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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 FORM 10-KSB (Mark one) þ Annual report under Section 13 or 15(d) of the Securities Exchange Act of 1934 For the fiscal year ended December 31, 2004 o Transition report under Section 13 or 15(d) of the Securities Exchange Act of 1934 For the transition period from _______________ to ______________ Commission file number 001-15069 Duraswitch Industries, Inc.  Nevada
    
    88-0308867(State or other jurisdiction of
    
    (I.R.S. Employerincorporation or organization)
    
    Identification No.)234 S. Extension Road
    
    85210Mesa, Arizona
    
    (Zip Code)(Address of principal executive offices)
 (480) 586-3300
(Issuers telephone number) Securities registered under Section 12(b) of the Exchange Act: None Securities registered under Section 12(g) of the Exchange Act: Common Stock, par value $0.001 Check whether the issuer: (1) filed all reports required to be filed by Section 13 or 15(d) of the
Exchange Act during the past 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 þ No o. Check if there is no disclosure of delinquent filers in response to Item 405 of Regulation S-B
contained herein, and no disclosure will 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-KSB or any amendment to this Form 10-KSB. þ State issuers revenue for its most recent fiscal year. $1,757,053 The aggregate market value of common stock held by nonaffiliates of the registrant (5,741,421
shares) based on the closing price of the registrants common stock as reported on the NASDAQ
SmallCap Market on March 15, 2005 was $10,908,700. For purposes of this computation, all officers,
directors, and 10% beneficial owners of the registrant are deemed to be affiliates. Such
determination should not be deemed to be an admission that such officers, directors, or 10%
beneficial owners are, in fact, affiliates of the registrant. Number of issuers shares of common stock outstanding as of March 15, 2005 was 9,614,673. DOCUMENTS INCORPORATED BY REFERENCE Portions of the registrants Proxy Statement for the 2005 Annual Meeting of Stockholders are
incorporated by reference into Part III of this Form 10-KSB.




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Duraswitch Industries, Inc.
Form 10-KSB
For the Year Ended December 31, 2004 Table of Contents PagePART IItem 1.
    
    Description of Business
    
    
    3Item 2.
    
    Description of Property
    
    
    11Item 3.
    
    Legal Proceedings
    
    
    12Item 4.
    
    Submission of Matters to a Vote of Security Holders
    
    
    12PART IIItem 5.
    
    Market for Common Equity and Related Stockholder Matters
    
    
    13Item 6.
    
    Managements Discussion and Analysis or Plan of Operation
    
    
    13Item 7.
    
    Financial Statements
    
    
    20Item 8.
    
    Changes In and Disagreements With Accountants on Accounting and Financial Disclosure
    
    
    35Item 8A.
    
    Controls and Procedures
    
    
    35Item 8B.
    
    Other Information
    
    
    35PART IIIItem 9.
    
    Directors, Executive Officers, Promoters and Control Persons; Compliance With Section 16(a) of the Exchange Act
    
    
    36Item 10.
    
    Executive Compensation
    
    
    36Item 11.
    
    Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
    
    
    36Item 12.
    
    Certain Relationships and Related Transactions
    
    
    36Item 13.
    
    Exhibits
    
    
    36Item 14.
    
    Principal Accountant Fees and Services
    
    
    37SIGNATURES
    
    
    
    
    38EX-10.12EX-14EX-21EX-23.1EX-31EX-32
  Statement Regarding Forward-Looking Statements The statements contained in this report onForm 10-KSBthat are not purely historical are
forward-looking statements within the meaning of applicable securities laws. Forward-looking
statements include statements regarding our expectations, anticipations, intentions,
beliefs, or strategies regarding the future. Forward-looking statements also include statements
regarding revenue, margins, and expenses for fiscal 2005 and thereafter; statements regarding our
licensees ability to successfully market and manufacture products using our technologies; the
potential for our technologies in key markets; our ability to drive high-volume applications
resulting in revenue growth; potential acquisitions or strategic alliances; our ability to
successfully integrate and commercialize additional technologies into our licensing model; and
liquidity and anticipated cash needs and availability. All forward-looking statements included in
this report are based on information available to us as of the filing date of this report, and we
assume no liability to update any such forward-looking statements. Our actual results could differ
materially from the forward-looking statements. Among the factors that could cause actual results
to differ materially are the factors discussed in Item 1, Business  Risk Factors. 2




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PART I 
 Item 1. Description of Business. Overview Duraswitch is a licensor of patented, enabling technologies. We currently license electronic
pushbutton, rotary and omni-directional switch technologies and are actively searching for
additional innovative technologies. We maintain our executive offices at 234 S. Extension Road, Suite 103, Mesa, Arizona 85210,
and our telephone number is (480) 586-3300. Our website is located at www.duraswitch.com.Through
our website, we make available free of charge our annual report on Form 10-KSB, our quarterly
reports on Form 10-QSB, our current reports on Form 8-K, our proxy statements, and any amendments
to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange
Act of 1934. These reports are available as soon as reasonably practicable after we electronically
file those reports with the Securities and Exchange Commission. We also post on our website the
charters of our Audit, Compensation, and Nominations and Corporate Governance Committees; our Code
of Conduct, and Code of Ethics for the CEO and Senior Financial Officers, and any amendments or
waivers thereto; and any other corporate governance materials contemplated by SEC or NASDAQ
regulations. These documents are also available in print to any stockholders requesting a copy from
our corporate secretary at our principal executive offices. Strategy Our goal is to become a competitive licensor of proprietary emerging technologies that enable
unique design and functionality solutions for relevant industries. In order to achieve this
objective, we intend to expand our licensing model into additional proprietary technologies.Our
licensing model employs a network of manufacturers and technology alliances that sell to and
manufacture products for the OEMs. In some instances, we expect that OEMs may also license
technology directly for in-house production or for their suppliers. We believe this strategy
provides an avenue to commercialize additional technologies and open new mutually beneficial
relationships. We intend to pursue growth opportunities that expand our portfolio of licensable
technologies as it makes economic sense. Our licensing model requires proprietary technologies to succeed. Our first technology is our
electronic switch technology that was developed internally and then licensed. We expect to expand
our portfolio of licensable patented technologies through acquisitions or licenses from inventors
or assignees. We have proposed to change the name of our company to InPlay Technologies, Inc. We believe
that the proposed change in our companys name will enable us to establish an image consistent with
our strategy of leveraging our licensing model with additional technologies. The Duraswitch brand
will continue to be associated with the companys patented switch technologies. If the corporate
name change is approved by our stockholders at our 2005 annual meeting, we also intend to change
our common stock trading symbol. Electronic Switch Technologies We have developed, patented and licensed innovative technologies utilizing a magnetic-based
design for electronic switches. These technologies include pushbutton, rotary dials and
mouse/cursor controls that can be used in a wide range of applications. We believe our patented
technologies provide innovative solutions to the electronic switch design challenges faced by
original equipment manufacturers (OEMs), product designers and component suppliers. We license to switch manufacturers and OEMs the right to produce and sell products using our
technologies. We form strategic partnerships with suppliers of complementary products to further
market awareness of our technologies and provide material sourcing for our licensees. By partnering
with established manufacturers, we are expanding the use of our technologies by leveraging our
licensees manufacturing capabilities and customer relationships. Our goal is to continue to expand
our portfolio of licensable intellectual property for electronic components as well as other
emerging technologies. Electronic Switch Industry Analysis.Electronic switches and Integrated Control Panels
(ICPs) are used in a wide variety of consumer, industrial and agricultural products, such as
appliances, military equipment, airplanes, automobiles, security systems, temperature controls,
point-of-sale systems, elevators, medical equipment, computers, gas pumps, beverage dispensers,
gaming units, fitness equipment, consumer electronics and commercial food preparation equipment. History of Electronic Switches.In the last hundred years, two basic switches have dominated
the market for our 3




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switch technologies: electro-mechanical and membrane. In its simplest form, an
electronic switch controls the flow of electric current: press the switch to complete the circuit
and the current flows to operate a microprocessor, which in turn, performs the desired function.
Electro-mechanical switches operate by pushing, turning or sliding a button, knob or lever to
mechanically activate a series of movable parts that will close or complete a circuit within the
switch itself. Although they offer excellent tactile feedback for the user, electro-mechanical
switches are bulky, mechanically complex and can be difficult to integrate into certain ICPs. Membrane switches consist of multiple, thin-film layers topped by an overlay with printed
graphics or instructions to operate the device in which the switch is incorporated. A typical
example of a membrane switch is found on most microwave oven control panels. Without tactile
feedback, users may activate the switch multiple times, which could cause the opposite effect of
what the user intended. To solve the feedback response problem, membrane switch manufacturers
typically have offered a beep sound, light, or status icon on a display to inform the user when
the switch has been activated. However, this solution increases the cost, complexity and size of
the product to which it is added, thus decreasing the advantages of a membrane switch over an
electro-mechanical switch. The second option to overcome the feedback response problem is to incorporate a metal, rubber
or plastic dome as part of the membrane switch. When pressed by a user, the center of the dome will
invert and contact the circuit on the membrane layer beneath it. Domed membrane switches are prone
to failure due to material fatigue, are much less reliable than membrane switches without domes and
require inconsistent amounts of force to be activated. These limitations have frustrated users and
increased the cost and design complexity while decreasing the reliability of the switch. Duraswitch Electronic Switch Competitive Advantages The keys to our technologies are simplicity of design and reliance on magnetic force, rather
than mechanical parts or the elastic properties of materials, to operate a switch. Based on our
experience and available research in the electronic switch and ICP industries, we believe our
technologies offer several competitive advantages compared to switches and ICPs using traditional
electro-mechanical or membrane switch technologies, including the following: Significantly Greater Durability and Reliability.Our technologies rely on a magnetic-based
design with few moving parts and virtually no stress, fatigue, or potential breaking points. By
eliminating or reducing the mechanical complexity and precision required by traditional
technologies, we believe switches made with our technologies are significantly more durable and
reliable than traditional electro-mechanical and membrane switches. From January 1998 to January
2001, we tested one of our PushGate® pushbutton switches. It exceeded 500 million activations on an
electronic counter. Additionally, multiple samples of new PushGate switch designs routinely
successfully complete durability tests of between three and 50 million activations. We believe
these test results support our belief in the reliability and durability of products manufactured
using our PushGate technologies. Inherent Feedback Response.Membrane switches and some electro-mechanical switches require
additional cues such as beeps, lights or status icons to artificially provide feedback to the user
which increases the complexity and total cost of the switch. Our PushGate design consistently
produces a distinctive click each time the user activates our switch and eliminates the costs
associated with additional cues. Ease of Integration in Slim Profile, Environmentally Sealed Design.Because switches produced
using our technologies use a thin, multiple layer design that incorporates a flexible circuit
rather than bulky mechanical parts, they are easily integrated into flat panel/slim profile
products currently desired by the market. This design also eliminates the need to breach the
surface of the ICP, enabling our ICPs to be easily sealed, cleaned, disinfected and protected from
harsh environmental conditions. Value Engineering Alternative.We believe switches produced using our technologies offer a
better overall value compared to switches using traditional technologies. The integration
attributes of our technologies allow for a complete value engineering alternative to switch panel
designs, which can allow for cost reductions in various components and manufacturing processes. In
addition, devices using our switches are more durable and reliable than electro-mechanical switches
and are therefore less costly to maintain. Increased Design Capabilities.Our technologies inherently enable various designs that are not
easily achieved with traditional technologies. For example, our PushGate pushbutton switch can be
designed for large or odd shaped buttons using one actuator; to withstand high impact, extreme
temperature and altitude; and for dual output and normally closed designs. 4




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Duraswitch Electronic Switch Technology Strategies Maintain and Further Our Patented Technologies Competitive Advantages.We intend to maintain
and further our patented technologies competitive advantages in order to make our technologies
standard in the industry. We intend to pursue this strategy by aggressively marketing our
technologies advantages and broaden market awareness within our target industries. We are focusing
our sales and marketing efforts on our licensing program and will work together with licensees and
technology partners to further develop these technologies for specific commercial applications as
it makes economic sense. Increase Market Awareness of Duraswitchs Patented Technological Advantages.We plan to
aggressively promote our patented technologies and design expertise to achieve widespread market
awareness of our technologies advantages. Our promotional efforts will target design engineers and
purchasing managers, whom we believe are the primary decision makers within the switch purchasing
market. These efforts will include increasing exposure in trade magazines, increasing traffic to
our website, participating actively in vendor-sponsored seminars for design engineers and
aggressively promoting our technologies in the trade media. We believe that promoting our success
and our licensees successes in providing custom-designed solutions for a number of high-profile
companies will further enhance market awareness of our technologies and their unique competitive
advantages. License Switch Manufacturers and OEMs.We plan to continue to offer to license Duraswitch
technologies to switch manufacturers, turnkey manufacturers and OEMs as a product extension and a
market differentiation. We intend to target manufacturers in countries where we currently have
little or no representation, as well as manufacturers and OEMs who directly manufacture for, or
have key customers in, our target markets. When targeting OEMs, we offer to license directly,
license preferred manufacturers or provide information on currently licensed manufacturers. We
believe this flexible approach and the simplified requirement of our license agreements, whereby a
non-exclusive licensee pays us per-switch royalties for use of our technologies, reduces barriers
common to traditional licensing models that often require significant up-front fees to gain access
and charge royalties on a percentage-of-sales basis. Provide Training, Design Engineering and Marketing Support.We plan to provide engineering and
sales training at our licensees facilities, quarterly sales training in various locations across
North America and Europe as well as Web cast training on engineering updates and sales strategies
for our technologies. We believe we add value to our licensees efforts by offering design reviews
for new projects and by offering direct access to online design manuals. We will continue to expand
our lead generation efforts to drive potential business to our licensees through e-mail and direct
marketing campaigns. We plan to continue to enhance communications of our technology updates and sales techniques in order
to support our licensees. Target Key Industries with Potential for High-Volume Applications.We intend to continue to
market the advantages of our patented technologies to key high-volume markets including appliance,
medical and industrial controls. We believe that we have developed the technologies that meet the
needs of these industries and can educate OEMs on the benefits of utilizing our technologies in
future designs. In marketing directly to OEMs, we plan to be a source for design ideas by educating
engineers on the benefits our technologies offer. We promote the solutions our technologies have
provided for similar industries. We will also support our licensees sales efforts through sales
calls and engineering support. Duraswitch Electronic Switch Technologies We have a number of switch applications based on our patented magnetic-based technologies. We
have licensed the PushGate®, thiNcoder® and MagnaMouse to our licensees. Our non-exclusive
licensees typically pay royalties of $0.08 per PushGate ($0.10 including the licensed component
charge), between $0.25 and $0.75 per thiNcoder, and between $0.25 and $0.75 per MagnaMouse,
depending on volume. Licensees are charged separately for any licensed components they purchase
from us. Current prices for licensed components range from $0.02 per PushGate to $1.75 per
thiNcoder subassembly. Fees for additional technologies will be determined upon release. The Duraswitch PushGate®.A typical Duraswitch PushGate switch consists of up to five bonded
micro-thin layers of material, which collectively measure less than 1/10th of an inch.
The top layer of the switch is printed with a graphical overlay that indicates which buttons must
be pressed to activate a desired function, such as the on, defrost and cook buttons on a
microwave oven. Below the top layer is a thin, flexible layer of permanent magnetic material. Below
the magnetic layer is spacer material containing a hole through which a patented metal disc is
pushed. The disc has a small, raised, off-center button that is pushed by the user through the
surface of the switch. A flexible circuit or printed circuit board (PCB) is located at the bottom
of the switch. When the button is pressed, the disc separates from the magnet and the underside of
the disc completes the circuit by touching the contacts located on the printed circuit. When the
button is 5




