. 124-2, Recognition and
Presentation of Other-Than-Temporary Impairments , or FSP 115-2 and FSP 124-2,
and (iii) FSP 107-1 and APB No. 28-1, Interim Disclosures about Fair Value of
Financial Instruments, or FSP 107 and APB 28-1, which are effective for interim
and annual periods ending after June 15, 2009. FSP 157-4 provides guidance on
how to determine the fair value of assets and liabilities under SFAS 157 in the
current economic environment and reemphasizes that the objective of a fair value
measurement remains an exit price. If we were to conclude that there has been a
significant decrease in the volume and level of activity of the asset or
liability in relation to normal market activities, quoted market values may not
be representative of fair value and the Company may conclude that a change in
valuation technique or the use of multiple valuation techniques may be
appropriate. FSP 115-2 and FSP 124-2 modify the requirements for recognizing
other-than-temporarily impaired debt securities and revise the existing
impairment model for such securities, by modifying the current intent and
ability indicator in determining whether a debt security is
other-than-temporarily impaired. FSP 107 and APB 28-1 enhance the disclosure of
instruments under the scope of SFAS 157 for both interim and annual
periods. We do not expect the adoption of these standards to have a
material effect on our financial position of results of operations.





In May 2009 the FASB issued SFAS No. 165, Subsequent Events, or SFAS 165. SFAS
165 establishes general standards of accounting for and disclosure of events
that occur after the balance sheet date but before financial statements are
issued or are available to be issued. SFAS 165 requires the disclosure of the
date through which an entity has evaluated subsequent events and the basis for
that date, that is, whether the date represents the date the financial
statements were issued or were available to be issued. SFAS 165 is effective in
the first interim period ending after June 15, 2009. We expect that SFAS 165
will have an impact on disclosures in our consolidated financial statements, but
the nature and magnitude of the specific effects will depend upon the nature,
terms and value of any subsequent events occurring after
adoption.





In June 2009 the FASB issued SFAS No. 167, Amendments to FASB Interpretation No.
46(R), or SFAS 167, that will change how we determine when an entity that is
insufficiently capitalized or is not controlled through voting (or similar
rights) should be consolidated. Under SFAS No. 167, determining whether a
company is required to consolidate an entity will be based on, among other
things, an entity's purpose and design and a company's ability to direct the
activities of the entity that most significantly impact the entity's economic
performance. SFAS 167 is effective for financial statements after January 1,
2010. We are currently evaluating the requirements of SFAS 167 and the impact of
adoption on their consolidated financial statements, if any.





77


Reclassifications





Certain
reclassifications were made to prior years’ consolidated financial statements to
conform to the current year presentation.





3.           Intangible Assets





The
following disclosure presents certain information about the Company’s acquired
intangible assets as of December 31, 2008 and 2007. All intangible assets
are being amortized over their estimated useful lives, as indicated below, with
no estimated residual values.


Gross
      Carrying
              
              
              
              
              
              
              
              
              
              
              
              Pro
      Rata Reduction
              
              
              ImpairmentAmount
      Before
              
              
              
              
              
              
              
              
              
              
              
              of
      Sol Logic Assets
              
              
              Charge
      on SolImpairment
              
              
              Accumulated
              
              
              
              
              
              
              
              
              From
      Purchase
              
              
              Logic
      IntangibleCharge
              
              
              Amortization
              
              
              Net
      Balance
              
              
              Amortization
              
              
              Accounting
              
              
              Assets
      Recorded
              
              
              Net
      BalanceAmortization
              
              at
      December
              
              
              at
      December
              
              
              at
      December
              
              
              Recorded
              
              
              Contingency
              
              
              at
      December 31,
              
              
              at
      December($
      in thousands)
              Period
              
              31,
      2007
              
              
              31,
      2007
              
              
              31,
      2007
              
              
              During
      2008
              
              
              Resolution
              
              
              2008
              
              31,
      2008Technology
              5
      years
              
              $
              3,178
              
              
              $
              (1,160
              )
              
              $
              2,018
              
              
              $
              (420
              )
              
              $
              (940
              )
              
              $
              (658
              )
              
              $
              -Trademark
      and Tradenames
              14.5
      years
              
              $
              377
              
              
              $
              (251
              )
              
              $
              126
              
              
              $
              (16
              )
              
              $
              -
              
              
              $
              -
              
              
              $
              110Customer
      relationship
              5
      years
              
              $
              293
              
              
              $
              (200
              )
              
              $
              93
              
              
              $
              (19
              )
              
              $
              (43
              )
              
              $
              (30
              )
              
              $
              -Non-Compete
      Agreement
              3
      years
              
              $
              325
              
              
              $
              (125
              )
              
              $
              200
              
              
              $
              (69
              )
              
              $
              (77
              )
              
              $
              (54
              )
              
              $
              -Patents
              4
      years
              
              $
              60
              
              
              $
              (60
              )
              
              $
              -
              
              
              $
              -
              
              
              $
              -
              
              
              
              
              
              
              $
              -Totals
              
              
              $
              4,233
              
              
              $
              (1,796
              )
              
              $
              2,437
              
              
              $
              (525
              )
              
              $
              (1,060
              )
              
              $
              (742
              )
              
              $
              110




As more
fully described in Note 6 to these consolidated financial statements, in
December 2007, the Company completed the acquisition of substantially all
the assets of Sol Logic, Inc. resulting in acquired intangible assets of
approximately $2,311,000.  Based on fair value methodologies, the
Company recorded approximately $2,018,000 in intangibles assets for developed
technology, $93,000 in customer relationship intangible assets and $200,000 for
a non-compete agreement.





In 2008,
we recorded an impairment charge of approximately $742,000 related to our
intangible assets related to our acquisition of Sol Logic in
2007.  This loss reflects the amount by which the carrying value of
this asset exceeded its estimated fair value determined by the assets’ future
discounted cash flows.  The impairment loss is recorded as a component
of Operating expenses in the consolidated Statement of Operations for
2008.  We recorded no impairment losses for long-lived or intangible
assets during the twelve months ended December 31, 2007.





Amortization
expense for the twelve months ended December 31, 2008 and 2007 was
approximately $525,000 and $16,000, respectively.





The
estimated acquired intangible amortization expense for the next five fiscal
years is as follows:





Fiscal Year Ended December 31,
            
            Estimated Amortization Expense   ($
      in thousands)2009
            
            $162010
            
            162011
            
            162012
            
            162013
            
            16Thereafter
            
            30Totals
            
            $110





78


4.           Goodwill





The
changes in the carrying amount of goodwill for the years ended December 31,
2008 and 2007 are as follows:





($
      in thousands)
            
            TotalBalance
      of Goodwill as of January 1, 2007
            
            $
            3,416Goodwill
      acquired
            
            
            1,036Impairment
      lossesBalance
      of Goodwill as of December 31, 2007
            
            $
            4,452De-recognition
      of goodwill resulting from amended purchase accounting
      agreement
            
            
            (1,036
            )Impairment
      losses
            
            
            —Balance
      of Goodwill as of December 31, 2008
            
            $
            3,416





As more
fully described in Note 6 to these consolidated financial statements, in
December 2007, the Company completed the acquisition of substantially all
the assets of Sol Logic, Inc. resulting in goodwill acquired of
approximately $1,036,000.  On March 28, 2008, the Company entered
into Amendment No. 1 to Asset Purchase Agreement (the “Purchase Agreement
Amendment”) to amend the Purchase Agreement. The terms of the Purchase Agreement
Amendment resulted in the de-recognition of the goodwill originally recorded of
$1,036,000.





The
Company annually, or more frequently if events or circumstances indicate a need,
tests the carrying amount of goodwill for impairment. The Company performs its
annual impairment test in the fourth quarter of each year. A two-step impairment
test is used to first identify potential goodwill impairment and then measure
the amount of goodwill impairment loss, if any. These tests were conducted by
determining and comparing the fair value of our reporting units, as defined in
SFAS 142, to the reporting unit’s carrying value. In 2006, we determined that
our only reporting unit is Identity Management. Based on the results of these
impairment tests, we determined that our goodwill assets were not impaired as of
December 31, 2008 and 2007.





5.           
 Investments
 
 In
conjunction with the sale of the Company’s wholly-owned subsidiary, Digital
Imaging Asia Pacific, as more fully described in Note 7 to these consolidated
financial statements, in March 2005, the Company and Argus Solutions Ltd each
agreed to purchase $250,000 of each others common stock at a per share price
equal to 108% of the closing price of each others’ stock as determined by the
American Stock Exchange and Australian Stock Exchange, respectively. As legal
consideration, each Company paid the other cash of $250,000. The Company and
Argus consummated the transaction through the exchange of common shares. The
Company exchanged 71,225 shares of its common stock for 1,929,914 shares of
common stock of Argus Solutions Ltd., which represents approximately one percent
of the voting equity of Argus. In accordance with Statement of Financial
Accounting Standards No. 153, “Exchange of Nonmonetary Assets, an amendment
of APB Opinion No. 29”, the Company recorded this transaction as a
nonmonetary exchange based on the fair value of the shares exchanged as
determined by the closing price of the Company’s shares on the American Stock
Exchange on the transaction date of $3.25 or $231,000.
 
