**U.S. SECURITIES AND EXCHANGECOMMISSION**

**Washington, D.C.20549**

** **

**FORM 10-QSB**

 

| **(Mark  One)**                                                                                                                                                               |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                          |   |
| **ý**                                                                                                                                                                    | **QUARTERLY  REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                          |   |
| **For the quarterly period ended September 30, 2003**                                                                                                                    |
|                                                                                                                                                                          |   |
| **o**                                                                                                                                                                         | **TRANSITION  REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT** |
|                                                                                                                                                                          |   |
| **For the transition period from              to             ** |
|                                                                                                                                                                          |   |
| **Commission file number 001-15757**                                                                                                                                          |

 

**IMAGEWARE SYSTEMS, INC.**

(ExactName of Small Business Issuer as Specified in Its Charter)

 
| **California**                                                   |   | **33-0224167**                     |
|------------------------------------------------------------------|--------|------------------------------------|
| (State  or Other Jurisdiction of Incorporation or  Organization) |   | (IRS  Employer Identification No.) |
|                                                             |   |                               |
| **10883 Thornmint Road  San Diego, CA 92127**                    |
| (Address  of Principal Executive Offices)                        |
|                                                             |   |                               |
| **(858) 673-8600**                                               |
| (Issuer’s  Telephone Number, Including Area Code)           |

 

Check whether the issuer (1)filed all reports required to be filed by Section 13 or 15(d) of theExchange Act during the past 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes ý  No o

 

State the number of sharesoutstanding of each of the issuer’s classes of common equity, as of the latestpracticable date: As of November 10, 2003, the number of outstandingshares of the Registrant’s common stock, par value $.01, was 5,489,390.

 

Transitional Small BusinessDisclosure Format (check one) Yes o  No ý

 

 

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**IMAGEWARE SYSTEMS, INC. INDEX**

** **
| PART I.    | FINANCIAL  INFORMATION |
|------------|------------------------|
|       | ITEM 1.                | FINANCIAL STATEMENTS  (UNAUDITED) |
|       |                   | Condensed  Consolidated Balance Sheets as of September 30, 2003 and  December 31, 2002 |
|       |                   | Condensed  Consolidated Statements of Operations for the three and nine months ended  September 30, 2003 and 2002 |
|       |                   | Condensed  Consolidated Statements of Cash Flows for the nine months ended September 30,  2003 and 2002 |
|       |                   | Condensed  Consolidated Statements of Comprehensive Income (Loss) for the three and nine  months ended September 30, 2003 and 2002 |
|       |                   | Notes  to Condensed Consolidated Financial Statements |
|       | ITEM  2.               | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |
|       | ITEM 3.                | Controls  and Procedures |
|       |                   |   |
| PART II.   | OTHER INFORMATION      |
|       | ITEM 2.                | CHANGES IN SECURITIES |
|       | ITEM 6.                | EXHIBITS AND REPORTS  ON FORM 8-K |
|       |                   |   |
| SIGNATURES |                   |

 

2

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**PART IFINANCIAL INFORMATION**

 

**ITEM 1. FINANCIAL STATEMENTS (UNAUDITED)**

 