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released, the magnet pulls the disc away from the switch contacts into its resting
position, and the circuit is broken. This magnetic-based design produces a consistent tactile
feedback response to the user each time the switch is activated. The PushGate can be designed in a membrane-type construction using a graphical overlay, or
used as the actuator under a custom keycap or housing. In 2001, we introduced the PushGate Island construction which reduces the number of material
layers and allows for the switching element of the PushGate to be fabricated as a freestanding
subassembly that can be easily inserted into a foam layer. The ability to manufacture the PushGate
as an Island simplifies the manufacturing process and reduces cost. In 2002, we introduced a number of unique constructions including the Large-Key PushGate,
High-Impact PushGate and Normally Closed-Normally Open design incorporating PushGate technology.
Each of these constructions provide distinct advantages in certain applications. In 2003, we introduced a Tact Switch design using our patented magnetically coupled armature. In 2004, we introduced additional PushGate designs including the Extreme Temperature/Altitude
PushGate and Peel-and-Place PushGate. The Duraswitch thiNcoder®.The Duraswitch thiNcoder resembles a typical volume control knob on
a car radio or a selector knob on a washing machine, except that unlike an electro-mechanical
rotary switch, our switch is integrated on a flex-circuit. The entire assembly can be less than
1/10th of an inch thick below the overlay. The Duraswitch thiNcoder consists of a rotary
knob containing embedded magnets all fastened to a flat surface. The top of the surface displays
instructions for the user. The bottom of the
surface seals a circular space below the magnet containing small gold-plated balls. Between
the magnets and the gold-plated balls are printed electronic circuits, which are activated through
contact with the gold-plated balls. When the user turns the knob, the magnet within the rotary knob
causes the gold-plated balls to rotate within their circular space. As the balls roll across the
flex-circuit membrane, they close or open the circuit and convey the users instructions to the
device. The design of the Duraswitch thiNcoder also allows for a tactile feedback response to the
user, such that the user can feel each click as the knob is turned. The thiNcoder has been used
for medical devices, agricultural equipment and industrial controls. The thiNcoder can also be
designed as a 5-bit encoder for applications that require a large number of selector positions such
as an appliance. The Duraswitch MagnaMouse.The Duraswitch MagnaMouse is an omni-directional switch that works
by using a disc-shaped actuator held by magnetic attraction. Pushing on the switch surface or any
custom designed key cap closes the contact and actuates the MagnaMouse. Electrodes are arranged to
produce different outputs when contacted in different locations. The MagnaMouse allows for the
integration of cursor control devices into ultra-thin, durable control panels, as well as a highly
reliable actuator under joystick controls. The Duraswitch PushFlex.The Duraswitch PushFlex technology combines a commonly available
magnet sheet and a magnetically receptive actuating layer to create a unique switch construction.
The actuating layer is a slotted flat configuration that aligns to holes cut in the magnetic layer.
Together, these layers form a web of switches. PushFlex offers an alternative to both domes and
conductive rubber keypads. The web configuration eliminates the need for individual placement of
domes, keeping assembly costs down. The entire tooling, sourcing and molding process for conductive
rubber keypads is eliminated. Because PushFlex offers a compelling cost-per-key value proposition,
development of the technology has been aimed at applications using numerous pushbuttons like a
typical keyboard. Customers Our success depends in part on our licensees ability to incorporate our technologies into
OEMs designs and products in key industry segments. As a result, we have licensed various custom
and turnkey switch manufacturers to produce switches for devices in a wide variety of industries.
Some of the key industries in which our licensees operate include the following: elevator, beverage
dispensing, energy management, test and measurement, medical, point-of-sale, appliance, vending
machine, gaming, recreational marine, industrial automation, health and fitness, restaurant
equipment, gas pump, mass transit, computer, lighting and sound, aerospace and industrial controls. In April 2000, we entered into an agreement whereby we received $4 million from Delphi
Automotive Systems LLC (Delphi) in exchange for: (a) Delphis exclusive right to utilize and
manufacture our patented switch technologies for the automotive industry, (b) a warrant to purchase
225,000 shares of our common stock at $7 per share and (c) an option to purchase approximately 1.65
million shares of our stock at $7 per share. The license agreement with Delphi generated 6




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licensing revenue of $1,407,978, or 80% of licensing revenue and $409,753 or 54% of licensing revenue in 2004
and 2003, respectively. In 2004, licensing revenue from Delphi primarily resulted from the
recognition of the first minimum royalty payment and recognition of deferred licensing revenue
which was recorded in 2000. In 2003, licensing revenue from Delphi primarily resulted from the
recognition of deferred licensing revenue. Intellectual Property Our success also depends in part on maintaining and protecting our proprietary technologies.
As a result, we have adopted an intellectual property protection policy designed to deter and stop
infringement. To deter infringement, we file United States and foreign patents for relevant
material technological advances and warn against potential infringement by posting patent numbers
on our products, packaging and published materials. Examples of these materials include our
website, brochures, advertisements and some technology samples. We have not had to become involved
in infringement litigation to protect our intellectual property, however, we intend to prosecute
litigation against infringers if necessary. In order to protect our trade secrets and other intellectual property, we also require our
employees, contract workers, consultants, advisors and collaborators to enter into confidentiality
agreements, which prohibit the disclosure of proprietary information to third parties or the use of
our proprietary information for commercial purposes. Our technical and sales employees also must
agree to disclose and assign to us all methods, improvements, modifications, developments,
discoveries and inventions conceived or developed on the job, using our property, or relating to
our business. As of December 31, 2004, we had $777,013 of capitalized costs related to patents, net
of accumulated amortization. As of March 15, 2005, we held 20 United States patents and 21 foreign patents. We also have
patent applications pending in the United States, Mexico, Canada, France, Great Britain, China,
Taiwan, Italy and Germany. We have made further filings under the Patent Cooperation Treaty, which
makes it possible to seek patent protection for an invention simultaneously in each of a large
number of countries by filing an international patent application. We have registered the following trademarks with the United States Patent and Trademark
Office: DuraswitchÒ, Duraswitch as a stylized word with a unique D, The World is
SwitchingÒ, PushGate®, and thiNcoder®. In addition, we have registration pending for
InPlay Technologies. Research, Development and Commercial Application Engineering We have three people in our research, development and commercial application engineering
department who focus on supporting our licensees in the design and implementation of products using
our technologies. These efforts include engineering manuals, design reviews, and on-site training
and manufacturing support. In 2002 and 2001, we dedicated a large amount of our resources to research and development and
the protection of our patented technologies. Through those efforts, we believe we developed a
portfolio of patented and patent-pending technologies that meet the needs of our licensees, their
customers and our target markets. In 2004 and 2003, we focused our engineering efforts on the
commercialization of these technologies through our licensees. Our research, development and
commercial application engineering department will continue to adapt our technologies as needed for
commercialization through our licensees, and patent any unique constructions. During 2004, 2003 and 2002, we spent $472,485, $917,610, and $2,614,905, respectively, on
research, development and commercial application engineering efforts. In late 2002, we announced
cost-cutting initiatives that included significant personnel reductions. We made additional
reductions in research and development personnel during 2003 and expect 2005 research, development
and commercial application engineering expenses to be comparable to 2004 levels. Sales and Marketing We have four people in the sales and marketing department who focus on supporting our existing
licensees, marketing our technologies to OEMs, obtaining new licensees and forming technology
alliances. In support of our licensees, we train their internal and independent sales and marketing
teams on Duraswitch technologies. Website: www.duraswitch.com.We believe design engineers and purchasing managers, the
individuals most likely to make the decision to incorporate our technologies in their products,
frequently use the Internet to search for design solutions. Therefore, our website,
www.duraswitch.com, is a key component of our current direct marketing efforts. Most of our
advertising and promotional materials direct readers to our website. In addition to attracting
potential licensees to our website for information, we use our website to generate interest in our
technologies. Using our website as a promotional tool 7




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is also less expensive than other methods, is
interactive and reaches a global audience. Our website has several features, including the
following:  
    information about the advantages of our patented technologies, accompanied by articles
published by third parties about our products;
    virtual demonstrations of our technologies and products;
    technical data to assist design engineers in designing ICPs and electronic products
using Duraswitch components;
    e-mail communication links to our design engineers and sales representatives to
facilitate dialogue about how our technologies can be integrated into customers products;
    information on products available through our current licensees customers; and
    benefits and the process for obtaining information about licensing rights to utilize
and manufacture Duraswitch technologies. Licensee Support.Our existing licensees and their sales representatives are an extension of
our marketing effort as they sell our technologies to their customers. We provide direct support by
attending sales calls and with one-on-one design reviews and conference calls. We also provide
generalized support and training to keep licensees abreast of technology developments, improvements
in processes, and sales tools. To communicate this, we have created a licensee-only section on our
website that includes:  
    Click: an e-newsletter highlighting engineering, manufacturing and procurement updates;
    The REPort: an e-newsletter with sales tips, licensee success stories, and technology updates;
    web cast training: interactive presentations on Duraswitch technologies given multiple
times to accommodate various time zones, and also archived;
    online training manuals: complete design and manufacturing manuals for our technologies
available online to ensure updates and enhancements are available immediately;
    sales presentations, marketing literature, images and logos available for licensees to
download and integrate with their own branded sales materials; and
    strategic technology partner contacts for procurement and support for complementary
products that our licensees often use when manufacturing our technologies. We are also able to negotiate with vendors who provide magnets, adhesives and other materials
used in the manufacture of our technologies to provide our licensees with preferred pricing. Public Relations.We target technical periodicals for media exposure in an effort to raise
awareness of Duraswitch technologies and our licensing strategy. Our public relations campaigns
have included editorial coverage of our technologies, co-operative advertising opportunities with
licensees and listings in industry-specific supplier guides. We believe this is a cost-effective
method of capturing the attention of design engineers and OEMs and educating them on the benefits
of our technologies. Articles on our technologies have been included in numerous trade publications
including Design News, EDN (Electronic Design News), EE Times, ECN (Electronic Component News), EPN
(Electronic Product News),as well as industry-specific publications such as Appliance Magazine,
National Petroleum News, and Elevator World. Seminars and Trade Shows.We present training seminars about our technologies at some
vendor-sponsored events for product design engineers. At these seminars, we are able to meet
attendees and provide them with information about our technologies through multi-media
presentations, product demonstrations, brochures and samples. We support the efforts of, and often
partner with, licensees and technology partners to broaden awareness of our technologies at these
events. For example, at electronica 2004, the worlds largest international summit for the
electronics industry held bi-annually in Germany, Duraswitch technologies were represented in
several licensee booths in addition to our own sales teams attendance. In October 2004, we also
attended electronicAsia to meet with potential licensees. Our sales and marketing team conducts regional training seminars for licensees and their sales
representatives. Over the past year, we held four regional seminars, training approximately 145
sales representatives that are associated with our licensees on the advantages of our technologies. Competition We operate in an industry characterized by intense competition. Our licensing model requires
proprietary patented technologies to succeed. Our first technology is our electronic switch
technology that was developed internally and then licensed. We expect to expand our portfolio of licensable
technologies through acquisitions or licenses from inventors or assignees. We expect to encounter
competition in the area of business opportunities from other entities having similar business
objectives. Many of these potential competitors may possess financial, technical, human and other
resources greater 8




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than ours. We anticipate that we will face increased competition in the future as
new companies enter the market. We believe that the primary competitors for our licensed electronic switch technologies are
manufacturers of electro-mechanical and dome membrane switches. Many of these manufacturers have
established products, broad brand and name recognition and significantly greater resources than we
do. Our strategy has not been to compete directly with these manufacturers, but to offer to license
them our switch technologies. If these manufacturers, as licensees, incorporate our technology into
their switches, we will have converted our competitors into business partners and Duraswitch
technology advocates. While a licensing business model fosters cooperation, switch manufacturers may not adopt
Duraswitchs technologies. In particular, manufacturers may be reluctant to alter current designs
or have other long-standing relationships that may affect the manufacturers decision to use one
technology over another, even if our technologies offer additional benefits. Employees As of March 15, 2005, we had 14 employees. None of our employees are covered by collective
bargaining agreements and we consider our employee relations to be good. Risk Factors You should carefully consider the following factors, in addition to those discussed elsewhere
in this report, in evaluation of our company and our business: We depend on our relationship with Delphi.We enter into license agreements and other similar
contractual relationships under which we license our technologies. Any termination or breach of our
relationship with Delphi, cessation of operations by Delphi, or non-performance under the license
agreement by Delphi, could have a material adverse effect on our business. Our license agreement
with Delphi requires Delphi to pay us minimum royalty payments of $12 million during 2004 through
2007. The first $1 million royalty payment was recognized as revenue effective June 30, 2004 and
was received in July 2004. Subsequent payments are due as follows: $2 million in July 2005; $3
million in July 2006; and $6 million in July 2007. Delphi can maintain exclusivity for the
automotive industry through June 30, 2012 by making additional minimum royalty payments during that
period. After June 30, 2012, either party may convert the agreement to a non-exclusive agreement
through 2020. To date, Delphi has only produced prototype quantities of switches under their
license agreement. There is no assurance and currently no indication that we will recognize revenue
from Delphi beyond the minimums specified in the agreement. We depend on our ability to identify and obtain additional technologies for our patent
portfolio.Our success will depend in part upon our ability to identify and obtain proprietary
technologies under terms and conditions that create an economic benefit for our company. Our
success is also dependent upon our ability to commercialize these technologies to economic
viability. Our technologies may not gain market acceptance.Our success will depend in part on the
commercial acceptance of our patented technology portfolio and our ability to license those patents
to companies with the ability to incorporate the technologies in a wide range of products. To be
accepted, our technologies must meet the expectations of our potential customers. We market our switch technologies directly to OEMs, whose products utilize switches, and to
our licensees to encourage them to incorporate our technologies in the switches they supply to
OEMs, focusing on the advantages of our switches over the electro-mechanical and dome membrane
switches. If the OEMs or our licensees ultimately decide to continue with their existing switch
technologies, our business would be adversely affected. Should we be unable to protect our proprietary technologies, their value and our competitive
position would be significantly impaired.Although we seek to protect our intellectual property
rights through patents, copyrights, trade secret protection and other measures,  
    we may be unable to adequately protect our technologies;
    competitors may be able to develop similar or better technologies independently;
    any of our pending patent applications may not be issued; or
    intellectual property laws may not continue to protect our intellectual property
rights, particularly as we expand our licensing in foreign countries where the local laws
do not provide strong protection of intellectual properties 9