 In
accordance with Statement of Financial Accounting Standards (“SFAS”)
No. 115, “Accounting for Certain Investments in Debt and Equity Securities”
and based on the Company’s intentions regarding these instruments, they were
classified as marketable equity securities into trading or available-for-sale
categories. Marketable securities that are bought and held principally for the
purpose of selling them in the near term are classified as trading securities
and are reported at fair value, with unrealized gains and losses recognized in
earnings. Marketable securities not classified as trading are classified as
available-for-sale and are carried at fair market value, with the unrealized
gains and losses, net of tax, included in the determination of comprehensive
income and reported in shareholders’ equity. Marketable equity securities are
included in other non-current assets. The Company reviews its marketable equity
holdings in publicly-traded companies on a regular basis to determine if any
security has experienced an other-than-temporary decline in fair value. The
Company considers the investee company’s cash position, earnings and revenue
outlook, and stock price performance, among other factors, in its review. If it
is determined that an other-than-temporary decline exists in a marketable equity
security, the Company writes down the investment to its market value and records
the related write-down as an investment loss in its Statement of
Operations.
 
 At
December 31, 2007, the Company wrote off its remaining investment in Argus
common stock as the market value of the common stock was determined to be
$0.  The write-down amounted to $39,000 and was due to a decline in
the fair value of the equity security which, in the opinion of management, was
considered to be other than temporary.  The write-down is included in
the caption Other income, net in the accompanying consolidated Statement of
Operations for the twelve months ended December 31, 2007.
  79
 6. Acquisition
 
 In
December 2007, the Company entered into an agreement for the purchase of
certain assets of Sol Logic, Inc. (“Sol Logic”) pursuant to an Asset
Purchase Agreement (the “Asset Purchase Agreement”).  The assets acquired
include certain customer contracts, software licenses and intellectual property
(collectively, the “Acquired Assets”).  As a result of this asset
acquisition, the Company integrated real-time voice recognition, multiple
language translation and voice analytic capabilities into its biometric
offerings. The Asset Purchase Agreement contained various customary
representations and warranties on behalf of Sol Logic.
 
 In
consideration for the acquisition of the Acquired Assets, the Company:
(1) issued to Sol Logic on December 19, 2007 (the “Closing”) 935,089
shares of restricted common stock of the Company (the “Initial Shares”), and
(2) on June 19, 2008 (the “Additional Issuance Date”) was required to
issue to Sol Logic that number of shares of restricted common stock (the
“Additional Shares” and collectively with the Initial Shares, the “Shares”)
equal to the quotient obtained by dividing $1,502,000 by the greater of
(A) $1.633 and (B) the volume weighted average closing price of the
Company’s common stock over the 20 trading-day period ending on June 18,
2008, as reported on the Over-the-Counter Bullet Board (“OTCBB”).  Fifty
percent of the Initial Shares and ten percent of the Additional Shares were held
in escrow until the one-year anniversary of the Closing. The Company recorded
the obligation to issue the required number of shares on the Additional Issuance
Date as a current liability in the accompanying Consolidated Balance Sheet as of
December 31, 2007 under the caption “Acquisition related
obligation”.
 
 On
March 28, 2008, the Company entered into Amendment No. 1 to Asset
Purchase Agreement (the “Purchase Agreement Amendment”) to amend the Purchase
Agreement.  The Purchase Agreement Amendment provided that in consideration
for the Acquired Assets, the Company issue to Sol Logic an aggregate of 677,940
shares of restricted Common Stock (the “Initial Shares”). Of these shares,
467,545 were issued to Sol Logic on December 19, 2007, the date of the
Purchase Agreement. The remaining 210,395 shares were issued to Sol Logic upon
execution of the Purchase Agreement Amendment.  In conjunction with these
issuances, the Company simultaneously rescinded the issuance of 257,149 common
shares originally placed into escrow on December 19, 2007.
 
 In the
event the Company’s revenues on certain specified products set forth in the
Purchase Agreement Amendment either equal or exceed $3,000,000 for the six-month
period commencing on March 6, 2008 and ending on September 6, 2008 or
equal or exceed $5,000,000 for the eighteen-month period commencing on
March 6, 2008 and ending on September 6, 2009, the Company was
obligated to issue that number of additional shares of Common Stock (the
“Additional Shares” and together with the Initial Shares, the “Shares”) obtained
by dividing $1,921,924 by the greater of $1.10 or the volume weighted average
closing price of the Company’s common stock over the 20 trading-day period
immediately prior to the date the Additional Shares are issued, subject to the
terms of the escrow described below.  Pursuant to the Purchase Agreement
Amendment, the maximum number of Additional Shares that may be issued is
1,747,204. The Company did not attain the specified revenue levels required
pursuant to the terms of the Purchase Agreement Amendment and on September 6,
2009, the contingent consideration provision contained in the Purchase Agreement
Amendment expired with no additional consideration due.
  Concurrently
with the execution of the Purchase Agreement Amendment, the Company entered into
Amendment No. 1 to Registration Rights Agreement (the “Rights Agreement
Amendment”) to amend the Rights Agreement.  Under the terms of the Rights
Agreement Amendment, the Company was required to register an additional 371,755
of the Initial Shares, for a total of 677,940 shares of Common Stock, for resale
by Sol Logic.
 
 As a
result of recording the terms of the Purchase Agreement Amendment, the aggregate
purchase price, not including direct transaction costs of approximately $274,000
was approximately $1,019,000. The value of the 677,940 common shares issued was
determined based on the average market price of the Company’s common stock over
the 2-day period before and after the terms of the Purchase Agreement Amendment
were consummated on March 6, 2008 in accordance with EITF 99-12,
“Determination of the Measurement Date for the Market Price of Acquirer
Securities Issued in a Purchase Business Combination’. As of December 31, 2008,
the Company had incurred approximately $131,000 in expenses related to the
issuance and registration of the Company’s equity securities issued pursuant to
the Sol Logic asset purchase. Such issuance and registration costs have been
recognized as a reduction of the fair value of the Company’s common stock in
accordance with FASB Statement of Financial Accounting Standards No 141,
“Business Combinations” (“FAS 141”).
  80
 
 In
connection the Purchase Agreement Amendment, the Company agreed to pay
additional consideration in future periods, based upon the attainment of certain
revenue levels on certain specified products. FAS 141 requires, in situations
involving a contingent consideration agreement that might result in the
recognition of an additional element of cost when the contingency is resolved,
the recognition of a purchase accounting liability in an amount equal to the
lesser of the maximum amount of contingent consideration or the excess (the
amount by which the amounts assigned to the assets acquired exceeds the cost of
the acquired entity). Accordingly, the Company, upon execution of the Purchase
Agreement Amendment, recorded a purchase accounting liability of approximately
$1,060,000 as a current liability. When the contingency is resolved and the
consideration is issued or becomes issuable, any excess of the fair value of the
contingent consideration issued or issuable over the amount that was recognized
as a liability shall be recognized as an additional cost of the acquisition. Any
such additional cost would result in increases in goodwill. If the amount
initially recognized as a liability exceeds the fair value of the consideration
issued or issuable, that excess shall be allocated as a pro rata reduction of
the amounts assigned to the acquired assets. As more fully described in Note 4
to these consolidated financial statements, the Company determined that the
intangible assets acquired in the Sol Logic acquisition were impaired at
December 31, 2008 as the carrying value of these assets exceeded their estimated
fair value determined by the assets’ future discounted cash
flows.  The Company did not attain the specified revenue levels
required pursuant to the terms of the Purchase Agreement Amendment and on
September 6, 2009, the contingent consideration provision contained in the
Purchase Agreement Amendment expired with no additional consideration due. The
Company has recorded the resolution of the purchase accounting contingency as a
recognized subsequent event and has allocated the excess of the contingent
liability of $1,060,000 as a pro rata reduction of the amounts assigned to the
acquired assets prior to the recording of an impairment charge of approximately
$742,000.
 