**IMAGEWARE SYSTEMS, INC.****CONDENSEDCONSOLIDATED BALANCE SHEETS********ASSETS**

**(INTHOUSANDS)**

 
|                                                                                                                                                                                                                                                                                                                                            |   | **September 30,  2003** |       | **December 31,  2002** |       |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------------|------------|-----------------------------|------------|
|                                                                                                                                                                                                                                                                                                                                            |   | **(UNAUDITED)**              |       |                        |       |
|                                                                                                                                                                                                                                                                                                                                            |   |                         |       |                        |       |
| Current Assets:                                                                                                                                                                                                                                                                                                                                 |   |                         |       |                        |       |
| Cash                                                                                                                                                                                                                                                                                                                                            |   | $                            | 634        |                        | $          | 215 |   |
| Restricted cash and cash equivalents                                                                                                                                                                                                                                                                                                            |   | —                       |       | 60                          |       |
| Accounts receivable, net                                                                                                                                                                                                                                                                                                                        |   | 1,375                        |       | 3,295                       |       |
| Inventory                                                                                                                                                                                                                                                                                                                                       |   | 1,692                        |       | 1,882                       |       |
| Other current assets                                                                                                                                                                                                                                                                                                                            |   | 450                          |       | 422                         |       |
| Total Current Assets                                                                                                                                                                                                                                                                                                                            |   | 4,151                        |       | 5,874                       |       |
|                                                                                                                                                                                                                                                                                                                                            |   |                         |       |                        |       |
| Property and equipment, net                                                                                                                                                                                                                                                                                                                     |   | 794                          |       | 1,040                       |       |
| Other assets                                                                                                                                                                                                                                                                                                                                    |   | 1,039                        |       | 744                         |       |
| Intangible assets, net of accumulated  amortization                                                                                                                                                                                                                                                                                             |   | 1,216                        |       | 1,562                       |       |
| Goodwill                                                                                                                                                                                                                                                                                                                                        |   | 5,298                        |       | 5,298                       |       |
| **Total Assets**                                                                                                                                                                                                                                                                                                                                |   | **$**                        | **12,498** | ** **                  | **$**      | **14,518** | ** ** |
|                                                                                                                                                                                                                                                                                                                                            |   |                         |       |                        |       |
| **LIABILITIES AND SHAREHOLDERS’  EQUITY**                                                                                                                                                                                                                                                                                                  |   |                         | ** ** |                        | ** ** |
|                                                                                                                                                                                                                                                                                                                                            |   |                         |       |                        |       |
| Current Liabilities:                                                                                                                                                                                                                                                                                                                            |   |                         |       |                        |       |
| Accounts payable                                                                                                                                                                                                                                                                                                                                |   | $                            | 2,039      |                        | $          | 3,233 |   |
| Deferred revenue                                                                                                                                                                                                                                                                                                                                |   | 802                          |       | 976                         |       |
| Accrued expenses                                                                                                                                                                                                                                                                                                                                |   | 1,342                        |       | 1,500                       |       |
| Accrued expenses - related parties                                                                                                                                                                                                                                                                                                              |   | 0                            |       | 47                          |       |
| Accrued interest                                                                                                                                                                                                                                                                                                                                |   | 253                          |       | 198                         |       |
| Notes & advances payable to bank and  third parties                                                                                                                                                                                                                                                                                         |   | 207                          |       | 786                         |       |
| Notes payable to related parties                                                                                                                                                                                                                                                                                                                |   | 104                          |       | 218                         |       |
| Total Current Liabilities                                                                                                                                                                                                                                                                                                                       |   | 4,747                        |       | 6,958                       |       |
|                                                                                                                                                                                                                                                                                                                                            |   |                         |       |                        |       |
| Convertible notes payable, net of discount                                                                                                                                                                                                                                                                                                      |   | 1,298                        |       | 1,252                       |       |
| Warrant liability                                                                                                                                                                                                                                                                                                                               |   | 1,647                        |       | —                      |       |
| Pension obligation                                                                                                                                                                                                                                                                                                                              |   | 465                          |       | 406                         |       |
| Total Liabilities                                                                                                                                                                                                                                                                                                                               |   | 8,157                        |       | 8,616                       |       |
|                                                                                                                                                                                                                                                                                                                                            |   |                         |       |                        |       |
| Shareholders’ equity (deficit):                                                                                                                                                                                                                                                                                                            |   |                         |       |                        |       |
| Preferred stock, $.01 par value, authorized  4,000,000 shares Series B convertible redeemable preferred stock, designated  750,000 shares, 389,400 shares issued, and 269,400 shares outstanding at  September 30, 2003 and December 31, 2002, liquidation preference  $673,500 at September 30, 2003 and December 31, 2002 |   | 3                            |       | 3                           |       |
| Common stock, $.01 par value, 50,000,000  shares authorized, 5,489,390 shares issued and outstanding                                                                                                                                                                                                                                            |   | 54                           |       | 54                          |       |
| Additional paid in capital                                                                                                                                                                                                                                                                                                                      |   | 43,890                       |       | 41,272                      |       |
| Treasury stock, at cost - 6,704 shares                                                                                                                                                                                                                                                                                                          |   | (64                          | )          | (64                         | )          |
| Shareholder note receivable                                                                                                                                                                                                                                                                                                                     |   | (150                         | )          | (150                        | )          |
| Accumulated other comprehensive income                                                                                                                                                                                                                                                                                                          |   | 241                          |       | 113                         |       |
| Accumulated deficit                                                                                                                                                                                                                                                                                                                             |   | (39,633                      | )          | (35,326                     | )          |
| Total shareholders’ equity                                                                                                                                                                                                                                                                                                                 |   | 4,341                        |       | 5,902                       |       |
|                                                                                                                                                                                                                                                                                                                                            |   |                         |       |                        |       |
| **Total Liabilities and  Shareholders’ Equity**                                                                                                                                                                                                                                                                                            |   | **$**                        | **12,498** | ** **                  | **$**      | **14,518** | ** ** |

 

The accompanying notes are an integral partof these condensed consolidated financial statements.