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or recognize international treaties. Claims that we infringe third-party intellectual property rights could result in significant
expenses or restrictions on our ability to license technology.In recent years, there has been
significant litigation in the United States involving patents and other intellectual property
rights. From time to time, third parties may assert patent, copyright, trademark and other
intellectual property claims against technologies used in our business. Any such claims, with or
without merit, could be time-consuming to defend, would result in costly litigation and divert the
efforts of our personnel. Claims of intellectual property infringement might require us to enter
into costly royalty or license agreements. Additionally, we might be unable to obtain royalty or
license agreements on terms acceptable to us. A successful claim of patent or other intellectual
property infringement against us could have a material adverse affect on our business. We are not
currently involved in any litigation to protect our technologies from infringement or to defend
against claims of infringement. We may have difficulty protecting our intellectual property rights overseas.The laws of some
foreign countries do not protect proprietary rights to as great an extent as do the laws of the
United States, and many U.S. companies have encountered substantial infringement problems in some
foreign countries. Because some of our products are sold and a portion of our business is conducted
overseas, our exposure to intellectual property risks may be higher. Acquisitions could divert managements time and attention, dilute the voting power of existing
stockholders, and have a material adverse effect on our business.As part of our growth strategy,
we intend to acquire emerging proprietary technologies. Acquisitions that we may make in the future
could result in the diversion of time and personnel from our business. We also may issue shares of
common stock or other securities in connection with acquisitions, which could result in the
dilution of the voting power of existing stockholders and could dilute earnings per share. Any
acquisitions would be accompanied by other risks commonly encountered in such transactions,
including the following:  
    difficulties integrating the operations and personnel of acquired companies;
    additional financial resources required to fund the operations of acquired companies;
    potential disruption of our business;
    our ability to maximize our financial and strategic position by the incorporation of
acquired technology or businesses with our product offerings;
    difficulty of maintaining uniform standards, controls, procedures, and policies;
    potential loss of key employees of acquired companies;
    impairment of employee and customer relationships as a result of changes in management;
    significant expenditures to consummate acquisitions; and
    difficulties in meeting applicable regulatory requirements. Our quarterly revenue and operating results may fluctuate.Our results may fluctuate from
those in prior quarters and will continue to do so due to a variety of factors. These factors
include:  
    establishment, growth or loss of licensee relationships;
    timing of introductions, production and sales cycles of new products by our licensees
incorporating our technologies, which is at the discretion of our licensees and their
customers; and
    market acceptance of our technologies. Our stock price may be volatile.The stock market has experienced extreme volatility that
often has been unrelated or disproportionate to the performance of particular companies. These
market fluctuations may cause our stock price to decrease regardless of our performance. The market
price of our common stock has been, and in the future could be, significantly affected by factors
such as, but not limited to:  
    actual or anticipated fluctuations in operating results;
    announcements regarding our technologies or our competitors technologies, new
licensees or other business developments; and
    sales or the perception in the market of possible sales by insiders or others which
could have a disproportionate effect on our stock price due to our typically low trading
volume. The stock market has experienced significant price and volume fluctuations that have
particularly affected the market prices of the stocks of technology companies. Recently, the market
price of our common stock, like that of many technology companies, has experienced significant
fluctuations. For instance, from August 26, 1999, the date we became a reporting company, to March
24, 2005, the price of our common stock ranged from $0.56 to $17.92 per share. On March 24, 2005,
the last reported sale price of our common stock was $1.56. The market price of our common stock has been, and is likely to continue to be, significantly
affected by 10




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expectations of analysts and investors. Reports and statements of analysts do not
necessarily reflect our views. We depend on our management team.Our future success will be largely dependent on the efforts
of key management personnel. The loss of one or more of these key employees could have a material
adverse effect on our business. We depend upon the services of Robert J. Brilon, our Chief
Executive Officer, President, and Chief Financial Officer and Anthony J. Van Zeeland, our Chief
Technology Officer. Mr. Brilon has extensive experience in the formation, financing and management
of entrepreneurial companies. Mr. Van Zeeland has over 30 years experience in the switch industry.
We have employment agreements with Mr. Brilon for a term that expires April 30, 2005 and with Mr.
Van Zeeland for a term that expires December 31, 2007. Rights to acquire shares of common stock could result in dilution to other holders of common
stock.As of December 31, 2004, we had options to purchase 1,030,956 shares of common stock
outstanding under our stock option plans at a weighted average exercise price of $8.61 per share.
We have filed registration statements under the securities laws to register the common stock to be
issued under our stock option plans. As a result, shares issued under these plans will be freely
tradable without restriction unless acquired by affiliates of our company, who will be subject to
the volume and other limitations of Rule 144. In 2005, our Board of Directors approved the 2005
Stock Award Plan which provides for the issuance of up to 500,000 shares of stock. If the plan is
approved by stockholders, we will file a registration statement to register the common stock to be
issued under the plan. The existence of such stock options could adversely affect the terms on
which we can obtain additional financing, and the option holders can be expected to purchase shares
at a time when we, in all likelihood, would be able to obtain additional capital by offering shares
of common stock on terms more favorable to us than those provided by such options. We have a history of operating losses.We have had substantial losses since our inception. We
expect to continue committing substantial resources to the establishment and support of new
licensee relationships. We are unable to accurately estimate future revenue based upon historical performance and we
cannot assure you if and when we will become profitable. Risks related to rapidly changing technology.Our results of operations will depend in part on
successful management of the challenges of rapidly changing technology and evolving industry
standards characteristic of the market for switch technology. We may encounter additional
challenges as we expand our intellectual property portfolio into new markets. These challenges
include predicting the nature and timing of technological changes and the direction of evolving
industry standards and identifying, developing and successfully marketing new technologies as they
emerge. We work with our licensees and OEMs to design solutions specific to their needs and the
needs of their customers. Our growing international business activities subject us to risks that could reduce the demand
for our products and increase our operating expenses.In 2004, net revenue from international
licensees represented 11% of our total net revenue. We have been expanding our licensing business
with international licensees and expect that net revenue from international licensees will
increase. To date, all of our licensing revenue and substantially all of our costs have been
denominated in U.S. dollars. We expect that net revenue and substantially all of our costs will
continue to be denominated in U.S. dollars for the foreseeable future. We could be significantly
affected by other risks associated with international activities, including the following:  
    different technology standards and design requirements;
    longer payment cycles for and greater difficulties collecting accounts receivable;
    fluctuations in currency exchange rates;
    nationalization, expropriation and limitations on repatriation of cash;
    social, economic, banking and political risks;
    taxation;
    changes in U.S. laws and policies affecting trade, foreign investment and loans; and
    changes in enforcement of laws protecting intellectual property. 
 Item 2. Description of Property. Our principal administrative and design facilities are located in Mesa, Arizona, where we
presently lease 8,926 square feet of office space in a building located at 234 South Extension
Road. Our lease terminates on December 31, 2005, subject to our option to extend the term for three
additional one-year periods. We believe our current facilities will be sufficient for our
operational purposes for the foreseeable future and any additional facilities needed thereafter
will be available on commercially reasonable terms. 11




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Item 3. Legal Proceedings. From time to time we may be subject to claims and litigation incident to our business. As of
March 15, 2005, we were not a party to any material legal proceedings. 
 Item 4. Submission of Matters to a Vote of Security Holders. None. 12




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PART II 
 Item 5. Market for Common Equity and Related Stockholder Matters. Market Information Our common stock is listed on the NASDAQ SmallCap Market under the symbol DSWT. We expect to
change our common stock symbol in connection with the change in our company name to InPlay
Technologies, Inc. The following table sets forth high and low sale prices of the common stock for
each calendar quarter indicated as reported on the NASDAQ National Market or NASDAQ SmallCap
Market, as applicable. High
    
    
    LowFiscal Year Ended December 31, 2005First Quarter (through March 15, 2005)
    
    $
    2.60
    
    
    $
    1.30Fiscal Year Ended December 31, 2004First Quarter
    
    $
    2.75
    
    
    $
    1.60Second Quarter
    
    
    4.70
    
    
    
    2.05Third Quarter
    
    
    3.01
    
    
    
    1.95Fourth Quarter
    
    
    2.92
    
    
    
    1.80Fiscal Year Ended December 31, 2003First Quarter
    
    $
    1.30
    
    
    $
    0.67Second Quarter
    
    
    3.00
    
    
    
    0.50Third Quarter
    
    
    2.21
    
    
    
    1.25Fourth Quarter
    
    
    2.20
    
    
    
    1.45
 Dividends We have never declared any cash dividends on our common stock since we currently intend to
retain any future earnings to finance future growth. We do not intend to declare any dividends on
our common stock in the foreseeable future. Holders As of March 15, 2005, there were approximately 325 holders of record of our common stock. We
believe that our common stock is held by more than 2,000 beneficial holders. 
 Item 6. Managements Discussion and Analysis or Plan of Operation. The following discussion should be read in conjunction with our audited consolidated financial
statements and associated notes appearing elsewhere in this report. Overview We are a licensor of patented, enabling technologies. We currently license electronic
pushbutton, rotary and omni-directional switch technologies and are actively searching for
additional innovative technologies. We have developed, patented and licensed innovative technologies utilizing a magnetic-based
design for electronic switches. We are currently expanding the use of these technologies by
licensing manufacturers to produce and sell products using our technologies. We believe these
patented and patent-pending technologies allow us and our licensees to provide innovative solutions
to the design challenges faced by OEMs and component suppliers. In 2001, we completed our transition to our model of licensing our technologies rather than
manufacturing switches ourselves and expect substantially all of our future revenues to come from
our licensing efforts. As of March 15, 2005, we had 30 licensees of our switch technologies,
foreign and domestic. We anticipate that licensing revenue will fluctuate from period to period. It will be
difficult for us to predict the timing and magnitude of such revenue, as it depends on the
licensees ability to market, produce and ship products that 13




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incorporate our technologies. We believe that the amount of licensing revenue for any period
is not necessarily indicative of results for any future period. Our research, development and commercial application engineering expenses are comprised mainly
of personnel and occupancy costs. Our selling, general and administrative expenses are comprised
mainly of personnel costs, legal and accounting fees, depreciation, and insurance. Application of Critical Accounting Policies We have identified the policies below as critical to our business operations and the
understanding of our results of operations. The impact and any associated risks related to these
policies on our business operations are discussed throughout Managements Discussion and Analysis
or Plan of Operation when such policies affect our reported or expected financial results. In the ordinary course of business, we have made a number of estimates and assumptions
relating to the reporting of results of operations and financial condition in the preparation of
our financial statements in conformity with accounting principles generally accepted in the United
States. We base our estimates on historical experience and on various other assumptions that we
believe are reasonable under the circumstances. The results form the basis for making judgments
about the carrying values of assets and liabilities that are not readily apparent from other
sources. Actual results could differ significantly from those estimates under different assumptions
and conditions. We believe that the following discussion addresses our most critical accounting
policies, which are those that are most important to the portrayal of our financial condition and
results of operations and require our most difficult, subjective, and complex judgments, often as a
result of the need to make estimates about the effect of matters that are inherently uncertain. Revenue Recognition.We enter into licensing agreements with our customers. Our licensing
strategy incorporates a requirement whereby the licensee purchases licensed components from us. The
purchase price of the licensed components includes the royalty fee. When the components are
shipped, we recognize licensing revenue and licensing cost of goods sold. In some cases where no
licensed components are supplied, we are paid a royalty per switch manufactured by the licensee and
we recognize revenue in the period the switch is manufactured. In the case of the Delphi minimum
royalty payments, we recognize revenue as it is earned: either as Delphi sells products
incorporating our technologies; or in the event that the royalties earned on the sale of Delphi
products is less than the minimum royalty payment, we recognize the difference between royalties
previously recognized and the minimum royalty payment as revenue on June 30 of each applicable
year. Some of our licensees have prepaid royalties to us pursuant to their license agreements. These
prepayments are recorded as deferred revenue. This deferred revenue is recognized as licensing
revenue when earned under the licensing agreement. If a licensee purchases a licensed component
from us, the royalty is earned when the licensed component is shipped. If the licensee is directly
manufacturing our switches without purchasing licensed components from us, we consider the royalty
earned when the switch is manufactured. In the case of our exclusive license agreement with Delphi,
the up-front payment is nonrefundable and the portion of the $4.0 million payment allocated to
deferred revenue is being amortized over the initial seven-year term of the agreement. (See Note 8
of our Notes to Consolidated Financial Statements.) Inventory Valuation.Our inventory is primarily comprised of licensed components, which are
sold to licensees. We state inventories at the lower of cost or market value, determined using the
first-in, first-out method. Our policy is to write down our inventory for estimated obsolescence or
unmarketable inventory to the extent the cost exceeds the estimated market value. We base the
estimate on our assumptions about future demand and market conditions. If actual market conditions
are less favorable than those assumed in our estimates, additional inventory write-downs might be
required. We reflect any write-down of inventory in the period in which the facts giving rise to
the inventory write-down become known to us. Impairment or Disposal of Long-Lived Assets.We review our long-lived assets and identifiable
intangibles for impairment whenever events or changes in circumstances indicate that the carrying
amount of the asset may not be recoverable. Additionally, goodwill is reviewed on an annual basis.
Our intangible assets are primarily our patents and the goodwill associated with the acquisition of
Aztec Industries. If such assets were considered to be impaired, the impairment to be recognized
would be measured by the amount by which the carrying amount of the assets exceeds the fair market
value of the assets. We evaluate the recoverability of property and equipment and intangibles (excluding goodwill)
not held for sale by comparing the carrying amount of the asset or group of assets against the
estimated undiscounted future net cash flows expected to result from the use of the asset or group
of assets. If the undiscounted estimated cash flows are less than the carrying value of the asset
or group of assets being reviewed, an impairment loss would be recorded. The loss would be 14