 The
following table presents the allocation of the acquisition cost, including
professional fees and other related acquisition costs, to the assets acquired
and liabilities assumed, based on their fair values:
 
 ($ in
      thousands)
              
              As
      recordedper
                Dec. 19,
      2007
                Asset
                Purchase
                Agreement
              
              
              As adjustedper
                Mar. 6,
      2008
                Purchase
                Agreement
                AmendmentFixed
      assets, net
              
              $
              42
              
              
              $
              42Covenant
      not to compete
              
              
              200
              
              
              
              200Customer
      base
              
              
              93
              
              
              
              93Developed
      technology
              
              
              2,018
              
              
              
              2,018Goodwill
              
              
              1,036
              
              
              
              —Total
      assets acquired
              
              $
              3,389
              
              
              $
              2,353Cash
      and direct transaction costs
              
              $
              (410
              )
              
              $
              (466
              )Acquisition
      liability
              
              
              (1,502
              )
              
              
              (1,060
              )Common
      stock
              
              
              (9
              )
              
              
              (7
              )Additional
      paid in capital
              
              
              (1,468
              )
              
              
              (820
              )Total
      consideration issued and liabilities incurred
              
              $
              (3,389
              )
              
              $
              (2,353
              )Number
      of shares issued
              
              
              935,089
              
              
              
              677,940
 
 The
following (unaudited) pro forma consolidated results of operations have been
prepared as if the acquisition of Sol Logic, Inc. had occurred at
January 1, 2007:
 
 ($ in thousands)
              
              Twelve
      Months
                Ended
      December
                31, 2007(unaudited)Sales
              
              $
              8,902Net
      loss available to common shareholders
              
              $
              (6,690
              )Net
      loss per share available to common shareholders
              
              $
              (0.44
              )
 
 The pro
forma information is presented for informational purposes only and is not
necessarily indicative of the results of operations that actually would have
been achieved had the acquisition been consummated as of that time, nor is it
intended to be a projection of future results.
  81
 7.        
    Sale of
Businesses 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 party for a total of $400,000, including an initial cash
payment of $25,000.  The purchaser is required to pay up to the full
remaining amount of $375,000 in a series of quarterly installments equal to
12.5% of all newly acquired sales and license revenues relating to the PDI
product 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 Percentage Payments to the Company are less
than $50,000, the purchaser will pay the Company the difference between the
Percentage Payments and $50,000.  This component of the Company’s
business was previously classified as the Company’s Digital Photography
segment.
 
 The
Company decided to sell this component because it has incurred significant
operating losses in each of the last five years and has lost significant market
share in the last three years.  The assets sold consisted primarily of
a suite of software and related inventory including source, copyrights,
trademarks, documentation and client base.
  In 2007,
the Company recognized a gain of approximately $50,000 from the disposal of this
component representing the cash proceeds received less the value of net assets
sold.  At December 31, 2007, the Company has recorded the fair
value of the remaining amount due of $325,000 offset by a full valuation
allowance due to the uncertainty of the ultimate collectability of such amounts.
This determination was based upon the maximum repayment period of 6.5 years of
amounts owing the Company combined with the purchaser operating in a highly
competitive business environment evidenced by rapid technological
change.  Accordingly, the Company has deferred any remaining gain from
the disposal of this component until such time as the Company determines that
the realization of the remaining amounts owed is reasonably
assured.
 
 In 2008,
the Company recognized a gain of approximately $18,000 from the disposal of this
component representing the cash proceeds received less the value of net assets
sold. At December 31, 2008, the Company has continued to record the fair value
of the remaining amount due of $307,000 offset by a full valuation allowance due
to the uncertainty of the ultimate collectability of such amounts. This
determination was based upon the maximum repayment period of 5.5 years of
amounts owing the Company combined with the purchaser operating in a highly
competitive business environment evidenced by rapid technological
change.  Accordingly, the Company has deferred any remaining gain from
the disposal of this component until such time as the Company determines that
the realization of the remaining amounts owed is reasonably
assured.
 
 8.            
Related
Parties
  As more
fully described in Note 13 to these consolidated financial statements, on
November 14, 2008, the Company entered in to a series of convertible promissory
notes (the” Convertible Notes”), aggregating $110,000 with certain officers and
members of the Company’s Board of Directors. The Convertible Notes bear interest
at 7.0% per annum and were originally due February 14, 2009 for which a
forbearance waiver was obtained which is more fully described in Notes
13.
 
 In conjunction with the issuance of the
Convertible Notes, the Company issued an aggregate of 149,996 warrants to the
note holders to purchase Common Stock of the Company. The warrants have an
exercise price $0.55 per share and may be exercised at any time from November
14, 2008 until November 14, 2013.
 
 9.           
 Inventory
 
 Inventories
at December 31, 2008 were comprised of work in process of $9,000
representing direct labor costs on in-process projects and finished goods of
$10,000 net of reserves for obsolete and slow-moving items of
$93,000.  Inventories at December 31, 2007 were comprised of work
in process of $29,000 representing 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.  Appropriate consideration is given to obsolescence,
excessive levels, deterioration, and other factors in evaluating net realizable
value and required reserve levels.
  82
 10.         
 Property and
Equipment
 
 Property
and equipment at December 31, 2008 and 2007, consists of:
 
 ($
      in thousands)
              
              2008
              
              
              2007Equipment
              
              $
              1,397
              
              
              $
              1,411Leasehold
      improvements
              
              
              31
              
              
              
              149Furniture
              
              
              162
              
              
              
              1621,590
              
              
              
              1,722Less
      accumulated depreciation
              
              
              (1,482
              )
              
              
              (1,434
              )$
              108
              
              
              $
              288
 
 Total
depreciation expense for the years ended December 31, 2008 and 2007 was
approximately $247,000 and $242,000, respectively.
 
 11.           Costs and Estimated Earnings on
Uncompleted Contracts
 
 The
Company recognizes sales and cost of sales on long-term, fixed price contracts
involving significant amounts of customization using the percentage of
completion method based on costs incurred to date compared to total estimated
costs at completion.  Such amounts are included in the accompanying
consolidated Balance Sheets at December 31, 2008 and December 31, 2007 under the
caption “Billings in excess of costs and estimated earnings on uncompleted
contract”.
 
 Costs and
estimated earnings on uncompleted contracts and related amounts billed under
contract provisions as of December 31, 2008 and December 31, 2007 are as
follows:
 
 ($ in thousands)
              
              December
      31,
                2008
              
              
              December 31,
                2007Costs
      incurred on uncompleted contract
              
              $
              108
              
              
              $
              —Estimated
      earnings
              
              
              397
              
              
              
              —505
              
              
              
              —Less:
      Billings to date
              
              
              (784
              )
              
              
              —Billings
      in excess of costs and estimated earnings on uncompleted
      contract
              
              $
              (279
              )
              
              $
              —
 
 
 12.           Accrued Liabilities
 
 Principal
components of accrued liabilities consist of:
 
 ($
      in thousands)
              
              2008
              
              
              2007Compensated
      absences
              
              $
              230
              
              
              $
              215Wages
      and sales commissions
              
              
              128
              
              
              
              113Customer
      deposits
              
              
              336
              
              
              
              267Liquidated
      damages
              
              
              280
              
              
              
              280Royalties
              
              
              251
              
              
              
              251Professional
      fees
              
              
              28
              
              
              
              73Employee
      benefit plans
              
              
              113
              
              
              
              10Other
              
              
              164
              
              
              
              1321,530
              
              
              $
              1,341
 
 13.           Notes Payable and Line of
Credit
 
 Notes
payable consist of the following:
 
 ($
      in thousands)
              
              2008
              
              
              2007Notes payable to related
      parties:Convertible
      promissory notes to accrue interest at 7%. Face value of note
      $110,
                net of unamortized discount on note at December 31, 2008 of $12. Note
      due January 31, 2010
              
              
              98
              
              
              $
              —Total
      notes payable to related parties
              
              
              98
              
              
              
              —Total
      notes payable
              
              
              98
              
              
              $
              —Less
      current portion
              
              
              —
              
              
              
              —Long-term
      notes payable
              
              
              98
              
              
              $
              —
  83
 Future maturities of long-term debt are as follows as of December 31,
2008:
 
 ($
      in thousands)2009
              
              $
              —2010
              
              $
              982011
              
              $
              —2012
              
              $
              —2013
              
              $
              —$
              98
  On
November 14, 2008, the Company entered in to a series of convertible promissory
notes (the” Convertible Notes”), aggregating $110,000 with certain officers and
members of the Company’s Board of Directors. The Convertible Notes bear interest
at 7.0% per annum and were originally due February 14, 2009 for which a
forbearance waiver was obtained. The principal amount of the Convertible Notes
plus accrued but unpaid interest is convertible at the option of the holder into
Common Stock of the Company. The number of shares into which the Convertible
Notes are convertible shall be calculated by dividing the outstanding principal
and accrued but unpaid interest by $0.55 (the “Conversion Price”).
 
 In conjunction with the issuance of the
Convertible Notes, the Company issued an aggregate of 149,996 warrants to the
note holders to purchase Common Stock of the Company. The warrants have an
exercise price $0.55 per share and may be exercised at any time from November
14, 2008 until November 14, 2013.
 