 

3

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**IMAGEWARE SYSTEMS, INC.CONDENSED CONSOLIDATED STATEMENTSOF OPERATIONS(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)(UNAUDITED)**

 
|                                                  |   | **THREE MONTHS ENDED  September 30,** |   | **NINE MONTHS ENDED  September 30,** |   |
|-------------------------------------------------------|--------|--------------------------------------------|--------|-------------------------------------------|--------|
|                                                  |   | **2003**                                   |   | **2002**                                  |   | **2003** |   | **2002** |   |
|                                                  |   |                                       |   |                                      |   |   |   |   |   |
| **Revenues:**                                         |   |                                       |   |                                      |   |   |   |   |   |
| Product                                               |   | $                                          | 4,167  |                                      | $      | 3,942 |   | $ | 10,636 |   | $ | 10,601 |   |
| Maintenance                                           |   | 590                                        |   | 729                                       |   | 2,180 |   | 2,074 |   |
|                                                  |   | 4,757                                      |   | 4,671                                     |   | 12,816 |   | 12,675 |   |
| **Cost of revenues:**                                 |   |                                       |   |                                      |   |   |   |   |   |
| Product                                               |   | 1,405                                      |   | 1,695                                     |   | 4,482 |   | 4,620 |   |
| Maintenance                                           |   | 270                                        |   | 306                                       |   | 939 |   | 848 |   |
|                                                  |   |                                       |   |                                      |   |   |   |   |   |
| Gross profit                                          |   | 3,082                                      |   | 2,670                                     |   | 7,395 |   | 7,207 |   |
|                                                  |   |                                       |   |                                      |   |   |   |   |   |
| **Operating expenses:**                               |   |                                       |   |                                      |   |   |   |   |   |
| General & administrative                          |   | 1,461                                      |   | 1,646                                     |   | 4,343 |   | 5,037 |   |
| Sales and marketing                                   |   | 883                                        |   | 957                                       |   | 3,020 |   | 3,158 |   |
| Research & development                            |   | 509                                        |   | 538                                       |   | 1,439 |   | 1,563 |   |
| Depreciation and amortization                         |   | 219                                        |   | 245                                       |   | 692 |   | 660 |   |
|                                                  |   | 3,072                                      |   | 3,386                                     |   | 9,494 |   | 10,418 |   |
|                                                  |   |                                       |   |                                      |   |   |   |   |   |
| Income (loss) from operations                         |   | 10                                         |   | (716                                      | )      | (2,099 | ) | (3,211 | ) |
|                                                  |   |                                       |   |                                      |   |   |   |   |   |
| Interest (income) expense, net                        |   | 69                                         |   | 250                                       |   | 2,323 |   | 362 |   |
|                                                  |   |                                       |   |                                      |   |   |   |   |   |
| Other (income) expense, net                           |   | 57                                         |   | (2                                        | )      | (116 | ) | 21 |   |
|                                                  |   |                                       |   |                                      |   |   |   |   |   |
| Loss before income taxes                              |   | (116                                       | )      | (964                                      | )      | (4,306 | ) | (3,594 | ) |
|                                                  |   |                                       |   |                                      |   |   |   |   |   |
| Income tax expense (benefit)                          |   | —                                     |   | —                                    |   | — |   | — |   |
|                                                  |   |                                       |   |                                      |   |   |   |   |   |
| Net loss                                              |   | $                                          | (116   | )                                         | $      | (964 | ) | $ | (4,306 | ) | $ | (3,594 | ) |
|                                                  |   |                                       |   |                                      |   |   |   |   |   |
| Basic and diluted loss per common share -  see note 2 |   | $                                          | (0.02  | )                                         | $      | (0.18 | ) | $ | (0.79 | ) | $ | (0.66 | ) |
| Weighted-average shares (basic and diluted)           |   | 5,489,390                                  |   | 5,485,210                                 |   | 5,489,390 |   | 5,483,280 |   |

 

The accompanying notes are an integral partof these condensed consolidated financial statements.