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measured based on the estimated fair value of the asset or group of assets compared to its
carrying value. The estimated fair value would be based on the best information available under the
circumstances, including prices for similar assets and the results of valuation techniques,
including the present value of expected future cash flows using a discount rate commensurate with
the risks involved. We evaluate goodwill for impairment by comparing the estimated fair value of our company,
which is the only reporting unit, with the carrying value, including goodwill. The estimated fair
value is based on the best information available under the circumstances, including quoted market
prices in stock markets, valuation techniques based on earnings, or independent valuations. If the
fair value of our company exceeds the carrying amount, goodwill is not considered to be impaired.
If the carrying amount of our company exceeds our fair value, the fair value of the goodwill is
calculated, and the excess of the carrying value of the goodwill over its fair value is recorded as
an impairment loss. To determine the fair value of goodwill, our fair value is allocated to all of
our assets and liabilities, and any excess of fair value of our company over the fair value of our
assets and liabilities is the estimated fair value of goodwill. Results of Operations for the Year Ended December 31, 2004 Compared to the Year Ended December 31,
2003 Net Revenue.We recorded net revenue of $1,757,053 for the year ended December 31, 2004,
compared to $759,912 for the year ended December 31, 2003, an increase of $997,141. The increase is
due to the recognition of the first $1 million minimum royalty payment from Delphi. Our license agreement with Delphi generated licensing revenue of $1,407,978 or 80% of our
licensing revenue and total net revenue for the year ended December 31, 2004 and $409,753 or 54% of
our licensing revenue and total net revenue for the year ended December 31, 2003. Licensing revenue
from Delphi primarily resulted from the recognition of the first $1 million minimum royalty payment
and recognition of deferred licensing revenue which was recorded in 2000. Delphis license
agreement also includes minimum royalty payments of $11 million during 2005 through 2007. The
remaining installments are due as follows: $2 million in July 2005; $3 million in July 2006; and $6
million in July 2007. To date, the majority of non-exclusive licensing revenue has been related to our PushGate
pushbutton technology. The number of unit sales of royalty-bearing PushGates has fluctuated during
the last three years from approximately 2.8 million in 2002 to 2.3 million in 2003 to 1.8 million
in 2004. The decrease from 2002 to 2003 was primarily due to the 2002 sale of one million units to
one licensee not being replicated in 2003 and was offset by increased unit sales to other
licensees. The decrease from 2003 to 2004 was primarily due to a decrease in the number of new
licensees in 2004 purchasing initial inventories. In 2003, we had eight new licensees that
purchased approximately 740,000 units. In 2004 we had one new licensee. In 2004, the revenue impact
of the decrease in unit sales of PushGates was offset by the sale of other materials used in switch
construction that we sell to licensees as an additional service. Cost of Goods Sold.Total cost of goods sold and licensing cost of goods sold was $187,547 for
the year ended December 31, 2004, compared to $103,304 for the year ended December 31, 2003, an
increase of $84,243. The increase in cost of goods sold for the year ended December 31, 2004 versus
2003 was primarily due to two factors: 1) an increase in our cost of the PushGate licensed
components; and 2) increased sales of other low margin materials. The increase in our cost of the
PushGate licensed components was due to quality issues with licensed components that we received
from a foreign supplier. Because of the quality issues, we incurred additional costs to obtain
licensed components from a domestic supplier. We believe that our foreign supplier quality issues
will be resolved in the short term. The increases in the cost of goods sold of other materials
resulted from increased sales of low margin materials (such as magnet and spacer materials) that we
sell to our licensees as an additional service. We anticipate that our gross profit as a percentage
of revenue will fluctuate in future periods as we experience changes in the percentage of revenue
generated from sales of licensed components, royalties from licensees who manufacture products
utilizing our technologies without purchasing licensed components from us and the recognition of
deferred revenue from our licensing agreement with Delphi. Selling, General and Administrative Expenses.Selling, general and administrative expenses
were $1,907,034 for 2004, compared to $2,299,750 for 2003, a decrease of $392,716. The decrease in
selling, general and administrative expenses was primarily related to the full-year impact of
personnel reductions which were made in 2003 and decreased occupancy costs due to entering into a
new building lease. As revenue increases, additional commission expense will be incurred including
a 5% commission on cash received from Delphi related to their license agreement. Additionally, in
2005, we expect to incur additional expense to compensate our Board of Directors at a level more
commensurate with time spent and industry standards. We may incur additional expense to comply with
new SEC regulations in 2005 and we expect compliance costs to further increase in 2006. Research, Development and Commercial Application Engineering Expenses.Research, development
and 15




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commercial application engineering expenses were $472,485 for 2004, compared to $917,610 for
2003, a decrease of $445,125. The decrease was primarily attributable to costs related to decreased
research and development personnel and decreased occupancy costs. We anticipate that 2005 research,
development and commercial application engineering expenses will be comparable to 2004 expenses. In October 2002, we announced cost-cutting initiatives that included significant reductions in
research and development personnel focused on new technologies. In 2003, we continued the cost
cutting initiatives and made further personnel reductions. As part of our reduced research and
development activities, we entered into a new employment agreement with our co-founder and Chief
Technology Officer. The new agreement reduced his salary and time commitment to Duraswitch by 50%.
We have created a portfolio of patented and patent-pending technologies which are available through
our licensees. The efforts of our remaining personnel will continue to be directed at
commercializing our technologies as opposed to also focusing on the creation of new technologies.
They will continue to support our licensees in their efforts to commercialize our existing patented
and patent-pending technologies. Loss from Operations.As a result of the recognition of the Delphi minimum royalty revenue and
the decreases in selling, general and administrative expenses and research, development and
commercial application engineering expenses, loss from operations decreased to $810,013 for the
year ended December 31, 2004, compared to $2,560,752 for the year ended December 31, 2003, a
decrease of $1,750,739. Impairment Loss on Note Receivable.On April 21, 2004 we entered into an agreement to acquire
all of the shares of Active Recognition Technologies, Inc. (ART), a privately held developer and
licensor of vehicle and license plate recognition software. We are not required to close the
transaction unless ART achieves $400,000 of net revenue and $100,000 average earnings before
interest and taxes (EBIT) for two consecutive fiscal quarters prior to July 31, 2005. Since the
execution of the agreement, ART has not satisfied either of these conditions. During the twelve
months following the execution of the agreement, we committed to provide funding to ART, up to a
maximum of $500,000, in the form of convertible debt. The debt bears interest at 5% per annum,
matures April 2006, and is secured by a first priority lien on all assets of ART. At December 31,
2004, we had advanced $390,000 under the loan. The remaining $110,000 was advanced during the first
quarter of 2005. The loan is convertible, at our option, into 12.5% of ARTs outstanding capital
stock on a fully diluted basis upon the closing of the acquisition or the acceptance by ART of a
superior offer to purchase ART. If the closing of the acquisition occurs, we will issue 950,000
shares of our restricted common stock to the shareholders of ART. The shares have demand
registration rights no earlier than March 31, 2005. An additional 850,000 shares of restricted
common stock, or a prorated portion thereof, will be issued upon ART achieving accumulated EBIT of
$4 million over a three-year period. Both the initial acquisition shares and the earn-out shares
will be reduced if we convert any outstanding convertible debt into ART shares. We believe ART will not achieve the revenue or EBIT levels which are required as a condition
of closing. We also believe that there is no assurance that ART will achieve positive cash flow or
obtain additional financing that would allow it to repay the convertible debt or allow ART to
continue as a going concern for the next twelve months. As a result, we have recorded an impairment
loss for the year ending December 31, 2004 for the total commitment of $500,000. We have no
commitment to fund ART operations beyond the $500,000. We have entered into an agreement with ART whereby we earn commissions for business generated
for ART and we have a reseller agreement which allows us to sell ART license plate recognition
software technology. We are continuing to evaluate the potential for ART to attain a level of
revenue and EBIT that could result in our acquiring ART. We do not expect to close the acquisition
on the previously announced terms and cannot determine at this time if we will agree upon new
terms. Interest and Other Income-Net.Interest and other income-net was $37,935 for 2004 compared to
$10,191 for 2003, an increase of $27,744. Net Loss.The decrease of $1,278,483 or 50% in the net loss to $1,272,078 for the year ended
December 31, 2004 from $2,550,561 for the year ended December 31, 2003 was primarily a result of
the recognition of the Delphi minimum royalty revenue, decreased selling, general and
administrative expenses and decreased research, development and commercial application engineering
expenses. 16




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Results of Operations for the Year Ended December 31, 2003 Compared to the Year Ended December 31,
2002 Net Revenue.We recorded net revenue of $759,912 for the year ended December 31, 2003,
compared to $772,169 for the year ended December 31, 2002, a decrease of $12,257. The decrease is
due to the expected decrease in product revenue as a result of the completion of our transition
from manufacturing to licensing switch technologies. Licensing revenue was $759,912 and $747,494 for the years ended December 31, 2003 and 2002,
respectively, an increase of $12,418 or 2%. Our licensing revenue is primarily comprised of the
recognition of revenue resulting from the recognition of deferred revenue from our license
agreement with Delphi and per-switch revenue from non-exclusive licensees who manufacture switches
incorporating our technologies. The per-switch revenue includes royalties and revenue from the sale
of licensed components. Our license agreement with Delphi generated licensing revenue of $409,753 or 54% of our
licensing revenue and total net revenue for the year ended December 31, 2003 and $409,380 or 55% of
our licensing revenue and 53% of our total net revenue for the year ended December 31, 2002.
Licensing revenue from Delphi primarily resulted from the recognition of deferred licensing
revenue, which was recorded in 2000. Product revenue was $0 and $24,675 for the years ended December 31, 2003 and 2002,
respectively, a decrease of $24,675. The decrease reflects our transition to a technology licensing
company. The $24,675 of product revenue for the year ended December 31, 2002 was related to fees
received for engineering services we had provided to a customer in prior periods that were in
dispute. We do not expect to have any significant product revenue in the future. Cost of Goods Sold.Total cost of goods sold and licensing cost of goods sold was $103,304 for
the year ended December 31, 2003, compared to $156,406 for the year ended December 31, 2002, a
decrease of $53,102. The decrease in cost of goods sold and increase in gross profit as a
percentage of revenue to 86% in 2003 from 80% in 2002 was primarily due to a 2002 charge to
licensing cost of goods sold related to earlier versions of licensed components that will no longer
be promoted and will only be considered as an alternative to our current licensed component
inventories in limited circumstances. There was no comparable charge in 2003. Selling, General and Administrative Expenses.Selling, general and administrative expenses
were $2,299,750 for 2003, compared to $2,857,609 for 2002, a decrease of $557,859. The decrease in
selling, general and administrative expenses was primarily related to personnel reductions. Research, Development and Commercial Application Engineering Expenses.Research, development
and commercial application engineering expenses were $917,610 for 2003, compared to $2,614,905 for
2002, a decrease of $1,697,295. The decrease was primarily attributable to costs related to
decreased research and development personnel. In 2001, we added personnel and increased our
modeling and testing capabilities, resulting in increased costs. As we entered 2002, we began to
reduce these expenses primarily by reducing research and development personnel. In 2002 and 2003,
research and development expenses decreased each quarter from the preceding quarter. In October 2002, we announced cost-cutting initiatives that included significant reductions in
research and development personnel focused on new technologies. In 2003, we continued the cost
cutting initiatives and made further personnel reductions. As part of our reduced research and
development activities, we entered into a new employment agreement with our co-founder and Chief
Technology Officer. The new agreement reduced his salary and time commitment to Duraswitch by 50%. Loss from Operations.As a result of the decreases in selling, general and administrative
expenses and research, development and commercial application engineering expenses, loss from
operations decreased to $2,560,752 for the year ended December 31, 2003, compared to $4,856,751 for
the year ended December 31, 2002, a decrease of $2,295,999. Interest and Other Income-Net.Interest and other income-net was $10,191 for 2003 compared to
$150,699 for 2002, a decrease of $140,508. The decrease in other income-net is due to the decrease
in investment income as a result of lower interest rates and lower average cash balances. Net Loss.The decrease of $2,155,491 or 46% in the net loss to $2,550,561 for the year ended
December 31, 2003 from $4,706,052 for the year ended December 31, 2002 was primarily a result of
decreased selling, general and administrative expenses and decreased research, development and
commercial application engineering expenses. 17




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Liquidity and Capital Resources We had cash and cash equivalents of $2,832,455 on December 31, 2004. During the past two
years, we have experienced decreases in our cash and cash equivalents primarily as a result of cash
used in operations. Net cash used in operating activities during the year ended December 31, 2004 was $1,004,678.
Cash used in operating activities consisted primarily of the net loss. Net cash used in investing activities during the year ended December 31, 2004 was $439,092.
Our net cash used in investing activities was primarily related to our agreement to acquire ART and
included advances to them of $390,000 in the form of convertible debt. We funded the remaining
$110,000 of our $500,000 obligation during the first quarter of 2005. Net cash provided by financing activities during the year ended December 31, 2004 was $19,247,
consisting primarily of net proceeds from the sale of stock related to the exercise of employee
stock options, which was partially offset by principal payments on capital lease obligations. Our license agreement with Delphi requires Delphi to pay us minimum royalty payments totaling
$12 million during 2004 through 2007. The first $1 million minimum royalty payment was earned
effective June 30, 2004 and was received in July 2004. Subsequent payments are due as follows: $2
million in July 2005; $3 million in July 2006; and $6 million in July 2007. Delphi can maintain
exclusivity for the automotive industry through June 30, 2012 by making additional minimum annual
royalty payments during that period. After June 30, 2012, either party may convert the agreement to
a non-exclusive agreement through 2020. On April 21, 2004 we entered into an agreement to acquire all of the shares of ART, a
privately held developer and licensor of vehicle and license plate recognition software. We are not
required to close the transaction unless ART achieves $400,000 of net revenue and $100,000 average
EBIT for two consecutive fiscal quarters prior to July 31, 2005. Since the execution of the
agreement, ART has not satisfied either of these conditions. During the twelve months following the
execution of the agreement, we committed to provide funding to ART, up to a maximum of $500,000, in
the form of convertible debt. The debt bears interest at 5% per annum, matures April 2006, and is
secured by a first priority lien on all assets of ART. At December 31, 2004, we had advanced
$390,000 under the loan. The remaining $110,000 was advanced during the first quarter of 2005. The
loan is convertible, at our option, into 12.5% of ARTs outstanding capital stock on a fully
diluted basis upon the closing of the acquisition or the acceptance by ART of a superior offer to
purchase ART. If the closing of the acquisition occurs, we will issue 950,000 shares of our
restricted common stock to the shareholders of ART. The shares have demand registration rights no
earlier than March 31, 2005. An additional 850,000 shares of restricted common stock, or a prorated
portion thereof, will be issued upon ART achieving accumulated EBIT of $4 million over a three-year
period. Both the initial acquisition shares and the earn-out shares will be reduced if we convert
any outstanding convertible debt into ART shares. We believe ART will not achieve the revenue or EBIT levels which are required as a condition
of closing. We also believe that there is no assurance that ART will achieve positive cash flow or
obtain additional financing that would allow it to repay the convertible debt or allow ART to
continue as a going concern for the next twelve months. As a result, we have recorded an impairment
loss for the year ending December 31, 2004 for the total commitment of $500,000. We have no
commitment to fund ART operations beyond the $500,000. We have entered into an agreement with ART whereby we earn commissions for business generated
for ART and we have a reseller agreement which allows us to sell ART software technology. We are
continuing to evaluate the potential for ART to attain a level of revenue and EBIT that could
result in our acquiring ART. We do not expect to close the acquisition on the previously announced
terms and cannot determine at this time if we will agree upon new terms. We have a management services agreement with ART and are paid a monthly fee of $2,600. In
exchange, we provide office space and assistance with accounting and corporate marketing. The
agreement terminates upon the earlier of: the closing of the acquisition or December 31, 2005. At December 31, 2004, we had net operating loss carryforwards for federal income tax purposes
of $20.2 million which expire in 2011 through 2024 and net operating loss carryforwards for state
income tax purposes of $17.8 million which expire 2005 through 2009. We have experienced significant operating losses since our inception. We believe that our cash
on hand will be sufficient to meet our anticipated cash needs for working capital and capital
expenditures for at least 12 months. However, 18