 The Company initially recorded the
convertible notes net of a discount equal to the fair value allocated to the
warrants using the relative fair value method of approximately
$13,000.  The Company estimated the fair value of the warrants using
the Black-Scholes option pricing model and the following assumptions: term of 5
years, a risk free interest rate of 2.53%, a dividend yield of 0%, and
volatility of 96%.  The convertible notes also contained a beneficial
conversion feature, which resulted in additional debt discount of
$12,000.  The beneficial conversion amount was measured using the
accounting intrinsic value, i.e. the excess of the aggregate fair value of the
common stock into which the debt is convertible over the proceeds allocated to
the security.  The Company is accreting the beneficial conversion
feature over the life of the note.  For the twelve months ended
December 31, 2008 the Company recorded $12,000 as interest expense from the
amortization of the discount related to the fair value of the warrants and from
the accretion of the beneficial conversion feature.
  In August 2009, the Company received
from the Convertible Note holders a waiver of default and extension to January
31, 2010 of the maturity date of the Convertible Notes.  As consideration
for the waiver and note extension, the Company issued to the Convertible Note
holders an aggregate of 150,000 warrants to purchase shares of the Company’s
common stock.  The warrants have an exercise price of $0.54 per share and
expire on August 25, 2014.  The Company is currently seeking an
additional waiver of default from the holders of the Convertible
Notes.
 
 14.           Income Taxes
 
 The
significant components of the income tax provision (benefit) are as
follows:
 
 ($
      in thousands)
              
              December 31,2008
              
              
              2007CurrentFederal
              
              $
              —
              
              
              $
              —State
              
              
              —
              
              
              
              —Foreign
              
              
              —
              
              
              
              —DeferredFederal
              
              
              —
              
              
              
              —State
              
              
              —
              
              
              
              —Foreign
              
              
              —
              
              
              
              —$
              —
              
              
              $
              —
 
 84
 The
principal components of the Company’s deferred tax assets (liabilities) at
December 31, 2008 and 2007 are as follows:
 
 ($
      in thousands)
              
              2008
              
              
              2007Net
      operating loss carryforwards
              
              $
              17,306
              
              
              $
              16,118Intangible
      assets
              
              
              784
              
              
              
              713Impairment
      loss on intangible assets
              
              
              296
              
              
              
              -Stock
      based compensation
              
              
              552
              
              
              
              426Reserves
      and accrued expenses
              
              
              37
              
              
              
              (4
              )Other
              
              
              (46
              )
              
              
              (46
              )18,929
              
              
              
              17,207Less
      valuation allowance
              
              
              (18,929
              )
              
              
              (17,207
              )Net deferred tax assets
              
              $
              —
              
              
              $
              —
 
 A
reconciliation of the provision (benefit) for income taxes to the amount
computed by applying the statutory income tax rates to loss before income taxes
is as follows:
 
 2008
              
              
              2007Amounts
      computed at statutory rates
              
              $
              (1,944
              )
              
              $
              (1,593
              )State
      income tax, net of federal benefit
              
              
              (190
              )
              
              
              (125
              )Expiration
      of net operating loss carryforwards
              
              
              418
              
              
              
              485Federal
      research and development credit
              
              
              —
              
              
              
              —Other
              
              
              (5
              )
              
              
              6Net
      change in valuation allowance
              
              
              1,721
              
              
              
              1,227$
              —
              
              
              $
              —
 
 The
Company has established a valuation allowance against its deferred tax asset due
to the uncertainty surrounding the realization of such asset. Management
periodically evaluates the recoverability of the deferred tax asset. At such
time as it is determined that is more likely than not that deferred tax assets
are realizable, the valuation allowance will be reduced.
 
 At
December 31, 2008 and 2007, the Company had federal net operating loss
carryforwards of approximately $45,490,000 and $42,330,000, respectively, state
net operating loss carryforwards of approximately $31,514,000 and $29,576,000,
respectively, which may be available to offset future taxable income for
tax purposes. The federal net operating loss carryforwards expire at various
dates from 2009 through 2028. The state net operating loss carryforwards expire
at various dates from 2009 through 2018.
 
 The
Internal Revenue Code (“the Code”) limits the availability of certain tax
credits that arose prior to certain cumulative changes in a corporation’s
ownership resulting in a change of control of the Company.  The
Company has reduced its deferred tax assets to zero relating to its federal and
state research credits because of such limitations.
 
 The Code
also limits the availability of net operating losses that arose prior to certain
cumulative changes in a corporation’s ownership resulting in a change of control
of the Company. The Company’s use of its net operating loss carryforwards and
tax credit carryforwards will be significantly limited because the Company
underwent “ownership changes” in 1991, 1995, 2000, 2003 and 2004.
  In
June 2006, the FASB issued Interpretation No. 48, “Accounting for
Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109”
(“FIN 48”), which clarifies the accounting for uncertainty in income taxes
recognized in a company’s financial statements. The interpretation prescribes a
recognition threshold and measurement attribute criteria for the financial
statement recognition and measurement of an uncertain tax position taken or
expected to be taken in a tax return. The interpretation also provides guidance
on de-recognition, classification, interest and penalties, accounting in interim
periods, disclosure and transition.
 
 The
Company adopted the provisions of FIN 48 on January 1, 2007. The
implementation of FIN 48 did not have a material impact on the Company’s
financial statements. At the adoption date on January 1, 2007, and as of
December 31, 2007 and 2008, the Company recorded no cumulative effect
adjustments related to the adoption of FIN 48.
 
 Upon
adoption of FIN 48 on January 1, 2007, and as of December 31, 2007,
the Company had no unrecognized tax benefits or accruals for the potential
payment of interest and penalties. For the twelve months ended December 31,
2007 and 2008, no interest or penalties were recorded.
  85
 The
Company files tax returns in the U.S. federal jurisdiction, and in various
states and foreign jurisdictions. The Company is not aware of any jurisdictions
currently under examination by tax authorities.
  15.           Commitments
and Contingencies
 
 Employment
Agreements
 
 The
Company has employment agreements with its Chief Executive Officer and Senior
Vice President of Administration and Chief Financial Officer. The Company
may terminate the agreements with or without cause. Subject to the
conditions and other limitations set forth in each respective employment
agreement, each executive will be entitled to the following severance benefits
if the Company terminates the executive’s employment without cause or in the
event of an involuntary termination  (as defined in the employment
agreements) by the Company or by the executive: (i) a lump sum cash payment
equal to between six months and twenty-four months of base salary, based upon
specific agreements; (ii) continuation of the executive’s fringe benefits
and medical insurance for a period of three years; and (iii) immediate
vesting of 50% of each executive’s outstanding restricted stock awards and stock
options. In the event that the executive’s employment is terminated within the
six months prior to or the thirteen months following a change of control (as
defined in the employment agreements), the executive is entitled to the
severance benefits described above, except that 100% of each executive’s
restricted stock awards outstanding and stock options will immediately vest.
Each executive’s eligibility to receive any severance payments or other benefits
upon his termination is conditioned upon him executing a general release of
liability.
  Litigation
 
 The
Company is involved in certain legal proceedings generally incidental to its
normal business activities. While the outcome of such proceedings cannot be
accurately predicted, the Company does not believe the ultimate resolution of
any such existing matters should have a material effect on its financial
position, results of operations or cash flows.
 
 Leases
  The Company currently leases office and
research and development space under operating leases which expire at various
dates through December 2013.
 
 At
December 31, 2008, future minimum lease payments are as
follows:
 
 ($
      in thousands)2009
              
              $
              2512010
              
              $
              1612011
              
              $
              1642012
              
              $
              1642013
              
              $
              108$
              848
 
 Rental
expense from continuing operations incurred under operating leases for the years
ended December 31, 2008 and 2007 was approximately $545,000 and $579,000,
respectively.
  86
 16.
              Equity
 
 The
Company’s Articles of Incorporation were amended effective August 31, 1994
and authorize the issuance of two classes of stock to be designated “Common
Stock” and “Preferred Stock,” provide that both Common and Preferred Stock shall
have a par value of $.01 per share and authorize the Company to issue 50,000,000
shares of Common Stock and 4,000,000 shares of Preferred Stock. The Preferred
Stock may be divided into such number of series and with the rights,
preferences, privileges and restrictions as the Board of Directors
may determine.
 
 Series B
Convertible, Redeemable Preferred Stock
 
 In
April 1995, the Company’s Articles of Incorporation were amended to
authorize 750,000 shares of Series B Convertible Redeemable Preferred Stock
(“Series B”). Each 5.275 shares of Series B are convertible into one
share of the Company’s common stock.
 
 The
holders of Series B are entitled to cumulative preferred dividends payable
at the rate of $.2125 per share per annum commencing April 30, 1996,
subject to legally available funds. The Series B plus accrued but unpaid
dividends are convertible at the option of the holder into shares of common
stock at a conversion price equal to the original Series B issue price as
adjusted to prevent dilution. The Series B will automatically be converted
into shares of common stock upon the closing of an underwritten public offering
at a price per common share of not less than $31.65. If the public offering
price is less than $31.65 but at least $21.10 per share, the conversion shall
still be automatic upon written consent of a majority of the then outstanding
shareholders of Series B.
 