 

4

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**IMAGEWARE SYSTEMS, INC.**

**CONDENSEDCONSOLIDATED STATEMENT OF CASH FLOWS**

**(IN THOUSANDS)**

**(UNAUDITED)**

 
|                                                                         |   | **Nine Months Ended  September 30,** |       |
|------------------------------------------------------------------------------|--------|-------------------------------------------|------------|
|                                                                         |   | **2003**                                  |       | **2002** |   |
|                                                                         |   |                                      | ** ** |   | ** ** |
| **Cash flows from operating  activities**                                    |   |                                      |       |   |   |
| Net loss                                                                     |   | $                                         | (4,306     | ) | $ | (3,594 | ) |
| Adjustments to reconcile net loss to net  cash used by operating activities  |   |                                      |       |   |   |
| Depreciation and amortization                                                |   | 696                                       |       | 660 |   |
| Non cash interest and amortization of debt  discount and debt issuance costs |   | 1,779                                     |       | 241 |   |
| Change in assets and liabilities                                             |   |                                      |       |   |   |
| Accounts receivable, net                                                     |   | 1,920                                     |       | 1,257 |   |
| Inventory                                                                    |   | 190                                       |       | (1,425 | ) |
| Other current assets                                                         |   | (27                                       | )          | 75 |   |
| Intangible and other assets                                                  |   | (66                                       | )          | 38 |   |
| Accounts payable                                                             |   | (1,108                                    | )          | 371 |   |
| Accrued expenses                                                             |   | (162                                      | )          | 227 |   |
| Accrued interest                                                             |   | 55                                        |       | 82 |   |
| Deferred revenue                                                             |   | (174                                      | )          | 101 |   |
| Pension obligation                                                           |   | 59                                        |       | — |   |
| Total adjustments                                                            |   | 3,162                                     |       | 1,627 |   |
| Net cash used by operating activities                                        |   | (1,144                                    | )          | (1,967 | ) |
|                                                                         |   |                                      |       |   |   |
| **Cash flows from investing  activities**                                    |   |                                      |       |   |   |
| Purchase of property and equipment                                           |   | (162                                      | )          | (289 | ) |
| Restricted cash and cash equivalents                                         |   | 60                                        |       | 30 |   |
| Payment on advances from related  stockholders                               |   | (158                                      | )          | (135 | ) |
| Sale of property and equipment                                               |   | 59                                        |       | — |   |
|                                                                         |   |                                      |       |   |   |
| Net cash used by investing activities                                        |   | (201                                      | )          | (394 | ) |
|                                                                         |   |                                      |       |   |   |
| **Cash flows from financing  activities**                                    |   |                                      |       |   |   |
| Proceeds from issuance of notes payable  with warrants                       |   | 4,856                                     |       | 2,000 |   |
| Proceeds from issuance of short-term demand  notes payable                   |   |                                      |       | 500 |   |
| Repayment of notes payable                                                   |   | (2,500                                    | )          |   |   |
| Repayment of capital lease obligations                                       |   |                                      |       | (17 | ) |
| Debt issuance costs                                                          |   | (554                                      | )          | (272 | ) |
| Proceeds from (repayment of) bank line of  credit                            |   | (166                                      | )          | 398 |   |
|                                                                         |   |                                      |       |   |   |
| Net cash provided by financing activities                                    |   | 1,636                                     |       | 2,609 |   |
| Effect of exchange rate changes on cash                                      |   | 128                                       |       | 71 |   |
| Net increase in cash                                                         |   | 419                                       |       | 319 |   |
|                                                                         |   |                                      |       |   |   |
| Cash at beginning of period                                                  |   | 215                                       |       | 388 |   |
|                                                                         |   |                                      |       |   |   |
| Cash at end of period                                                        |   | $                                         | 634        |   | $ | 707 |   |

 