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##### Table of Contents



our capital expenditures and working capital requirements could increase depending on our
operating results and other adjustments to our operating plan as may be needed to respond to
competition or unexpected events. We continually evaluate our working capital needs and we may seek
to obtain additional working capital through debt or equity offerings. There can be no assurance
that additional funds will be available on acceptable terms. In the event that additional funds are
not available on acceptable terms, we could be required to reduce the scope of or cease operations. The following table sets forth our contractual obligations and commitments as of December 31,
2004: Payments Due by PeriodLess than 1Contractual obligations
    
    year
    
    
    1-3 years
    
    
    Thereafter
    
    
    TotalOperating leases
    
    $
    66,621
    
    
    $
    29,135
    
    
    $
    
    
    
    $
    95,756Purchase order obligations
    
    
    11,439
    (1)
    
    
    93,375
    (2)
    
    
    
    
    
    
    104,814Total contractual cash obligations
    
    $
    78,060
    
    
    $
    122,510
    
    
    $
    
    
    
    $
    200,570
   (1)
    
    Represents open commitments to acquire licensed components within the next twelve months.(2)
    
    Represents the cost of tooling for volume production of PushGate Island magnets which has
been built to our specifications. Commitment will be reduced by each component part which is
sold by the vendor. 19




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##### Table of Contents



Item 7. Financial Statements. REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM Board of Directors
Duraswitch Industries, Inc.
Mesa, Arizona We have audited the accompanying consolidated balance sheets of Duraswitch Industries, Inc. and
subsidiaries (the Company) as of December 31, 2004 and 2003, and the related consolidated
statements of operations, stockholders equity, and cash flows for each of the three years in the
period ended December 31, 2004. These financial statements are the responsibility of the Companys
management. Our responsibility is to express an opinion on these 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. The
Company is not required to have, nor were we engaged to perform, an audit of its internal control
over financial reporting. Our audit included consideration of internal control over financial
reporting as a basis for designing audit procedures that are appropriate in the circumstances, but
not for the purpose of expressing an opinion on the effectiveness of the Companys internal control
over financial reporting. Accordingly, we express no such opinion. An audit also includes
examining, on a test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates made by management,
as well as evaluating the overall financial statement presentation. We believe that our audits
provide a reasonable basis for our opinion. In our opinion, such consolidated financial statements present fairly, in all material respects,
the financial position of Duraswitch Industries, Inc. and subsidiaries at December 31, 2004 and
2003, and the results of their operations and their cash flows for each of the three years in the
period ended December 31, 2004 in conformity with accounting principles generally accepted in the
United States of America. DELOITTE & TOUCHE LLP
Phoenix, Arizona March 24, 2005 20




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DURASWITCH INDUSTRIES, INC. CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 2004 AND 2003 
 2004
    
    
    2003ASSETSCURRENT ASSETSCash and cash equivalents
    
    $
    2,832,455
    
    
    $
    4,256,978Accounts
receivable (net of allowance for doubtful accounts of $0 in 2004 and $12,000 in 2003)
    
    
    48,601
    
    
    
    49,763Inventory  Net (Note 4)
    
    
    217,083
    
    
    
    171,522Prepaid expenses and other current assets
    
    
    83,470
    
    
    
    113,434Total current assets
    
    
    3,181,609
    
    
    
    4,591,697PROPERTY AND EQUIPMENT  Net (Note 6)
    
    
    198,589
    
    
    
    314,712GOODWILL
    
    
    443,874
    
    
    
    443,874PATENTS  Net (Note 7)
    
    
    777,013
    
    
    
    789,184OTHER ASSETS (Note 5)
    
    
    66,297
    
    
    
    103,837TOTAL
    
    $
    4,667,382
    
    
    $
    6,243,304LIABILITIES AND STOCKHOLDERS EQUITYCURRENT LIABILITITESAccounts payable
    
    $
    59,674
    
    
    $
    73,452Accrued salaries and benefits
    
    
    187,289
    
    
    
    162,817Other accrued expenses and other current liabilities (Note 5)
    
    
    242,045
    
    
    
    164,469Deferred licensing revenue (Note 8)
    
    
    485,254
    
    
    
    471,033Current portion of capital leases payable
    
    
    
    
    
    
    8,213Total current liabilities
    
    
    974,262
    
    
    
    879,984LONG-TERM LIABILITIESOther non-current liabilities
    
    
    18,486
    
    
    
    29,687Deferred licensing revenue  long-term (Note 8)
    
    
    546,257
    
    
    
    960,638Total long-term liabilities
    
    
    564,743
    
    
    
    990,325Total liabilities
    
    
    1,539,005
    
    
    
    1,870,309COMMITMENTS AND CONTINGENCIES (Notes 3, 5 and 14)STOCKHOLDERS EQUITY (Notes 9 and 10)Preferred
stock, no par value, 10,000,000 shares authorized, no shares issued and outstanding in 2004 and 2003
    
    
    
    
    
    
    Common stock, $.001 par value, 40,000,000 shares authorized
in 2004 and 2003, 9,614,673 and 9,591,673 shares issued and
outstanding in 2004 and 2003, resepectively
    
    
    9,615
    
    
    
    9,592Additional paid-in capital
    
    
    27,410,916
    
    
    
    27,383,479Accumulated deficit
    
    
    (24,292,154
    )
    
    
    (23,020,076
    )Total stockholders equity
    
    
    3,128,377
    
    
    
    4,372,995TOTAL
    
    $
    4,667,382
    
    
    $
    6,243,304
 See notes to consolidated financial statements. 21




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DURASWITCH INDUSTRIES, INC. CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002 
 2004
    
    
    2003
    
    
    2002NET REVENUE (Note 3):Licensing (Note 8)
    
    $
    1,757,053
    
    
    $
    759,912
    
    
    $
    747,494Product
    
    
    
    
    
    
    
    
    
    
    24,675Total net revenue
    
    
    1,757,053
    
    
    
    759,912
    
    
    
    772,169COST OF GOODS SOLD:Licensing
    
    
    187,547
    
    
    
    103,304
    
    
    
    156,406Product
    

    
    
    
    
    
    
    
    
    
    Total cost of goods sold
    
    
    187,547
    
    
    
    103,304
    
    
    
    156,406Gross profit
    
    
    1,569,506
    
    
    
    656,608
    
    
    
    615,763OPERATING EXPENSES:Selling, general and administrative
    
    
    1,907,034
    
    
    
    2,299,750
    
    
    
    2,857,609Research, development and commercial
application engineering
    
    
    472,485
    
    
    
    917,610
    
    
    
    2,614,905Total operating expenses
    
    
    2,379,519
    
    
    
    3,217,360
    
    
    
    5,472,514LOSS FROM OPERATIONS
    
    
    (810,013
    )
    
    
    (2,560,752
    )
    
    
    (4,856,751
    )OTHER (EXPENSE) INCOME:Impairment loss on note receivable (Note 5)
    
    
    (500,000
    )
    
    
    
    
    
    
    Interest and
other income - net
    
    
    37,935
    
    
    
    10,191
    
    
    
    150,699NET LOSS
    
    $
    (1,272,078
    )
    
    $
    (2,550,561
    )
    
    $
    (4,706,052
    )NET LOSS PER COMMON SHARE,
BASIC AND DILUTED
    
    $
    (0.13
    )
    
    $
    (0.27
    )
    
    $
    (0.49
    )WEIGHTED AVERAGE SHARES OUTSTANDING,
BASIC AND DILUTED
    
    
    9,603,717
    
    
    
    9,591,090
    
    
    
    9,532,463
 See notes to consolidated financial statements. 22




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DURASWITCH INDUSTRIES, INC. CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY
YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002 
 AdditionalCommon Stock
    
    
    Paid-in
    
    
    AccumulatedShares
    
    
    Amount
    
    
    Capital
    
    
    Deficit
    
    
    TotalBALANCE, DECEMBER 31, 2001
    
    
    9,528,695
    
    
    $
    9,529
    
    
    $
    27,285,470
    
    
    $
    (15,763,463
    )
    
    $
    11,531,536Employee stock options exercised
    
    
    5,500
    
    
    
    5
    
    
    
    31,844
    
    
    
    
    
    
    
    31,849Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (4,706,052
    )
    
    
    (4,706,052
    )BALANCE, DECEMBER 31, 2002
    
    
    9,534,195
    
    
    
    9,534
    
    
    
    27,317,314
    
    
    
    (20,469,515
    )
    
    
    6,857,333Employee stock options exercised
    
    
    22,696
    
    
    
    23
    
    
    
    26,200
    
    
    
    
    
    
    
    26,223Issuance of stock for services
    
    
    34,782
    
    
    
    35
    
    
    
    39,965
    
    
    
    
    
    
    
    40,000Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (2,550,561
    )
    
    
    (2,550,561
    )BALANCE, DECEMBER 31, 2003
    
    
    9,591,673
    
    
    
    9,592
    
    
    
    27,383,479
    
    
    
    (23,020,076
    )
    
    
    4,372,995Employee stock options exercised
    
    
    23,000
    
    
    
    23
    
    
    
    27,437
    
    
    
    
    
    
    
    27,460Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,272,078
    )
    
    
    (1,272,078
    )BALANCE, DECEMBER 31, 2004
    
    
    9,614,673
    
    
    $
    9,615
    
    
    $
    27,410,916
    
    
    $
    (24,292,154
    )
    
    $
    3,128,377
 See notes to consolidated financial statements. 23




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DURASWITCH INDUSTRIES, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002 
 2004
    
    
    2003
    
    
    2002CASH FLOWS FROM OPERATING ACTIVITIES:Net loss
    
    $
    (1,272,078
    )
    
    $
    (2,550,561
    )
    
    $
    (4,706,052
    )Adjustments to reconcile net loss to net cash used in
operating activities:Depreciation and amortization
    
    
    214,535
    
    
    
    421,779
    
    
    
    410,976Impairment loss on note receivable
    
    
    500,000
    
    
    
    
    
    
    
    Issuance of stock for services
    
    
    
    
    
    
    40,000
    
    
    
    (Gain) loss on disposal of equipment
    
    
    (12,335
    )
    
    
    8,932
    
    
    
    7,205Reserve for inventory obsolescence
    
    
    
    
    
    
    22,000
    
    
    
    125,000Bad debt expense
    
    
    
    
    
    
    
    
    
    
    11,000Changes in operating assets and liabilities:Accounts receivable
    
    
    1,162
    
    
    
    (38,572
    )
    
    
    79,743Inventory
    
    
    (45,561
    )
    
    
    (607
    )
    
    
    (41,996
    )Prepaid expenses and other current assets
    
    
    43,914
    
    
    
    61,874
    
    
    
    18,537Other assets
    
    
    (1,224
    )
    
    
    
    
    
    
    Accounts payable
    
    
    (13,778
    )
    
    
    49,519
    
    
    
    (60,879
    )Accrued salaries and benefits
    
    
    24,472
    
    
    
    (337,596
    )
    
    
    (75,325
    )Other accrued expenses and other current liabilities
    
    
    (32,424
    )
    
    
    (67,504
    )
    
    
    65,061Other non-current liabilities
    
    
    (11,201
    )
    
    
    (7,063
    )
    
    
    (144,490
    )Deferred licensing revenue
    
    
    (400,160
    )
    
    
    (393,733
    )
    
    
    (406,727
    )Net cash used in operating activities
    
    
    (1,004,678
    )
    
    
    (2,791,532
    )
    
    
    (4,717,947
    )CASH FLOWS FROM INVESTING ACTIVITIES:Increase in patents
    
    
    (35,619
    )
    
    
    (90,255
    )
    
    
    (192,803
    )Funding of note receivable
    
    
    (390,000
    )
    
    
    
    
    
    
    Decrease in other assets
    
    
    
    
    
    
    
    
    
    
    7,914Proceeds from sale of equipment
    
    
    17,549
    
    
    
    137,230
    
    
    
    Purchases of property and equipment
    
    
    (31,022
    )
    
    
    (43,537
    )
    
    
    (91,027
    )Net cash (used in) provided by investing activities
    
    
    (439,092
    )
    
    
    3,438
    
    
    
    (275,916
    )CASH FLOWS FROM FINANCING ACTIVITIES:Net proceeds from exercise of employee stock options
    
    
    27,460
    
    
    
    26,223
    
    
    
    31,849Principal payments on capital leases
    
    
    (8,213
    )
    
    
    (18,110
    )
    
    
    (17,457
    )Net cash provided by financing activities
    
    
    19,247
    
    
    
    8,113
    
    
    
    14,392DECREASE IN CASH AND CASH EQUIVALENTS
    
    
    (1,424,523
    )
    
    
    (2,779,981
    )
    
    
    (4,979,471
    )CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR
    
    
    4,256,978
    
    
    