 The
holders of Series B, on an as-converted basis, have the same voting rights
per share as the Company’s common shares; provided, that the holders of
Series B has a special right to elect one director if the Company defaults
in the payment of any dividend to the holders of Series B. The holders of
Series B are entitled to initial distributions of $2.50 per share of
Series B outstanding, upon liquidation and in preference to common shares
and any other series of preferred stock plus all accrued but unpaid
dividends.
 
 Any time
after December 31, 2000, the Company has the right to redeem all or some of
the outstanding shares of Series B at a price equal to the original issue
price, plus all accrued but unpaid dividends.
 
 The
Company had 239,400 shares of Series B outstanding as of December 31,
2008 and 2007.  At December 31, 2008 and 2007, the Company had
cumulative undeclared dividends of approximately $34,000 and $9,000
respectively.
  Series C
Convertible Preferred Stock
 
 In
November 2006, the Company’s Articles of Incorporation were amended to
authorize 3,500 shares of Series C Convertible Preferred Stock
(“Series C”). Each share of Series C Preferred Stock is convertible at
any time at the option of the holder into a number of shares of common stock
equal to the stated value (initially $1,000 per share, subject to adjustment),
plus any accrued and unpaid dividends, divided by the conversion price
(initially $1.50 per share, subsequently adjusted to $0.50 per share and subject
to further adjustment). Subject to certain limitations, the conversion price per
share shall be adjusted in the event of certain subsequent stock dividends,
splits, reclassifications, dilutive issuances, rights offerings, and
reclassifications.  Certain activities may not be undertaken by the Company
without the affirmative vote of a majority of the holders of the outstanding
shares of Series C Preferred Stock.  The Series C preferred
stock does not have voting rights and is not redeemable except at liquidation.
The Company may be subject to losses arising from non-delivery of shares within
a specified period of time under the “buy in” provision. At January 1, 2007, the
Company had issued a total of 2,500 shares of Series C Convertible Preferred
Stock.
  The
holders of Series C are entitled to receive cumulative dividends, at the
option of the Company, (i) in common stock upon conversion of the
Series C preferred stock, or (ii) in cash after the payment of cash
dividends to the holders of Series B Preferred Stock at the rate per share
(as a percentage of the stated value per share) of 8% per
annum.
 
 The
holders of Series C are entitled to initial distributions of $1,000 per
share of Series C outstanding, upon liquidation and in preference to common
shares and any other series of preferred stock with the exception of
Series B Preferred Stock, plus all accrued but unpaid
dividends.
 
 The
Company had 2,200 shares of Series C outstanding as of December 31,
2008 and 2007.  At December 31, 2008 and 2007, the Company had
cumulative undeclared dividends of approximately $404,000 and
$234,000.
 
 During
the twelve months ended December 31, 2007, 300 shares of Series C were
converted into 206,778 shares of the Company’s common stock.  There
were no conversions during the corresponding period in 2008.
  Series D
Convertible Preferred Stock
 
 In
March 2007, the Company’s Articles of Incorporation were amended to
authorize 2,000 shares of Series D 8% Convertible Preferred Stock
(“Series D Preferred Stock”). In August 2008, the Company’s Articles of
Incorporation were further amended to increase the number of authorized shares
of Series D Preferred Stock from 2,000 to 3,000.  Each share of
Series D Preferred Stock is convertible at any time at the option of the
holder into a number of shares of common stock equal to the stated value
(initially $1,000 per share, subject to adjustment), plus any accrued and unpaid
dividends, divided by the conversion price (initially $1.90 per share,
subsequently adjusted to 0.50 per share and subject to further adjustment).
Subject to certain limitations, the conversion price per share shall be adjusted
in the event of certain subsequent stock dividends, splits, reclassifications,
dilutive issuances, rights offerings, and reclassifications.  Certain
activities may not be undertaken by the Company without the affirmative vote of
a majority of the holders of the outstanding shares of Series D Preferred
Stock.  The Series D Preferred Stock does not have voting rights and
is not redeemable except at liquidation. The Company may be subject to losses
arising from non-delivery of shares within a specified period of time under the
“buy in” provision.
  87
 The
Company had 2,198 and 1388 shares of Series D outstanding as of
December 31, 2008 and 2007, respectively.  At December 31,
2008 and 2007, the Company had cumulative undeclared dividends of approximately
$230,000 and $98,000.
 
 During
March 2007, the Company issued a total of 1,500 shares of Series D Preferred
Stock and generated gross proceeds of $1.5 million.  During the twelve
months ended December 31, 2007, 112 shares of Series D were converted
into 79,248 shares of the Company’s common stock.
 
 In
conjunction with the March 2007 issuance of the Series D Preferred Stock,
the Company issued warrants to the holders of the Series D Preferred 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 on the balance
sheet.  The proceeds from the Series D Preferred Stock financing
were allocated to the warrants and the Series D Preferred Stock based on
the relative fair value of each on the date of issuance.  This
allocation process resulted in the initial recognition of a discount
attributable to an embedded beneficial conversion feature of approximately
$344,000.  The discount was amortized over the minimum period from the
date of issuance to the date at which the preferred shareholders are permitted
to convert as a dividend to the Series D Preferred Stock
shareholders.
 
 The
issuance of common stock and warrants pursuant to the Common Stock Financing
triggered certain antidilution clauses in the Company’s Series D Preferred
Stock agreement. As a result of these antidilution clauses, the Company was
required to adjust the conversion price of the Series D Preferred Stock
from $1.90 per share to $1.50 per share.  This antidilution feature
will cause an additional 210,528 common shares to be issued upon conversion of
the Series D Preferred Stock into common stock. In accordance with EITF
Issue 00-27, “Application of Issue No. 98-5 to Certain Convertible
Instruments”, this antidilution feature resulted in the additional recognition
of a discount attributable to an embedded beneficial conversion feature of
approximately $470,000.  This discount was amortized over the minimum
period from the date of the conversion price adjustment to the date at which the
preferred shareholders are permitted to convert as a dividend to the
Series D Preferred Stock shareholders.
 
 Commencing in August 2008 and ending in
September 2008, (the”2008 Series D Preferred Stock Financing”), the Company
issued to certain investors 810 shares of Series D Preferred Stock for aggregate
gross proceeds of $810,000.  In conjunction with the 2008 Series D
Preferred Stock Financing, the Company issued warrants to the investors of the
Series D Preferred Stock to purchase 1,620,000 shares of the Company’s common
stock at $0.50 per share.  These warrants have been classified as
equity instruments on the Company’s Consolidated Balance Sheet at December 31,
2008. The proceeds from the 2008 Series D Preferred Stock Financing were
allocated to the warrants and the Series D Preferred Stock based on the relative
fair value of each on the date of issuance.  This allocation process
resulted in the initial recognition of a discount attributable to an embedded
beneficial conversion feature of approximately $186,000.  This
discount was amortized over the minimum period from date of issuance to the date
at which the preferred shareholders are permitted to convert as a dividend to
the Series D Preferred Stock shareholders.
 
 The issuance of the Series D Preferred
Stock and warrants pursuant to the 2008 Series D Preferred Stock Financing
triggered certain antidilution clauses in the Company’s Series C and previously
issued Series D Preferred Stock agreements.  As a result of these
antidilution clauses, the Company was required to adjust the conversion price of
the Series C and Series D Preferred Stocks from $1.00 to $0.50 per
share.  This antidilution feature will cause an additional 3,588,000
common shares to be issued upon conversion of the Series C and Series D
Preferred Stocks into common stock.  In accordance with EITF Issue
00-27,”Application of Issue 98-5 to Certain Convertible Instruments”, this
antidilution feature resulted in the additional recognition of a discount
attributable to an embedded beneficial conversion feature of approximately
$3,588,000.  This discount was amortized over the minimum period from
date of issuance to the date at which the preferred shareholders are permitted
to convert as a dividend to the Series D Preferred Stock
shareholders.
 
 As
compensation to the placement agent for the 2008 Series D Preferred Stock
Financing, the Company agreed to pay approximately $33,000 in
cash.  The cash payment has been recorded as an adjustment to
additional paid in capital as a reduction of net proceeds.
  88
 Common
Stock
  On
March 12, 2008, the Company received $541,666 from the exercise of
541,666 warrants to purchase shares of the Company’s common stock, par value
$0.01 per share (the “Warrant Financing”). The warrants were originally issued
in connection with a private placement of Common Stock to certain accredited
investors (the “Investors”). The Financing was previously reported in a Current
Report on Form 8-K filed on September 26, 2007. The Company agreed to
reprice all warrants issued in the Financing, which originally had an exercise
price of $1.67 per share, to an exercise price of $1.00 per share, in
consideration for their immediate exercise (the “Warrant Repricing”) by the
Investors who participated in the Warrant Repricing or their transferees, as
applicable (the “Participating Investors”).
 