5

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**IMAGEWARE SYSTEMS, INC.**

**CONDENSED CONSOLIDATED STATEMENTSOF COM****PREHENSIVE INCOME (LOSS)**

**(IN THOUSANDS)**

**(UNAUDITED)**

 
|                                    |   | **THREE MONTHS ENDED  SEPTEMBER 30,** |     | **NINE MONTHS ENDED  SEPTEMBER 30,** |     |
|-----------------------------------------|--------|--------------------------------------------|----------|-------------------------------------------|----------|
|                                    |   | **2003**                                   |     | **2002**                                  |     | **2003** |   | **2002** |   |
|                                    |   |                                       | * * |                                      | * * |   | * * |   | * * |
| Net loss                                |   | $                                          | (116     | )                                         | $        | (964 | ) | $ | (4,306 | ) | $ | (3,594 | ) |
| Other comprehensive income (loss):      |   |                                       |     |                                      |     |   |   |   |   |
| Foreign currency translation adjustment |   | 29                                         |     | (9                                        | )        | 128 |   | 71 |   |
| Comprehensive income (loss)             |   | $                                          | (87      | )                                         | $        | (973 | ) | $ | (4,178 | ) | $ | (3,523 | ) |

 

The accompanying notes are an integral part ofthese consolidated financial statements.

 

6

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**IMAGEWARE SYSTEMS, INC.**

 

**NOTES TO CONDENSED CONSOLIDATED FINANCIA****L STATEMENTS**

 

**NOTE1.  DESCRIPTION OF BUSINESS ANDOPERATIONS**

 

ImageWare Systems, Inc. (“we”, “our” or “theCompany”), was incorporated in the State of California on February 6,1987.  ImageWare Systems, Inc. developssoftware solutions for digital imaging, biometrics, law enforcement and securecredentials. Through its ID product line, ImageWare applies its core technologyto create secure identification systems for airports, universities, governmentagencies and private businesses. ImageWare’s law enforcement product lineempowers its customers to quickly capture, search, retrieve and share digitalphotographs and criminal history records on stand-alone, networked or Web-basedplatforms. ImageWare additionally leverages its imaging technology to createsoftware and Web-based solutions for professional photographers.

 

*Liquidity and Capital Resources*

 

The accompanying condensedconsolidated financial statements have been prepared in conformity withaccounting principles generally accepted in the United States of America, whichcontemplate continuation of the Company as a going concern.  The condensed consolidated financialstatements included in this report have been prepared assuming that the Companywill be successful in obtaining the additional capital it needs to fundoperations and implement its business plan. The Company used approximately$2,086,000 in operations during the year ended December 31, 2002 and$1,144,000 in operations during the nine months ended September 30, 2003,suffered net losses of $4,306,000 and $3,594,000 for the nine months endedSeptember 30, 2003 and 2002, respectively, has an accumulated deficit ofapproximately $39,633,000 at September 30, 2003, and has negative workingcapital of $596,000 at September 30, 2003 which raises substantial doubtabout the Company’s ability to continue as a going concern. These condensedconsolidated financial statements do not include any adjustments relating tothe recoverability and classification of recorded asset amounts, or amounts andclassification of liabilities that might be necessary should the Company beunable to continue as a going concern.

 

The Company operates inmarkets that are emerging and highly competitive. There is no assurance thatthe Company will operate at a profit in the future.

 

New financing will berequired to fund working capital and operations. The Company is exploring thepossible sale of equity securities and/or debt financing, and believes thatadditional financing will be available under terms and conditions that areacceptable to the Company. However, there can be no assurance that additionalfinancing will be available. In the event financing is not available in thetime frame required, the Company will be forced to reduce its rate of growth,if any, reduce operating expenses, curtail sales and marketing activities andreschedule research and development projects. In addition, the Companymight be required to sell certain of its assets or license its technologies toothers. These actions, while necessary for the continuance of operations duringa time of cash constraints and a shortage of working capital, could adverselyaffect the Company’s business.

 

*Basis of Presentation*

 

The preparation of financialstatements in conformity with accounting principles generally accepted in theUnited States of America requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities, the disclosure ofcontingent assets and liabilities at the date of the financial statements andthe reported amounts of revenue and expenses during the reporting period.Actual results could differ from those estimates.

 

The accompanying condensedconsolidated unaudited financial statements of ImageWare have been preparedpursuant to the rules and regulations of the Securities and Exchange Commission(“SEC”) regarding interim financial reporting. Accordingly, they do not includeall of the information and footnotes required by generally accepted accountingprinciples for annual financial statements and should be read in conjunctionwith the consolidated financial statements for the year ended December 31,2002 and notes thereto included in the Company’s Annual Report on Form 10-KSB,filed with the SEC on April 15, 2003. In the opinion of management,

 

7

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theaccompanying condensed consolidated financial statements contain alladjustments, consisting only of adjustments of a normal recurring nature,necessary for a fair presentation of the Company’s financial position as ofSeptember 30, 2003, and its results of operations for the periods presented.These condensed consolidated unaudited financial statements are not necessarilyindicative of the results to be expected for the entire year.