    7,036,959
    
    
    
    12,016,430CASH AND CASH EQUIVALENTS, END OF YEAR
    
    $
    2,832,455
    
    
    $
    4,256,978
    
    
    $
    7,036,959SUPPLEMENTAL DISCLOSURE OF CASH FLOW
INFORMATION - Cash paid for interest
    
    $
    555
    
    
    $
    2,714
    
    
    $
    5,413
 See notes to consolidated financial statements. 24




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DURASWITCH INDUSTRIES, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
 1. NATURE OF BUSINESS Duraswitch Industries, Inc. (the Company) is a licensor of patented, enabling technologies.
The Company was founded to commercialize a patented new design for electronic switches -
pushbuttons, rotary dials and mouse/cursor controls  that can be used to operate or control
products in a wide variety of commercial and consumer applications. The Company has built domestic
and foreign patent protection for its technologies and is entering into license agreements with
switch manufacturers and other equipment manufacturers (OEMs) worldwide to achieve widespread
distribution of its technologies. The Company began licensing manufacturers in 2000, after several
years of initial manufacturing to prove the technology in the marketplace. The Company has
completed this transition and expects almost all of its future revenue to come from its licensing
efforts. Licensing royalties for the Companys patented switch technologies are earned on a per
switch basis. The Companys goal is to become a competitive licensor of proprietary emerging technologies
that enable unique design and functionality solutions for relevant industries. In order to achieve
this objective, the Company intends to expand its licensing model into additional proprietary
technologies.The Companys licensing model employs a network of manufacturers and technology
alliances that sell to and manufacture products for the OEMs. In some instances the Company expects
that OEMs may also license technology directly for in-house production or for their suppliers. The
Company believes this strategy provides an avenue to commercialize additional technologies and open
new mutually beneficial relationships. The Company intends to pursue growth opportunities that
expand its portfolio of licensable technologies as it makes economic sense. The Company has experienced significant operating losses since its inception. The Company
raised net proceeds of approximately $8.2 million from its public offering in August 1999. In May
2000, the Company received $4.0 million from Delphi Automotive Systems LLC (Delphi) for the
exclusive right to utilize and manufacture the Companys patented switch technologies for the
automotive industry, a warrant to purchase 225,000 shares of stock and a short-term option to
purchase approximately 1.65 million shares of common stock. In June 2000, Delphi exercised its
option to purchase approximately 1.65 million shares of the Companys common stock at $7 per share,
representing approximately 18% of the Companys outstanding shares, for approximately $11.5 million
in cash. The Company believes that it will be able to meet its presently projected cash and working
capital requirements for at least the next 12 months. The timing and amounts of cash used will
depend on many factors, including the Companys ability to increase revenue, control expenditures
and become profitable. 2. SUMMARY OF SIGNIFICANT ACCOUNTING PRINCIPLES The consolidated financial statements include the accounts of the Company and its wholly owned
subsidiaries. The consolidated financial statements are prepared in accordance with accounting
principles generally accepted in the United States of America. The following paragraphs summarize
the significant accounting policies followed by the Company in the preparation of its financial
statements. Principles of Consolidation.All material intercompany balances and transactions have been
eliminated in consolidation. Cash Equivalents.The Company considers all highly liquid debt instruments purchased with
maturities of three months or less to be cash equivalents. Inventory.Inventory is carried at the lower of cost, determined using the FIFO (first-in,
first-out) method, or market. The Company writes down its inventory for estimated obsolescence or
unmarketable inventory to the extent the cost exceeds the estimated market value. The Company bases
the estimate on its assumptions about future demand and market conditions. If actual market
conditions are less favorable than those assumed in its estimates, additional inventory write-downs
might be required. The Company reflects any write-down of inventory in the period in which the
facts giving rise to the inventory write-down become known to it. 25




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##### Table of Contents



Property and Equipment.Depreciation is computed using the straight-line method over the
useful lives of the related assets as follows: Computer software
    
    3 yearsComputer equipment
    
    3 to 5 yearsOther machinery and equipment
    
    5 yearsOffice furniture and fixtures
    
    7 years
 Leasehold improvements are amortized over the lesser of their estimated useful life or the
term of the lease. Patents.Patents are reported at cost, net of accumulated amortization, and are amortized
using the straight-line method over the estimated life of twenty years. Goodwill.The Company tests goodwill for impairment on an annual basis or on an interim basis
if an event occurs or circumstances change that would reduce the fair value of a reporting unit
below its carrying value. Revenue Recognition.The Company enters into licensing agreements with its customers. The
Companys licensing strategy incorporates a requirement whereby the licensee purchases defined
licensed components from the Company. The purchase price of the licensed components includes the
royalty fee for the rights to manufacture, assemble and sell patented Duraswitch technologies. When
the components are shipped, the Company recognizes licensing revenue and cost of goods sold. In
some cases, where no components are supplied, the Company is paid a royalty per switch manufactured
and the Company recognizes revenue in the period the switch is manufactured. The Companys
non-exclusive licensees typically pay royalties of $0.08 per PushGate ($0.10 including the licensed
component cost), between $0.25 and $0.75 per thiNcoder, and between $0.25 and $0.75 per MagnaMouse,
depending on volume. The terms of some of its license agreements require prepayment of royalties to
the Company. The prepayments are recorded as deferred revenue and licensing revenue is recognized
when the royalties are earned under the licensing agreements. In the case of the Delphi minimum
royalty payments, the Company recognizes revenue as it is earned: either as Delphi sells products
incorporating Duraswitch technologies; or in the event that the royalties earned on the sale of
Delphi products are less than the minimum royalty payment, the Company recognizes the difference
between royalties previously recognized and the minimum royalty payment as revenue on June 30 of
each applicable year. The up-front payment amount allocated to deferred revenue, received from
Delphi in 2000, is being amortized over the initial seven-year term of the exclusive license
agreement ending June 30, 2007. Stock-Based Compensation.At December 31, 2004, the Company has three stock-based employee
compensation plans which are described more fully in Note 10. SFAS No. 123, Accounting for
Stock-Based Compensation, encourages, but does not require, companies to record as compensation
expense, over the vesting period, the fair value of all stock-based awards on the date of grant.
The Company elected to account for these plans using the intrinsic value method of accounting
prescribed by APB Opinion No. 25, Accounting for Stock Issued to Employees,and related
interpretations. No stock-based employee compensation cost is reflected in the Companys operating
results, as all options granted under those plans had an exercise price equal to the market value
of the underlying common stock on the date of grant. The fair value of all stock option grants is
estimated on the date of grant in accordance with SFAS No. 123 using the Black-Scholes option
pricing model with the following assumptions: an expected risk-free interest rate of 3.1 percent,
2.4 percent, and 2.9 percent for options granted in 2004, 2003 and 2002, respectively, an expected
life of three years, an expected volatility rate of 84 percent, 80 percent and 69 percent for
options granted in 2004, 2003 and 2002, respectively, and an expected dividend rate of zero
percent. The following table illustrates the effect on net income and earnings per share if the
Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee
compensation: 26




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##### Table of Contents



Year Ended December 31,2004
    
    
    2003
    
    
    2002Net loss, as reported
    
    $
    (1,272,078
    )
    
    $
    (2,550,561
    )
    
    $
    (4,706,052
    )Less: Total stock-based
employee expense determined
under fair value based method
for all awards, net of
related tax effects
    
    
    (147,953
    )
    
    
    (234,265
    )
    
    
    (350,212
    )Pro forma net loss
    
    $
    (1,420,031
    )
    
    $
    (2,784,826
    )
    
    $
    (5,056,264
    )Loss per share:Basic and diluted, as reported
    
    $
    (0.13
    )
    
    $
    (0.27
    )
    
    $
    (0.49
    )Basic and diluted, pro forma
    
    $
    (0.15
    )
    
    $
    (0.29
    )
    
    $
    (0.53
    )
 Income Taxes.Deferred taxes are provided on temporary differences between the tax basis of
assets and liabilities for financial reporting purposes and income tax purposes. The valuation
allowance reduces deferred tax assets to an amount that represents the Companys best estimate of
the amount of such deferred tax assets that, more likely than not, will be realized. Loss Per Common Share.Basic loss per share is computed by dividing the net loss by the
weighted average number of common shares outstanding during the period. Diluted loss per share is
computed using the weighted average number of shares of common stock outstanding plus the effect of
any stock options or warrants if they are dilutive. All stock options and warrants were
anti-dilutive in 2004, 2003 and 2002. Impairment of Long-Lived Assets and Long-Lived Assets to be Disposed of.The Company reviews
its long-lived assets and identifiable intangibles for impairment whenever events or changes in
circumstances indicate that the carrying amount of the asset may not be recoverable. If such assets
were considered to be impaired, the impairment to be recognized would be measured by the amount by
which the carrying amount of the assets exceeds the fair market value of the assets. Assets to be
disposed of are reported at the lower of the carrying amount or fair value less costs to sell. The Company evaluates the recoverability of property and equipment and intangibles not held
for sale by comparing the carrying amount of the asset or group of assets against the estimated
undiscounted future net cash flows expected to result from the use of the asset or group of assets.
Goodwill from acquisitions related to a group of assets being evaluated for impairment is included
in the evaluation. If the undiscounted estimated cash flows are less than the carrying value of the
asset or group of assets being reviewed, an impairment loss would be recorded. The loss would be
measured based on the estimated fair value of the asset or group of assets compared to cost. The
estimated fair value would be based on the best information available under the circumstances,
including prices for similar assets and the results of valuation techniques, including the present
value of expected future cash flows using a discount rate commensurate with the risks involved. New Accounting Pronouncements.In November 2004, the FASB issued SFAS No. 151, Inventory Costs
- An amendment of ARB 43, Chapter 4. SFAS No. 151 amends the guidance in ARB No. 43, Chapter 4,
Inventory Pricing, to clarify the accounting for abnormal amounts of idle facility expense,
freight, handling costs, and wasted material (spoilage). Paragraph 5 of ARB 43, Chapter 4,
previously stated that . . . under some circumstances, items such as idle facility expense,
excessive spoilage, double freight, and rehandling costs may be so abnormal as to require treatment
as current period charges. . . . SFAS 151 requires that those items be recognized as
current-period charges regardless of whether they meet the criterion of so abnormal. In addition,
SFAS 151 requires that allocation of fixed production overheads to the costs of conversion be based
on the normal capacity of the production facilities. The Company is required to adopt the statement
effective for inventory costs incurred beginning January 1, 2006. The Company does not expect that
this standard will have a material effect on its financial position or results of operations. In
December 2004, the FASB issued SFAS No. 123(R),
Share-Based Payment.SFAS No. 123(R)
requires that the cost of share-based payments be recognized as expense in the financial statements
based on the fair value of the equity or liability instruments used. Currently, the Company is
required to disclose the effect on earnings per share if the Company had applied the fair value
recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation, of expensing. The
Company is required to adopt the statement effective January 1, 2006. The Company has not yet
determined what impact the adoption of SFAS No. 123(R) will have on the financial statements
of the Company 27




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In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets-an amendment
of APB Opinion No. 29. The guidance in APB Opinion No. 29, Accounting for Nonmonetary Transactions,
is based on the principle that exchanges of nonmonetary assets should be measured based on the fair
value of the assets exchanged. The guidance in that Opinion, however, included certain exceptions
to that principle. SFAS 153 amends Opinion 29 to eliminate the exception for nonmonetary exchanges
of similar productive assets and replaces it with a general exception for exchanges of nonmonetary
assets that do not have commercial substance. A nonmonetary exchange has commercial substance if
the future cash flows of the entity are expected to change significantly as a result of the
exchange. The Company is required to adopt the statement effective for nonmonetary asset exchanges
occurring beginning January 1, 2006. The Company does not expect that this standard will have a
material effect on its financial position or results of operations. Fair Value of Financial Instruments.The carrying values of cash and cash equivalents,
accounts receivable and accounts payable approximate fair values due to the short-term maturities
of these instruments. The fair value of capital leases approximates the carrying value of these instruments because the terms are similar to
those in the marketplace under which they could be replaced. Use of Estimates.The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America necessarily requires the Company 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 expenses during the reporting period. Actual results could differ
from those estimates. Reclassifications.Certain reclassifications were made to the 2003 and 2002 financial
statements to conform to the 2004 presentation. 3. CONCENTRATIONS The Company maintained its cash and cash equivalents in two financial institutions at December
31, 2004. At December 31, 2004, the Company maintained cash and cash equivalents at financial
institutions in excess of federal depository insurance. In 2004 and 2003, Delphi represented 80 percent and 54 percent of net revenue, respectively.
In 2002, Delphi represented 53 percent of net revenue and Memtron Technologies Inc. and Xymox
Technologies Inc. each represented 11 percent of net revenue. In 2004, net revenue from Delphi was
$1,407,978 and included $1.0 million related to the recognition of the first minimum royalty
payment and recognition of deferred licensing revenue which was recorded in 2000. 4. INVENTORY The Companys inventory is primarily comprised of licensed components and other raw materials.
The licensed components are sold to licensees and the other materials are primarily used for
research and development projects and marketing samples. The sale of licensed components and other
materials to licensees is recognized as licensing revenue and the cost of the components and other
materials sold to licensees is recorded as licensing cost of goods sold when the components and
other materials are shipped to the licensee. Inventory consists of the following at December 31: 2004
    
    
    2003Raw materials:Licensed components
    
    $
    292,093
    
    
    $
    247,607Other materials
    
    
    21,990
    
    
    
    21,415Reserve for obsolete inventory
    
    
    (97,000
    )
    
    
    (97,500
    )Inventory  net
    
    $
    217,083
    
    
    $
    171,522
 The Company recorded charges of $0, $22,000, and $125,000 to increase the reserve for obsolete
inventory in 2004, 2003 and 2002, respectively. 28