 In
connection with the Warrant Repricing, the Company also issued to the
Participating Investors new warrants (the “Warrants”) to purchase up to an
aggregate of 270,833 shares of Common Stock with an exercise price of $1.20 per
share. The Warrants may be exercised at any time from March 12, 2008 until
March 12, 2013. In addition, if the shares of Common Stock issuable upon
exercise of the Warrants are not registered for resale with the Securities and
Exchange Commission on or before the later of September 12, 2008 or the end
of the applicable holding period for resales of securities by non-affiliates
under Rule 144 of the Securities Act, but in any event no later than
March 12, 2009, the Warrants may be exercised by the Participating
Investors by “cashless” exercise.
 
 As more
fully disclosed in Note 6 to these condensed consolidated financial statements,
in March 2008 the Company amended the Asset Purchase Agreement relating to
the purchase of certain assets of Sol Logic, Inc. As a result of amending
the Asset Purchase Agreement, the Company rescinded the issuance of 257,149
shares of common stock originally issued to Sol Logic and placed into escrow on
December 19, 2007.
 
 In 2008
and 2007, the Company issued 81,144 and 63,240 shares of common stock,
respectively, pursuant to stock-based compensation agreements with certain
employees.
 
 The issuance of common stock and
warrants in March 2008 pursuant to the Warrant Financing triggered certain
antidilution clauses in the Company’s Series C and Series D Preferred
Stock agreements. As a result of these antidilution clauses, the Company was
required to adjust the conversion price of the Series C and Series D
Preferred Stock from $1.50 per share to $1.00 per share. This antidilution
feature will cause an additional 733,335 common shares to be issued upon
conversion of the Series C Preferred Stock into common stock and an
additional 462,669 common shares to be issued upon conversion of the
Series D Preferred Stock into common stock. In accordance with EITF Issue
00-27, “Application of Issue No. 98-5 to Certain Convertible Instruments”,
this antidilution feature resulted in the additional recognition of a discount
attributable to an embedded beneficial conversion feature of approximately
$1,100,000 related to Series C Preferred Stock and $694,000 related to
Series D Preferred Stock. This discount was amortized over the minimum
period from the date of the conversion price adjustment to the date at which the
preferred shareholders are permitted to convert as a dividend to the
Series C and Series D Preferred Stock shareholders.
 
 On
September 25, 2007, the Company sold to certain accredited investors a
total of 2,016,666 shares of the Company’s common stock, par value $0.01 per
share, at a purchase price of $1.50 per share for 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”) to purchase up to an aggregate of
1,008,333 shares of Common Stock with an exercise price of $1.67 per share. The
Investor Warrants have been classified as equity instruments on the balance
sheet in accordance with the provisions of Emerging Issues Task Force (“EITF”)
Issue 00-19, “Accounting for Derivative Financial Instruments Indexed to, and
Potentially Settled in, a Company’s Own Stock”.
 
 The
issuance of common stock and warrants pursuant to the Common Stock Financing
triggered certain antidilution and exercise price reduction clauses in existing
warrant agreements. As a result of these modifications, the Company was required
to issue an additional 113,834 warrants and reduce the exercise price of certain
previously issued warrants. As these warrants were classified as permanent
equity, and the adjustment was related to antidilution features within these
financial instruments, this increase in warrants and reduction of exercise price
resulted in no adjustments to the financial statements.
 
 As
compensation to the placement agent for the Common Stock Financing, the Company
paid approximately $212,000 in placement agent fees and agreed to reimburse up
to $25,000 of placement agent legal expense incurred in connection with this
financing.  In addition, the Company issued the placement agent for
the financing, and certain of its affiliates, a 5.5 year warrant (the “Placement
Agent Warrants”) to purchase up to an aggregate of 151,249 shares of Common
Stock on the same terms and conditions included in the Investor Warrants. The
cash payment has been recorded as adjustment to additional paid in capital as a
reduction of net proceeds.  The Placement Agent Warrants have been
classified as equity instruments on the balance sheet.
  89
 During
the twelve months ended December 31, 2007 the Company issued 206,778 shares
of its common stock pursuant to the conversion of 300 shares of Series C
Preferred Stock and issued 79,248 shares of its common stock pursuant to the
conversion of 112 shares of Series D Preferred Stock.
 
 During
the twelve months ended December 31, 2007, the Company issued 795,956
shares of its common stock pursuant to the exercise of common stock purchase
warrants.  The Company received gross proceeds of approximately
$1,121,000 from these warrant exercises.
 
 In
December 2007, the Company issued 935,089 shares of its common stock
pursuant to its acquisition of substantially all the assets of Sol
Logic, Inc.
 
 During
the twelve months ended December 31, 2007, 300 shares of Series C were
converted into 206,778 shares of the Company’s common stock.  During
the twelve months ended December 31, 2007, 112 shares of Series D were
converted into 79,248 shares of the Company’s common stock.
 
 Warrants
 
 As of
December 31, 2008, warrants to purchase 10,471,167 shares of common stock
at prices ranging from $0.50 to $5.48 were outstanding. All warrants are
exercisable as of December 31, 2008, and expire at various dates through
March 2013.
 
 The following table summarizes warrant activity for the following periods:
 
 Warrants
              
              
              Weighted-
                Average
                Exercise PriceBalance
      at December 31, 2006
              
              
              5,821,149
              
              
              $
              2.37Granted
              
              
              1,286,776
              
              
              $
              1.34Expired
      / Canceled
              
              
              (224,998
              )
              
              $
              3.16Exercised
              
              
              (927,097
              )
              
              $
              1.59Balance
      at December 31, 2007
              
              
              5,955,830
              
              
              $
              2.24Granted
              
              
              6,251,984
              
              
              $
              0.53Expired
      / Canceled
              
              
              (1,194,981
              )
              
              $
              2.39Exercised
              
              
              (541,666
              )
              
              $
              1.00Balance
      at December 31, 2008
              
              
              10,471,167
              
              
              $
              1.00
  The
following table summarized information about warrants outstanding and
exercisable at December 31, 2008:
 
 Exercise Price
              
              Number
                Outstanding
              
              Weighted—Average
                Remaining Life
                (Years)
              
              Weighted—Average
                Exercise Price$
              .50
              
              8,124,138
              
              2.0
              
              $
              .50$
              .55
              
              149,996
              
              4.9
              
              $
              .55$
              1.20
              
              270,833
              
              4.2
              
              $
              1.20$
              1.43
              
              75,149
              
              5.0
              
              $
              1.43$
              1.67
              
              617,916
              
              4.24
              
              $
              1.67$
              2.14
              
              34,600
              
              0.9
              
              $
              2.14$
              2.68
              
              635,767
              
              1.56
              
              $
              2.68$
              4.66
              
              63,012
              
              0.1
              
              $
              4.66$
              5.48
              
              499,756
              
              0.1
              
              $
              5.4810,471,167
  90
 In
conjunction with the issuance of the Series D Preferred Stock, the Company
issued warrants to the holders of the Series D Preferred Stock to purchase
1,620,000 of the Company’s common stock at $0.50 per share.  These
warrants have been classified as equity instruments on the balance
sheet.
 
 As
partial compensation to the placement agent for the Preferred Stock Financing,
the Company issued the placement agent for the financing, and certain of its
affiliates, a 5 year warrant (the “Placement Agent Warrants”) to purchase up to
an aggregate of 65,600 shares of Common Stock on the same terms and conditions
included in the Investor Warrants. The cash payment has been recorded as
adjustment to additional paid in capital as a reduction of net
proceeds.  The Placement Agent Warrants have been classified as equity
instruments on the balance sheet.
  The issuance of common stock and
warrants pursuant to the Common Stock Financing triggered certain antidilution
and exercise price reduction clauses in existing warrant agreements. As a result
of these modifications, the Company was required to issue an additional
4,145,555 warrants and reduce the exercise price of certain previously issued
warrants. As these warrants were classified as permanent equity and their
anti-dilution rights were likewise classified as equity, the adjustment was
related to the execution of an existing warrant features within these financial
instruments rather than an actual modification and this increase in warrants and
reduction of exercise price resulted in no adjustment to the financial
statements.
  17.
              Stock Option
      Plans
 
 On
August 31, 1994, the directors of the Company adopted the Company’s 1994
Employee Stock Option Plan (the “1994 Plan”) and the 1994 Nonqualified Stock
Option Plan (the “Nonqualified Plan”). The 1992 Stock Option Plan and options
previously granted were cancelled by the Board of Directors.
 
 The 1994
Plan originally provided for officers and other key employees to receive
nontransferable incentive stock options to purchase up to 170,616 shares of the
Company’s common stock. The number of stock options issued and outstanding and
the number of stock options remaining available for future issuance are shown in
the table below. The option price per share must be at least equal to 100% of
the market value of the Company’s common stock on the date of grant and the term
may not exceed ten years.
 