 

8

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*Stock based compensation*

 

Stock-basedcompensation to employees has been recognized as the difference between the pershare fair value of the underlying stock and the stock option exercise at theinitial grant date.  The cost of stockoptions granted for services, other than those issued to employees, are recordedat the fair value of the stock option.

 

Hadcompensation cost for the Company’s stock option plan been determined based onthe fair value at the grant date for awards consistent with the provisions ofStatement of Financial Accounting Standards. (“SFAS”) No. 123, Accounting forStock-Based Compensation, the Company’s net losses would have been increased tothe pro forma amount indicated below for the three and nine months endedSeptember 30, 2003 and 2002:

 
|                                                             |   | **THREE MONTHS ENDED  SEPTEMBER 30,** |   | **NINE MONTHS ENDED  SEPTEMBER 30,** |   |
|------------------------------------------------------------------|--------|--------------------------------------------|--------|-------------------------------------------|--------|
|                                                             |   | **2003**                                   |   | **2002**                                  |   | **2003** |   | **2002** |   |
|                                                             |   |                                       |   |                                      |   |   |   |   |   |
| Net Loss:                                                        |   |                                       |   |                                      |   |   |   |   |   |
| As reported                                                      |   | $                                          | (116   | )                                         | $      | (964 | ) | $ | (4,306 | ) | $ | (3,594 | ) |
| Stock based compensation included in net  loss                   |   | —                                     |   | —                                    |   | — |   | — |   |
| Stock based employee compensation under  fair value based method |   | (159                                       | )      | (226                                      | )      | (458 | ) | (672 | ) |
| Pro forma net loss                                               |   | $                                          | (275   | )                                         | $      | (1,190 | ) | $ | (4,764 | ) | $ | (4,266 | ) |
|                                                             |   |                                       |   |                                      |   |   |   |   |   |
| Basic loss per common share:                                     |   |                                       |   |                                      |   |   |   |   |   |
| As reported                                                      |   | $                                          | (0.02  | )                                         | $      | (0.18 | ) | $ | (0.79 | ) | $ | (0.66 | ) |
| Pro forma                                                        |   | $                                          | (0.05  | )                                         | $      | (0.22 | ) | $ | (0.88 | ) | $ | (0.79 | ) |

 

**NOTE2.  NET LOSS PER COMMON SHARE**

 

Basic loss per common share is calculated bydividing net loss available to common shareholders for the  period by the weighted-average number ofcommon shares outstanding during the period. Diluted earnings per common shareis calculated by dividing net loss available to common shareholders for theperiod by the weighted-average number of common shares outstanding during theperiod, adjusted to include, if dilutive, potential dilutive shares consistingof convertible preferred stock, stock options, convertible notes payable andwarrants, calculated using the treasury stock method. During the periods endedSeptember 30, 2003 and 2002, the Company has excluded the followingsecurities from the calculation of diluted loss per share, as their effectwould have been antidilutive due to the Company’s net loss:

 
| **Potential Dilutive Securities:** |   | **Number of  Common Shares  Convertible into at  September 30, 2003** |   | **Number of  Common Shares  Convertible into at  September 30, 2002** |   |
|------------------------------------|--------|----------------------------------------------------------------------------|--------|----------------------------------------------------------------------------|--------|
|                               |   |                                                                       |   |                                                                       |   |
| Convertible preferred stock        |   | 63,781                                                                     |   | 62,749                                                                     |   |
| Stock options                      |   | 905,313                                                                    |   | 633,955                                                                    |   |
| Convertible notes payable          |   | 2,332,854                                                                  |   | 464,037                                                                    |   |
| Warrants                           |   | 4,453,916                                                                  |   | 2,881,577                                                                  |   |

 

The following table setsforth the computation of basic and diluted loss per share for the three andnine month periods ended September 30, 2003 and 2002 (amounts in thousandsexcept share and per share amounts):

 