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5. NOTE RECEIVABLE FROM ACTIVE RECOGNITION TECHNOLOGIES, INC. On April 21, 2004 the Company entered into an agreement to acquire all of the shares of Active
Recognition Technologies, Inc. (ART), a privately held developer and licensor of vehicle and
license plate recognition software. As a condition of closing, ART must achieve $400,000 of net
revenue and $100,000 average earnings before interest and taxes (EBIT) for two consecutive fiscal
quarters prior to July 31, 2005. Since the execution of the agreement, ART has not satisfied either
of the conditions. During the twelve months following the execution of the definitive agreement,
the Company has committed to provide funding to ART, up to a maximum of $500,000, in the form of
convertible debt. The debt bears interest at 5% per annum, matures April 2006, and is secured by a
first priority lien on all assets of ART. At December 31, 2004, the Company had advanced $390,000
under the loan. The remaining $110,000 was advanced during the first quarter of 2005. The loan is
convertible, at the Companys option, into 12.5% of ARTs outstanding capital stock on a fully
diluted basis upon the closing of the acquisition or the acceptance by ART of a superior offer to
purchase ART. If the closing of the acquisition occurs, the Company will issue 950,000 shares of
its restricted common stock to the shareholders of ART. The shares have demand registration rights
no earlier than March 31, 2005. An additional 850,000 shares of restricted common stock, or a prorated portion thereof, will be issued upon ART achieving accumulated
EBIT of $4 million over a three year period. Both the initial acquisition shares and the earn-out
shares will be reduced if the Company converts any outstanding convertible debt into ART shares. The Company believes ART will not achieve the revenue or EBIT levels which are required as a
condition of closing. The Company also believes that there is no assurance that ART will achieve
positive cash flow or obtain additional financing that would allow it to repay the convertible debt
or allow ART to continue as a going concern for the next twelve months. As a result, the Company
has recorded an impairment loss for the year ending December 31, 2004 for the total commitment of
$500,000. The Company has no commitment or to fund ART operations beyond the $500,000. The Company
does not expect to close the acquisition on the previously announced terms and cannot determine at
this time if we will agree upon new terms. The Company has a management services agreement with ART and is paid a monthly fee of $2,600.
In exchange, the Company provides office space and assistance with accounting and corporate
marketing. The Company has entered into an agreement with ART whereby the Company will earn commissions
on business generated for ART. The Company also has a reseller agreement with ART which allows the
Company to sell ART software technology. 6. PROPERTY AND EQUIPMENT Property and equipment consists of the following at December 31: 2004
    
    
    2003Computer equipment and software
    
    $
    443,495
    
    
    $
    439,614Other machinery and equipment
    
    
    328,841
    
    
    
    325,236Leasehold improvements
    
    
    133,743
    
    
    
    138,073Office furniture and fixtures
    
    
    71,377
    
    
    
    73,669Total
    
    
    977,456
    
    
    
    976,592Accumulated depreciation
    
    
    (778,867
    )
    
    
    (661,880
    )Property and equipment  net
    
    $
    198,589
    
    
    $
    314,712
 Depreciation expense for property and equipment was $143,317, $353,833, and $349,919 for the
years ended December 31, 2004, 2003, and 2002, respectively. During the second quarter of 2003, the Company began outsourcing the manufacture of research
and development pieces and marketing samples and further reduced its research and development
activities. As a result, equipment which had previously been utilized in these activities was
offered for sale to our licensees and on our website. During 2004, the Company recorded a gain on
the sale of Assets Held for Sale of $16,163. During 2003 the Company recorded an impairment loss of
$21,194 and a gain on the sale of Assets Held for Sale of $55,335. Both the impairment loss and the
gains have been included in selling, general and administrative expenses. At December 31, 2004, the
net carrying value of the remaining equipment that is classified as Assets Held for Sale is $0. 29




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7. PATENTS Amortization expense for patents was $47,790, $44,518, and $37,628 for the years ended
December 31, 2004, 2003 and 2002, respectively. The estimated amortization expense for existing
patents is approximately $49,000 for each of the next five years. The gross carrying amount and accumulated amortization of patents are as follows: 2004
    
    
    2003Patents
    
    $
    1,010,671
    
    
    $
    975,052Accumulated amortization
    
    
    (233,658
    )
    
    
    (185,868
    )Patents  net
    
    $
    777,013
    
    
    $
    789,184
 8. DEFERRED LICENSING REVENUE In April 2000, the Company entered into a license agreement with Delphi that gives Delphi the
exclusive right to utilize and manufacture the Companys patented switch technologies for the
automotive industry. In connection with the license agreement, the Company also issued a warrant to
Delphi to purchase 225,000 shares of common stock at $7.00 per share and a short-term option to
purchase 1,651,846 shares of common stock at $7.00 per share. In exchange, Delphi paid the Company
a nonrefundable payment of $4.0 million and agreed to pay a royalty fee for each switch sold by
Delphi. The term of the exclusive license agreement is seven years. The agreement also requires
Delphi to make minimum royalty payments totaling $12 million during the initial seven-year term
ending June 30, 2007. The Company recognizes the difference between royalties previously recognized
and the minimum royalty payment as revenue on June 30 of each applicable year. The first payment of
$1 million was recognized as revenue on June 30, 2004 and was received in July 2004. Subsequent
payments are due as follows: $2 million in July 2005; $3 million in July 2006; and $6 million in
July 2007. Delphi can maintain exclusivity for the automotive industry through June 30, 2012 by
making additional minimum annual royalty payments during that period. After June 30, 2012, either
party may convert the agreement to a non-exclusive agreement through 2020. To date, Delphi has only
produced prototype quantities of switches under their license agreement. There is no assurance and
currently no indication that the Company will recognize revenue from Delphi beyond the minimums
specified in the agreement. The estimated fair value of the warrant and the option was $1,134,338, as determined using the
Black-Scholes valuation model. The remaining value of the nonrefundable payment totaling $2,865,662
was recorded as deferred revenue and is being amortized over the initial seven-year term of the
exclusive license agreement. The licensing agreement with Delphi generated licensing revenue of $1,407,978, $409,753 and
$409,380 for the years ended December 31, 2004, 2003 and 2002, respectively, which primarily
resulted from the revenue recognition of the first minimum royalty payment in 2004 and recognition
of deferred licensing revenue which was recorded in 2000. 9. STOCKHOLDERS EQUITY Common Stock.In 2003, the Company issued 34,782 shares at a value of $40,000 in exchange for
consulting services. Preferred Stock.As of December 31, 2004, no preferred stock is outstanding. The Companys
Board of Directors is authorized, subject to any limitations prescribed by Nevada law, but without
further action by the stockholders, to provide for the issuance of serial preferred stock in one or
more series; to establish from time to time the number of shares to be included in these series; to
fix the designations, powers, preferences, and rights of the shares of each such series and any
qualifications, limitations, or restrictions thereof; and to increase or decrease the number of
shares of any such series, but not below the number of shares of such series then outstanding,
without any further vote or action by the stockholders. The Board of Directors may authorize and
issue serial preferred stock with voting or conversion rights that could adversely affect the
voting power or other rights of the holders of common stock. Warrants.On April 20, 2000, the Company sold a warrant to Delphi to purchase 225,000 shares
of common stock at an exercise price of $7.00 per share. This warrant expired on April 20, 2004. 30




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In connection with the public offering that closed in September 1999, the underwriter was
granted warrants to purchase 200,000 shares of common stock at an exercise price of $8.25 per
share. These warrants expired on August 26, 2004. A summary of changes in outstanding warrants is as follows: Warrants
    
    
    Price RangeBalance, December 31, 2001
    
    
    472,059
    
    
    $
    3.19-$8.25Issued
    
    
    Exercised
    
    
    Balance, December 31, 2002
    
    
    472,059
    
    
    $
    3.19-$8.25Issued
    
    
    Exercised
    
    
    Expired
    
    
    (47,059
    )
    
    $
    3.19Balance, December 31, 2003
    
    
    425,000
    
    
    $
    7.00-$8.25Issued
    
    
    Exercised
    
    
    Expired
    
    
    (425,000
    )
    
    $
    7.00-$8.25Balance, December 31, 2004
    
    
    
    
    
    $
    
 10. STOCK OPTION PLANS Effective May 1, 1997, the Board of Directors approved a stock option plan (the 1997 Option
Plan). This plan provides for the granting of incentive and nonqualified stock options to
officers, directors and employees of the Company. The plan also provides for the granting of
nonqualified stock options to any director, consultant or other individual whose participation the
Board of Directors determines to be in the best interest of the Company. The number of shares
authorized for options under the 1997 Option Plan is 823,535. The Companys 1999 Stock Option Plan (the 1999 Option Plan) was adopted by the Companys
Board of Directors and was ratified by the stockholders on March 8, 1999. The number of shares of
common stock authorized subject to options under the 1999 Option Plan is 235,294 shares. The Companys 2000 Stock Option Plan (the 2000 Option Plan) was adopted by the Companys
Board of Directors and was ratified by the stockholders on June 19, 2000 and was amended on May 20,
2002. The number of shares of common stock authorized subject to options under the 2000 Option Plan
is 500,000 shares. The total number of shares available for grant under all three plans is 48,287 at December 31,
2004. The Company accounts for the fair value of the options issued to non-employees in accordance
with SFAS No. 123, Accounting for Stock-Based Compensation. The Company did not record compensation
cost during 2004, 2003 and 2002 as no options were granted to non-employees other than to directors
during that time period. As permitted by SFAS No. 123, the Company has elected to continue to measure cost for its
stock-based compensation plans with employees and directors using the intrinsic value method of
accounting prescribed by APB Opinion No. 25, Accounting for Stock Issued to Employees. Accordingly,
no compensation cost has been recognized, as the option prices are equal to or greater than fair
market value of the stock on the grant dates. Options granted under all plans expire up to ten years from the date of grant. Options that
expire or terminate prior to exercise are added to the shares available for future grants. During June 2004, the Companys Compensation Committee authorized an option exchange with our
CEO. Pursuant to the agreement, options to purchase 50,000 shares of common stock at an exercise
price of $10.85 per share previously granted to him were cancelled. During December 2004, the
Company granted him new options to purchase 50,000 shares of common stock at an exercise price of
$2.05 per share, which was the market price of the Companys common stock 31




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at the time of the new grant of options. The Company had not provided him with any oral or
written agreement or implied promise to compensate him for increases in the market price of Company
common shares for the period from the date of cancellation of the original options until the grant
of the new options. With respect to the new grant of options during December 2004, the options were
exercisable at the time of grant. A summary of changes in stock options is as follows: WeightedAverageOption
    
    
    ExerciseShares
    
    
    PriceBalance, December 31, 2001
    
    
    811,699
    
    
    $
    10.13Granted
    
    
    301,400
    
    
    $
    3.39Exercised
    
    
    (5,500
    )
    
    $
    6.14Expired or terminated
    
    
    (34,900
    )
    
    $
    7.35Balance, December 31, 2002
    
    
    1,072,699
    
    
    $
    9.61Granted
    
    
    156,500
    
    
    $
    1.86Exercised
    
    
    (22,696
    )
    
    $
    1.16Expired or terminated
    
    
    (164,063
    )
    
    $
    7.19Balance, December 31, 2003
    
    
    1,042,440
    
    
    $
    9.02Granted
    
    
    85,000
    
    
    $
    2.14Exercised
    
    
    (23,000
    )
    
    $
    1.19Expired or terminated
    
    
    (73,484
    )
    
    $
    9.17Balance, December 31, 2004
    
    
    1,030,956
    
    
    $
    8.61
 2004
    
    
    2003
    
    
    2002Exercisable at the end of the year
    
    
    1,030,956
    
    
    
    990,940
    
    
    
    1,029,633Weighted average fair value of options
granted during the year
    
    $
    1.18
    
    
    $
    0.99
    
    
    $
    1.52
 A summary of options outstanding and exercisable as of December 31, 2004 is as follows: Options Outstanding and ExercisableWeightedAverage
    
    WeightedRemaining
    
    AverageOptions
    
    Contractual
    
    ExerciseRange of Exercise Price
    
    Outstanding
    
    Life
    
    Price$0.81 - $1.06
    
    
    150,500
    
    
    
    7.9
    
    
    $
    1.04$1.83 - $3.38
    
    
    236,200
    
    
    
    7.3
    
    
    $
    2.13$6.00 - $10.85
    
    
    397,901
    
    
    
    5.2
    
    
    $
    7.07$13.01 - $22.31
    
    
    246,355
    
    
    
    3.0
    
    
    $
    21.94$0.81 - $22.31
    
    
    1,030,956
    
    
    
    5.5
    
    
    $
    8.61
 32




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11. INCOME TAXES Net deferred tax assets consist of the following at December 31: 2004
    
    
    2003Deferred tax assets:Operating loss carryforwards
    
    $
    8,363,846
    
    
    $
    8,102,140Capitalized research and development
    
    
    1,193,917
    
    
    
    1,167,109Research and development credits
    
    
    1,566,156
    
    
    
    723,601Deferred licensing revenue
    
    
    412,604
    
    
    
    572,668Note receivable
    
    
    200,000
    
    
    
    Other
    
    
    135,919
    
    
    
    150,295Total
    
    
    11,872,442
    
    
    
    10,715,813Less valuation allowance
    
    
    (11,542,360
    )
    
    
    (10,340,742
    )Total
    
    
    330,082
    
    
    
    375,071Deferred tax liabilities:Patents
    
    
    (310,806
    )
    
    
    (314,474
    )Other
    
    
    (19,276
    )
    
    
    (60,597
    )Total
    
    $
    
    
    
    $
    
 During the years ended December 31, 2004, 2003 and 2002, the Company increased the valuation
allowance by $1,201,618, $1,370,186 and $1,993,272, respectively, against deferred tax assets. The
increase in the valuation allowance recorded in 2004, 2003 and 2002 includes $12,164, $6,146 and
3,463, respectively, for net operating loss carryforwards related to stock compensation. The
benefit of the utilization of these net operating loss carryforwards would be recorded as a credit
to additional paid-in capital. The valuation allowance reduces deferred tax assets to an amount
that represents managements best estimate of the amount of such deferred tax assets that, more
likely than not, will be realized. Realization of the deferred tax assets is dependent upon
generating sufficient future taxable income in the period that temporary differences and
carryforwards are expected to be available to reduce taxable income. The Company has net operating loss carryforwards for federal income tax purposes of $20.2
million which expire in 2011 through 2024 and net operating loss carryforwards for state income tax
purposes of $17.8 million which expire 2005 through 2009. The income tax provision differs from the amount of income tax determined by applying the U.S.
federal income tax rate to pretax income for 2004, 2003 and 2002 due to the following: 2004
    
    
    2003
    
    
    2002Benefit calculated at statutory rate
    
    $
    432,507
    
    
    $
    867,191
    
    
    $
    1,600,057Increase (decrease) in income resulting from:Research and development and other tax
credits
    
    
    667,658
    
    
    
    353,252
    
    
    
    180,259State income taxes, net
    
    
    76,960
    
    
    
    153,034
    
    
    
    282,363Permanent differences
    
    
    (8,562
    )
    
    
    (6,735
    )
    
    
    (60,335
    )Other, net
    
    
    20,891
    
    
    
    (2,702
    )
    
    
    (12,535
    )Valuation allowance
    
    
    (1,189,454
    )
    
    
    (1,364,040
    )
    