 The
Nonqualified Plan originally provided for directors and consultants to receive
nontransferable options to purchase up to 18,957 shares of the Company’s common
stock. The number of options issued and outstanding and the number of options
remaining available for future issuance are shown in the table below. The option
price per share must be at least equal to 85% of the market value of the
Company’s common stock on the date of grant and the term may not exceed
five years.
 
 Both the
1994 Plan and the Nonqualified Plan are administered by the Board of Directors
or a Committee of the Board which determines the employees, directors or
consultants which will be granted options and the terms of the options,
including vesting provisions which to date has been over a three year period.
Both the 1994 Plan and 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 terms of the 1999 Plan, the Company could, originally,
issue up to 350,000 non-qualified or incentive stock options to purchase common
stock of the Company. The number of options issued and outstanding and the
number of options remaining available for future issuance are shown in the table
below. The 1999 Plan has substantially the same terms as the 1994 Employee Stock
Option Plan and the 1994 Nonqualified Stock Option Plan and expires on
December 17, 2009.
  91
 ·
              We increased the share reserve of
      the amended and restated 1999 plan by 883,000 shares of our common stock.
      This number consists of an increase in the share reserve of 800,000 of our
      shares of common stock and 83,000 shares of our common stock that were
      reserved and available for grants under the 2001 Equity Incentive Plan,
      which we refer to as the 2001 plan. Prior to amendment, the 1999 plan had
      350,000 shares reserved for issuance under the 1999
      plan.
 
 ·
              Any shares not issued in
      connection with awards outstanding under the 2001 plan or the 1994
      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 1999 plan.
 
 ·
              Any shares not issued in
      connection with awards granted under the 1999 plan, will become available
      for issuance under the amended and restated 1999
    plan.
 
 ·
              The amended and restated 1999
      plan prohibits the grant of stock option or stock appreciation right
      awards with an exercise price less than fair market value of Common Stock
      on the date of grant.
 
 ·
              The amended and restated 1999
      plan also generally prohibits the “re-pricing” of stock options or stock
      appreciation rights, although awards may be bought out for a payment
      in cash or our stock.
 ·
                The amended and restated 1999
      plan permits the grant of stock based awards other than stock options,
      including the grant of “full value” awards such as restricted stock, stock
      units and performance shares.
 ·
                The
      amended and restated 1999 plan permits the qualification of awards under
      the plan (payable in either stock or cash) as “performance-based
      compensation” within the meaning of Section 162(m) of the
      Internal Revenue Code.
 
 On
September 12, 2001, the Company’s Board of Directors approved adoption of
the 2001 Equity Incentive Plan (the “2001 Plan”). Under the terms of the 2001
Plan, the Company may issue stock awards to employees, directors and
consultants of the Company, and such stock awards may be given for
non-statutory stock options (options not intended to qualify as an “incentive
stock option” within the meaning of Section 422 of the Internal Revenue
Code of 1986, as amended), stock bonuses, and rights to acquire restricted
stock. The Company originally reserved 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 options remaining available for future issuance are shown in the
table below.
 
 The 2001
Plan is administered by the Board of Directors or a Committee of the Board as
provided in the 2001 Plan. Options granted under the 2001 Plan shall not be less
than 85% 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
are determined by the Board and to date, options have been granted with a ten
year term and vesting over a three year period. While the Board may suspend
or terminate the 2001 Plan at any time, if not terminated earlier, it will
terminate on the day before its tenth anniversary of the date of
adoption.
  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
1,000,000 shares would be reserved for issuance under the plan.  In
December 2007, the Company’s shareholders approved this amendment resulting
in 1,000,000 shares being added to the 1999 Plan.
 
 Stock
Option Plans
 As
of December 31, 2008
 
 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
              
              
              20,250
              
              
              
              -0-1999
      Plan
              
              
              1,773,047
              
              
              
              653,0892001
      Plan
              
              
              256,017
              
              
              
              -0-Total
              
              
              2,049,314
              
              
              
              653,089
  92
 The following table summarizes employee
stock option activity since December 31, 2006:
 
 Options
              
              
              Weighted-
                Average
                Exercise PriceBalance
      at December 31, 2006
              
              
              1,603,164
              
              
              $
              2.45Granted
              
              
              165,250
              
              
              $
              2.38Expired/canceled
              
              
              (103,206
              )
              
              $
              2.58Exercised
              
              
              —
              
              
              $
              —Balance
      at December 31, 2007
              
              
              1,665,208
              
              
              $
              2.44Granted
              
              
              821,221
              
              
              $
              0.89Expired/canceled
              
              
              (437,115
              )
              
              $
              2.19Exercised
              
              
              —
              
              
              $Balance
      at December 31, 2008
              
              
              2,049,314
              
              
              $
              1.87
 
 At
December 31, 2008, a total of 1,239,422 options were exercisable at a
weighted average price of $2.42 per share. At December 31, 2007, a total of
1,212,753 options were exercisable at a weighted average price of $2.50 per
share. At December 31, 2006, a total of 810,527 options were exercisable at
a weighted average price of $2.66 per share.
  The
intrinsic value of options exercised during the twelve months ended
December 31, 2008, 2007 and 2006 was $0. The intrinsic value of options
exercisable at December 31, 2008, 2007 and 2006 was $0.
 
 The
following table summarizes information about employee stock options outstanding
and exercisable at December 31, 2008:
 
 Options Outstanding
              
              
              
              Options ExercisableExercise Price
              
              Number
                Outstanding
              
              Weighted-
                Average
                Remaining Life
                (Years)
              
              Weighted-
                Average
                Exercise Price
              
              Number
                Exercisable
              
              Weighted-
                Average
                Exercise Price$
              .17
      – .52
              
              321,221
              
              9.8
              
              $
              .20
              
              0
              
              $
              0$
              .58
      - 1.04
              
              96,000
              
              9.3
              
              $
              .92
              
              0
              
              $
              0$
              1.45
      - 1.71
              
              455,672
              
              8.4
              
              $
              1.52
              
              126,531
              
              $
              1.64$
              1.97
      – 2.15
              
              157,336
              
              5.4
              
              $
              2.01
              
              150,255
              
              $
              1.97$
              2.20
      – 2.49
              
              552,318
              
              6.5
              
              $
              2.39
              
              495,869
              
              $
              2.31$
              2.62
      – 2.74
              
              276,000
              
              6.6
              
              $
              2.63
              
              276,000
              
              $
              2.63$
              3.00
      – 6.51
              
              190,767
              
              3.5
              
              $
              3.28
              
              190,767
              
              $
              3.28Total
              
              2,049,314
              
              
              
              
              
              1,239,422
 
 The
weighted-average grant-date fair value per share of options granted to employees
during the years ended December 31, 2008 and 2007 was $0.54 and $1.48,
respectively.
 
 18.           Employee
Benefit Plan
 
 During
1995, the Company adopted a defined contribution 401(k) retirement plan
(the “Plan”). All U.S. based employees aged 21 years and older are eligible
to become participants after the completion of 60 days employment. The Plan
provides for annual contributions by the Company of 50% of employee
contributions not to exceed 8% of employee compensation.  Participants
may contribute up to 100% of the annual contribution limitations determined
by the Internal Revenue Service.
 
 Employees
are fully vested in their share of the Company’s contributions after the
completion of five years of service. In 2007, the Company made contributions of
approximately $28,000 for the 2006 plan year and made contributions of
approximately $75,000 for the 2007 plan year and has accrued a contribution of
approximately $6,000 for the 2007 plan year which was paid in January 2008.
In 2008, the Company has accrued a contribution of approximately $108,000 for
the 2008 plan year which was paid in 2009.
  93
 19.           Pension
Plan
  One of
the Company’s foreign subsidiaries maintains a defined benefit pension plan that
provides benefits based on length of service and final average earnings. The
following table sets forth the benefit obligation, fair value of plan assets,
and the funded status of the Company’s plan; amounts recognized in the Company’s
consolidated financial statements; and the assumptions used in determining the
actuarial present value of the benefit obligations as of
December 31:
 
 ($
      in thousands)
              
              2008
              
              
              2007Change
      in benefit obligation:Benefit
      obligation at beginning of year
              
              $
              1,636
              
              
              $
              1,457Service
      cost
              
              
              2
              
              
              
              2Interest
      cost
              
              
              84
              
              
              
              76Actuarial
      gain (loss)
              
              
              (9
              )
              
              
              (8
              )Effect
      of exchange rate changes
              
              
              (54
              )
              
              
              109Effect
      of curtailment
              
              
              —
              
              
              
              —Benefits
      paid
              
              
              —
              
              
              
              —Benefit
      obligation at end of year
              
              
              1,659
              
              
              
              1,636Change
      in plan assetsFair
      value of plan assets at beginning of year
              