    
    (1,989,809
    )Total
    
    $
    
    
    
    $
    
    
    
    $
    
 12. SELECTED QUARTERLY FINANCIAL DATA (Unaudited) The following table presents unaudited operating results for each quarter within the two most
recent years. The Company believes that all necessary adjustments, consisting only of normal
recurring adjustments, have been included in the amounts stated below to present fairly the
following quarterly results when read in conjunction with the financial statements included elsewhere in this report. Results of operations for any particular quarter are not
necessarily indicative of results of operations for a full fiscal year: 33




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##### Table of Contents



2004 - Quarter Ended,December 31
    
    
    September 30
    
    
    June 30
    
    
    March 31Net licensing revenue
    
    $
    198,380
    
    
    $
    199,413
    
    
    $
    1,179,615
    
    
    $
    179,645Gross profit
    
    
    148,613
    
    
    
    149,417
    
    
    
    1,130,544
    
    
    
    140,932Net income (loss)
    
    
    (923,690
    )
    
    
    (375,047
    )
    
    
    446,439
    
    
    
    (419,780
    )Net income (loss) per common share,
basic and diluted (1)
    
    $
    (0.10
    )
    
    $
    (0.04
    )
    
    $
    0.05
    
    
    $
    (0.04
    )
 2003 - Quarter Ended,December 31
    
    
    September 30
    
    
    June 30
    
    
    March 31Net licensing revenue
    
    $
    246,777
    
    
    $
    192,863
    
    
    $
    161,245
    
    
    $
    159,027Gross profit
    
    
    204,923
    
    
    
    161,989
    
    
    
    147,722
    
    
    
    141,974Net loss
    
    
    (528,898
    )
    
    
    (475,794
    )
    
    
    (821,042
    )
    
    
    (724,827
    )Net loss per common share,
basic and diluted (1)
    
    $
    (0.06
    )
    
    $
    (0.05
    )
    
    $
    (0.09
    )
    
    $
    (0.08
    )
   (1)
    
    Earnings per share are computed independently for each quarter and the full year based upon respective
average shares outstanding. Therefore, the sum of the quarterly net earnings per share may not equal
the annual amounts reported. 13. SEGMENT REPORTING The Company operates and reports internally as one segment and substantially all of its assets
are located in the United States. Revenue by geographic area is determined based upon the location
of the licensee or customer. The United States is the only country with net revenue in excess of 10
percent of total net revenue. Net revenue by geographic region for the years ended December 31,
2004, 2003, and 2002 is as follows: 2004
    
    
    2003
    
    
    2002United States
    
    $
    1,569,578
    
    
    $
    586,176
    
    
    $
    678,021Europe
    
    
    92,100
    
    
    
    106,577
    
    
    
    86,201Other
    
    
    95,375
    
    
    
    67,159
    
    
    
    7,947Total
    
    $
    1,757,053
    
    
    $
    759,912
    
    
    $
    772,169
 14. COMMITMENTS Management Services Agreement.The Company has a management services agreement with a company
owned and operated by the founders, two major stockholders. This management agreement requires the
Company to pay a management service fee equal to 1.1 percent of the invoiced sales price for all
Company-patented technology component switches and integrated switch panels sold by the Company.
Also, the Company has agreed to pay an equivalent percentage of any license or sublicense fees
received from the patented switch technologies. This agreement remains in effect until the
expiration of the last patent which may be issued on the switch technologies. During 2004, 2003
and 2002, the Company paid approximately $14,700, $3,100, and $5,100, respectively, under this
agreement. Employment Agreements.The Company has employment agreements with its executive officers.
These agreements call for a base salary and bonuses. These agreements also provide for salary and
benefits in the event of separation. Lease Agreements.Rent expense for the periods ended December 31, 2004, 2003 and 2002
approximated $52,000, $199,000, and $199,000, respectively. Rent payments in 2004 were
approximately $52,000. Future minimum rental payments are $66,621 in 2005, and $29,135 thereafter. 34




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##### Table of Contents



Item 8.
    Changes In and Disagreements With Accountants on Accounting and Financial Disclosure. None. 
  Item 8A.
    Controls and Procedures. We have evaluated, with the participation of our Chief Executive Officer and Chief Financial
Officer, the effectiveness of our disclosure controls and procedures as of December 31, 2004. Based
on this evaluation, our Chief Executive Officer and Chief Financial Officer has concluded that our
disclosure controls and procedures are effective to ensure that we record, process, summarize, and
report information required to be disclosed by us in our annual reports filed under the Securities
Exchange Act within the time periods specified by the Securities and Exchange Commissions rules
and forms. During the period covered by this report, there have not been any changes in our
internal controls over financial reporting that have materially affected, or are reasonably likely
to materially affect, our internal control over financial reporting. 
  Item 8B.
    Other Information. None. 35




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##### Table of Contents



Part III 
  Item 9.
    Directors, Executive Officers, Promoters and Control Persons; Compliance With Section 16(a) of the Exchange Act. The information required by this Item is incorporated herein by reference to the definitive
Proxy Statement to be filed pursuant to Regulation 14A of the Exchange Act for our 2005 Annual
Meeting of Stockholders. 
  Item 10.
    Executive Compensation. The information required by this Item is incorporated herein by reference to the definitive
Proxy Statement to be filed pursuant to Regulation 14A of the Exchange Act for our 2005 Annual
Meeting of Stockholders. 
  Item 11.
    Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters. The information required by this Item is incorporated herein by reference to the definitive
Proxy Statement to be filed pursuant to Regulation 14A of the Exchange Act for our 2005 Annual
Meeting of Stockholders. 
  Item 12.
    Certain Relationships and Related Transactions. The information required by this Item is incorporated herein by reference to the definitive
Proxy Statement to be filed pursuant to Regulation 14A of the Exchange Act for our 2005 Annual
Meeting of Stockholders. 
  Item 13.
    Exhibits. Exhibit No.
    
    Description of Exhibit2.1
    
    Stock Purchase Agreement dated as of April 1, 2004 among Duraswitch Industries, Inc.; Active
Recognition Technologies; Arthur Lawida; Ole Sorensen; and Alex Parrish (1)3.1
    
    Amended and Restated Articles of Incorporation (2)3.2
    
    Amended and Restated Bylaws (3)4.1
    
    Specimen Common Stock Certificate (2)10.1
    
    Employment and Separation Agreement dated November 20, 1998 by and between Duraswitch
Industries, Inc. and Robert J. Brilon (2)10.1.1
    
    Addendum #1 to Employment and Separation Agreement dated November 20, 1998 by and between
Duraswitch Industries, Inc. and Robert J. Brilon (4)10.1.2
    
    Addendum #2 to Employment and Separation Agreement dated November 20, 1998 by and between
Duraswitch Industries, Inc. and Robert J. Brilon (5)10.2
    
    1997 Stock Option Plan (2)10.3
    
    1999 Stock Option Plan (2)10.4
    
    2000 Stock Option Plan (5)10.5
    
    2000 Stock Option Plan Amendment (7)10.6
    
    Management Services Agreement dated May 1, 1997 by and between Total Switch, Inc. and VanDun, LLC (2)10.7
    
    Agreement for Assignment of Present and Future Inventions in Certain Subject Matter dated May
1, 1997 by and between Total Switch, Inc. and Anthony J. Van Zeeland (2)10.8*
    
    Licensing Agreement between Delphi Automotive Systems LLC and Duraswitch Industries, Inc.
dated April 20, 2000 (8)10.9
    
    Shareholders Agreement dated June 19, 2000 among Duraswitch Industries, Inc., Delphi
Automotive Systems Corporation, and the Primary Shareholders named therein (9)10.10
    
    Employment Agreement dated July 1, 2003 by and between Duraswitch Industries, Inc. and Anthony J. Van Zeeland (10)10.11
    
    Standard sublease dated November 1, 2003 by and between 234 South Extension, L.L.C. and Duraswitch Industries, Inc. (5)10.12
    
    Form of Indemnification Agreement14
    
    Code of Ethics
 36




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##### Table of Contents



Exhibit No.
    
    Description of Exhibit21
    
    List of Subsidiaries23.1
    
    Consent of Independent Registered Public Accounting Firm31
    
    Certification of Chief Executive Officer and Chief Financial Officer pursuant to Rule
13a-14(a) and Rule 15d  14(a), promulgated under the Securities Exchange Act of 1934, as
amended32
    
    Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
   (1)
    
    Incorporated by reference to the registrants Form 10-QSB as filed on April 29, 2004(2)
    
    Incorporated by reference to the registrants Form SB-2 as filed on August 26, 1999(3)
    
    Incorporated by reference to the registrants Form 10-KSB as filed on March 30, 2001(4)
    
    Incorporated by reference to the registrants Form 10-KSB as filed on March 30, 2000(5)
    
    Incorporated by reference to the registrants Form 10-K as filed on March 29, 2004(6)
    
    Incorporated by reference to the registrants Proxy Statement as filed on May 12, 2000(7)
    
    Incorporated by reference to the registrants Form 10-K as filed on March 23, 2002(8)
    
    Incorporated by reference to the registrants Form 8-K as filed on April 26, 2000(9)
    
    Incorporated by reference to the registrants Form 10-K as filed on March 25, 2003(10)
    
    Incorporated by reference to the registrants Form 10-Q as filed on August 5, 2003   * Certain information in this exhibit has been omitted and filed separately with the Securities and
Exchange Commission. Confidential treatment has been requested with respect to the omitted
portions. 
  Item 14.
    Principal Accountant Fees and Services. The information required by this Item is incorporated herein by reference to the definitive
Proxy Statement to be filed pursuant to Regulation 14A of the Exchange Act for our 2005 Annual
Meeting of Stockholders. 37




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##### Table of Contents



SIGNATURES In accordance with Section 13 or 15(d) of the Exchange Act, the registrant has caused this
report to be signed on its behalf by the undersigned, thereunto duly authorized. Date: March 28, 2005
    
    
    
    DURASWITCH INDUSTRIES, INC.By:
    
    /s/ Robert J. BrilonRobert J. BrilonChairman of the BoardPresident, Chief Executive Officer,Chief Financial Officer, Secretary and Treasurer
 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. Date: March 28, 2005
    
    By:
    
    /s/ Robert J. BrilonRobert J. BrilonChairman of the BoardPresident, Chief Executive Officer,Chief Financial Officer, Secretary and Treasurer(Principal Executive, Financial and Accounting Officer)Date: March 28, 2005
    
    By:
    
    /s/ John W. HailJohn W. HailDirectorDate: March 28, 2005
    
    By:
    
    /s/ Steven P. HansonSteven P. HansonDirectorDate: March 28, 2005
    
    By:
    
    /s/ P. Robert MoyaP. Robert MoyaDirectorDate: March 28, 2005
    
    By:
    
    /s/ William E. PeelleWilliam E. PeelleDirectorDate: March 28, 2005
    
    By:
    
    /s/ Anthony J. Van ZeelandAnthony J. Van ZeelandDirector, Chief Technology OfficerDate: March 28, 2005
    
    By:
    
    /s/ Michael A. Van ZeelandMichael A. Van ZeelandDirector
 38




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##### Table of Contents



Exhibit Index Exhibit No.
    
    Description of Exhibit2.1
    
    Stock Purchase Agreement dated as of April 1, 2004 among Duraswitch Industries, Inc.; Active
Recognition Technologies; Arthur Lawida; Ole Sorensen; and Alex Parrish (1)3.1
    
    Amended and Restated Articles of Incorporation (2)3.2
    
    Amended and Restated Bylaws (3)4.1
    
    Specimen Common Stock Certificate (2)10.1
    
    Employment and Separation Agreement dated November 20, 1998 by and between Duraswitch
Industries, Inc. and Robert J. Brilon (2)10.1.1
    
    Addendum #1 to Employment and Separation Agreement dated November 20, 1998 by and between
Duraswitch Industries, Inc. and Robert J. Brilon (4)10.1.2
    
    Addendum #2 to Employment and Separation Agreement dated November 20, 1998 by and between
Duraswitch Industries, Inc. and Robert J. Brilon (5)10.2
    
    1997 Stock Option Plan (2)10.3
    
    1999 Stock Option Plan (2)10.4
    
    2000 Stock Option Plan (5)10.5
    
    2000 Stock Option Plan Amendment (7)10.6
    
    Management Services Agreement dated May 1, 1997 by and between Total Switch, Inc. and VanDun, LLC (2)10.7
    
    Agreement for Assignment of Present and Future Inventions in Certain Subject Matter dated May
1, 1997 by and between Total Switch, Inc. and Anthony J. Van Zeeland (2)10.8*
    
    Licensing Agreement between Delphi Automotive Systems LLC and Duraswitch Industries, Inc.
dated April 20, 2000 (8)10.9
    
    Shareholders Agreement dated June 19, 2000 among Duraswitch Industries, Inc., Delphi
Automotive Systems Corporation, and the Primary Shareholders named therein (9)10.10
    
    Employment Agreement dated July 1, 2003 by and between Duraswitch Industries, Inc. and Anthony J. Van Zeeland (10)10.11
    
    Standard sublease dated November 1, 2003 by and between 234 South Extension, L.L.C. and Duraswitch Industries, Inc. (5)10.12
    
    Form of Indemnification Agreement14
    
    Code of Ethics21
    
    List of Subsidiaries23.1
    
    Consent of Independent Registered Public Accounting Firm31
    
    Certification of Chief Executive Officer and Chief Financial Officer pursuant to Rule
13a-14(a) and Rule 15d  14(a), promulgated under the Securities Exchange Act of 1934, as
amended32
    
    Certification pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002
   (1)
    
    Incorporated by reference to the registrants Form 10-QSB as filed on April 29, 2004(2)
    
    Incorporated by reference to the registrants Form SB-2 as filed on August 26, 1999(3)
    
    Incorporated by reference to the registrants Form 10-KSB as filed on March 30, 2001(4)
    
    Incorporated by reference to the registrants Form 10-KSB as filed on March 30, 2000(5)
    
    Incorporated by reference to the registrants Form 10-K as filed on March 29, 2004(6)
    
    Incorporated by reference to the registrants Proxy Statement as filed on May 12, 2000(7)
    
    Incorporated by reference to the registrants Form 10-K as filed on March 23, 2002(8)
    
    Incorporated by reference to the registrants Form 8-K as filed on April 26, 2000(9)
    
    Incorporated by reference to the registrants Form 10-K as filed on March 25, 2003(10)
    
    Incorporated by reference to the registrants Form 10-Q as filed on August 5, 2003   * Certain information in this exhibit has been omitted and filed separately with the Securities and
Exchange Commission. Confidential treatment has been requested with respect to the omitted
portions.