              
              497
              
              
              
              441Actual
      return of plan assets
              
              
              14
              
              
              
              11Company
      contributions
              
              
              47
              
              
              
              45Benefits
      paid
              
              
              —
              
              
              
              —Fair
      value of plan assets at end of year
              
              
              558
              
              
              
              497Funded
      status
              
              
              (1,101
              )
              
              
              (1,139
              )Unrecognized
      actuarial loss (gain)
              
              
              363
              
              
              
              342Unrecognized
      prior service (benefit) cost
              
              
              —
              
              
              
              —Additional
      minimum liability
              
              
              (363
              )
              
              
              (342
              )Unrecognized
      transition (asset) liability
              
              
              —
              
              
              
              —Net
      amount recognized
              
              
              (1,101
              )
              
              $
              (1,139
              )The
      weighted average assumptions used to determine benefit obligations for
      the
                years ended December 31 were:Discount
      rate
              
              
              4.60
              %
              
              
              4.60
              %Expected
      return on plan assets
              
              
              4.00
              %
              
              
              4.00
              %Rate
      of compensation increase
              
              
              N/A
              
              
              
              N/APlan
      AssetsPension
      plan assets were comprised of the following asset categories at
      December 31,Equity
      securities
              
              
              4.60
              %
              
              
              6.90
              %Debt
      securities
              
              
              92.00
              %
              
              
              89.50
              %Other
              
              
              3.40
              %
              
              
              3.60
              %Total
              
              
              100
              %
              
              
              100
              %Components
      of net periodic benefit cost are as follows:Service
      cost
              
              
              2
              
              
              
              2Interest
      cost on projected benefit obligations
              
              
              84
              
              
              
              76Expected
      return on plan assets
              
              
              —
              
              
              
              —Amortization
      of prior service costs
              
              
              —
              
              
              
              —Amortization
      of actuarial loss
              
              
              —
              
              
              
              —Net
      periodic benefit costs
              
              
              86
              
              
              
              78The
      weighted average assumptions used to determine net periodic benefit cost
      for
                the years ended December 31, wereDiscount
      rate
              
              
              4.60
              %
              
              
              4.60
              %Expected
      return on plan assets
              
              
              4.00
              %
              
              
              4.00
              %Rate
      of compensation increase
              
              
              N/A
              
              
              
              N/AThe
      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
              
              
              1,659
              
              
              
              1,636Accumulated
      benefit obligation
              
              
              1,659
              
              
              
              1,636Fair
      value of plan assets
              
              
              558
              
              
              
              497
  94
 The
following benefit payments are expected to be paid as follows:
 
 2009
              
              
              —2010
              
              
              —2011
              
              
              —2012
              
              
              —2013
              
              
              —2014
      — 2018
              
              
              126
 
 The
Company made contributions to the plan of approximately $40,289 during
2010.
 
 The
investment objectives for the plan are the preservation of capital, current
income and long-term growth of capital. All plan assets are managed in a
policyholder pool in Germany by outside investment managers. The measurement
date used to determine the benefit information of the plan was January 1,
2009.
 
 20.     
  SUBSEQUENT EVENTS
  In February 2009, the Company entered
in to a secured promissory note (the ‘Note”), for Five Million
Dollars ($5,000,000) with a third-party lender (“the Lender”). The Note
secures a credit facility for a total of up to Five Million Dollars
($5,000,000). The initial advance under the Note was One Million Dollars
($1,000,000). Subsequent advances shall be in increments of $1,000,000 and are
subject to the discretion of the Lender. The Note shall bear interest at 5.0%
per annum on the outstanding principal. Principal and interest was originally
due June 30, 2010. The Company will also pay the Lender additional interest on
the maturity date or such earlier date as may be required under the terms of the
Note equal to the greater of Four Hundred Thousand Dollars ($400,000) or an
amount equal to 2,000,000 multiplied by the average of the Closing prices for
the Common Stock of the Company for the ten (10) trading day period immediately
preceding the date of the payment of such interest payment.
  The Note is secured by all of the
assets of the Company. Under the terms of the Note, the entire outstanding
balance together with all accrued interest shall be payable on (i) the maturity
date (June 30, 2010), (ii) a change of control transaction, (iii) receipt by the
Company of proceeds from the sale of equity or equity linked securities of the
Company in excess of $2,500,000, (iv) receipt by the Company of proceeds from
the issuance by the Company of any type of additional debt instruments, or upon
the occurrence of an event of default under the terms of the
Note.
  In conjunction with the issuance of the
Note, the Company issued a warrant to purchase 4,500,000 shares of Common Stock
of the Company. The warrant has an exercise price $0.50 per share and may be
exercised at any time from February 12, 2009 until February 12, 2014.
Additionally, the Company entered into a Registration Rights Agreement requiring
the Company to provide certain registration rights to the Lender relative to the
4,500,000 shares of Common Stock of the Company issuable pursuant to the
warrant.
  The Company intends to use the proceeds
from the Note for general working capital purposes.
  On May 19, 2009, ImageWare Systems,
Inc. formed a wholly owned subsidiary in Mexico in order to support the
Company’s efforts to develop new business and service existing contracts to
provide products and service in Mexico.  The Mexican subsidiary,
ImageWare Mexico, S. DE R.L., is located in Mexico City and has one
employee.
  In June 2009, the Lender and the
Company agreed to amend the Note (“Amendment No.1”) whereby the Company received
a waiver of default and extension of certain date sensitive covenants contained
in the Note.  As consideration for the waiver and extension, the Company
issued to the Lender warrants to purchase 1,000,000 shares of Common Stock of
the Company at an exercise price of $0.50 per share.  Such warrants may be
exercised at any time from June 9, 2009 until June 9, 2014.  In conjunction
with the June 2009 waiver and extension, the interest rate on the Note was
changed to 9% per annum, retroactive to February 2009.
  95
 In June 2009, the Lender and the
Company further amended the Note (“Amendment No.2”) whereby the Lender advanced
the Company an additional $350,000 and amended certain terms of the Note. 
As consideration for the additional advance, the Company issued to the Lender
warrants to purchase 700,000 shares of Common Stock of the Company at an
exercise price of $0.50 per share.  Such warrants may be exercised at any
time from June 22, 2009 until June 22, 2014.
  In July and August 2009, the Company
undertook a series of warrant financings whereby the Company issued 2,401,075
warrants with an exercise price of $0.50 per share to incentivize certain
warrant holders to exercise their existing warrant of cash.  Pursuant to
this series of warrant financings, the Company issued an aggregate of 2,741,075
shares of common stock and raised approximately $1,371,000 in
cash.
  In July and August 2009, holders of
existing warrants exercised 929,395 of their warrants pursuant to cashless
exercise provisions and received 353,702 shares of common
stock.
  In October 2009, the Lender and the
Company amended the Note (“Amendment No. 3”) whereby the Lender agreed to make
additional advances in an aggregate amount up to One Million Dollars
($1,000,000) to only be used for the purpose of compromising certain of the
Company’s outstanding vendor payables or for paying the audit of the Company’s
financial statements.  The amendment calls for the Company to repay the
lender in full the amount of any and all Third Amendment Advances, together with
all accrued and unpaid interest thereon, on or before January 31,
2010.  On October 5,
2009, the Lender made an advance of $300,000 to the Company pursuant to these
provisions.  As consideration for the additional advance, the Company
issued to the Lender warrants to purchase 200,000 shares of Common Stock of the
Company at an exercise price of $0.60 per share.  Such warrants may be
exercised at any time from October 5, 2009 until October 5, 2014.  As
additional consideration, the Company assigned certain patents related to
discontinued product lines to the Lender with the condition that the Company
would participate in future proceeds generated from efforts by the Lender to
monetize the patents.
 On November 4, 2009, the Lender and the
Company amended the Note (“Amendment No. 4”) whereby the Lender made an
additional $350,000 advance (the “Additional Advance”) under the Note.  As
consideration for the Additional Advance, the Company executed an assignment of
all accounts receivable (the”Assignment of Receivables”) whereby the Company
assigned to the Lender all of the Company’s rights, title and interest in all
accounts receivable as of the date of Amendment No. 4.  In December 2009,
the Company paid back the $350,000 advance plus accrued
interest.
  In December 2009, the Lender advanced
an additional $325,000 under Amendment No.3.
  In January of 2010, holders of existing
warrants exercised 13,120 of their warrants pursuant to cashless exercise
provisions and received 5,665 shares of common stock.
  In January of 2010, the Company issued
847,258 shares of restricted stock to members of management and the
Board.  These shares will vest quarterly over a three year period. 
The restricted shares were issued as compensation for the cancellation of
1,412,096 warrants held by members of management and the Board.
  In
February 2010, the Lender and the Company amended the Note “(Amendment No. 5”)
whereby the Lender extended the due date of amounts due on January 31, 2010 to
March 15, 2010.
   96