9

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|                                      |   | **THREE MONTHS ENDED  SEPTEMBER 30,** |   | **NINE MONTHS ENDED  SEPTEMBER 30,** |   |
|-------------------------------------------|--------|--------------------------------------------|--------|-------------------------------------------|--------|
|                                      |   | **2003**                                   |   | **2002**                                  |   | **2003** |   | **2002** |   |
| Numerator                                 |   |                                       |   |                                      |   |   |   |   |   |
| Net loss                                  |   | $                                          | (116   | )                                         | $      | (964 | ) | $ | (4,306 | ) | $ | (3,594 | ) |
| Less Series B preferred dividends         |   | (15                                        | )      | (15                                       | )      | (46 | ) | (48 | ) |
| Net loss available to common shareholders |   | $                                          | (131   | )                                         | $      | (979 | ) | $ | (4,352 | ) | $ | (3,642 | ) |
|                                      |   |                                       |   |                                      |   |   |   |   |   |
| Denominator                               |   |                                       |   |                                      |   |   |   |   |   |
| Weighted-average shares outstanding       |   | 5,489,390                                  |   | 5,485,210                                 |   | 5,489,390 |   | 5,483,280 |   |
|                                      |   |                                       |   |                                      |   |   |   |   |   |
| Basic and diluted loss per share          |   | $                                          | (0.02  | )                                         | $      | (0.18 | ) | $ | (0.79 | ) | $ | (0.66 | ) |

 

**NOTE3.  SEGMENT INFORMATION**

 

Prior to its acquisition ofG & A in March 2001, the Company operated in one business segment.During 2002, the Company reorganized its reportable segments into geographicalgroups: Americas, International and Digital Photography. In the Company’s Americassegment, the Company develops, sells and supports a suite of modular softwareproducts and designs systems used by law enforcement and public safety agenciesto manage criminal history records and investigate crime as well as develops,sells and supports software and designs systems which utilize digital imagingin the production of photo identification cards, documents and identificationbadging systems. The Americas segment includes North, Central and SouthAmerica. The Company’s International segment includes all geographic areasother than North, Central and South America. The Company’s Internationalsegment develops, sells and supports software and designs systems utilizingdigital imaging in the production of photo identification cards, documents andidentification badging systems. The Digital Photography segment developsdigital imaging software which enables professional photographers to quicklyand easily take photos and create a database of information that can be sent tophotography laboratories for processing.

 

Subsequent to the nine months endedSeptember 30, 2002, the Company has re-evaluated its organizational andinternal financial reporting structure. Accordingly, the Company has realigned its business segments alongproduct and service lines for operating decision purposes and to better assessperformance.  Financial reportingsegments have been changed to reflect this alignment.

 

The table below summarizes information aboutreportable segments for the three and nine months ended September 30, 2003and 2002:

 

10

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|                         |   | **THREE MONTHS ENDED  September30,** |     | **NINE MONTHS ENDED  September 30,** |     |
|------------------------------|--------|--------------------------------------|----------|-------------------------------------------|----------|
|                         |   | **2003**                             |     | **2002**                                  |     | **2003** |   | **2002** |   |
|                         |   | **(in  thousands)**                  |     | **(in  thousands)**                       |     |
| Net Revenue:                 |   |                                 | * * |                                      | * * |   | * * |   | * * |
| Law Enforcement              |   | $                                    | 691      |                                      | $        | 941 |   | $ | 2,633 |   | $ | 3,233 |   |
| Identification               |   | 3,584                                |     | 3,338                                     |     | 9,227 |   | 8,631 |   |
| Digital Photography          |   | 482                                  |     | 391                                       |     | 956 |   | 811 |   |
| Total consolidated net sales |   | $                                    | 4,757    |                                      | $        | 4,670 |   | $ | 12,816 |   | $ | 12,675 |   |
|                         |   |                                 |     |                                      |     |   |   |   |   |
| Operating income (loss):     |   |                                 |     |                                      |     |   |   |   |   |
| Law Enforcement              |   | $                                    | (180     | )                                         | $        | (59 | ) | $ | (255 | ) | $ | 98 |   |
| Identification               |   | 97                                   |     | (586                                      | )        | (1,649 | ) | (2,667 | ) |
| Digital Photography          |   | 93                                   |     | (71                                       | )        | (195 | ) | (642 | ) |
|                         |   |                                 |     |                                      |     |   |   |   |   |
| Other unallocated amounts:   |   |                                 |     |                                      |     |   |   |   |   |
| Interest expense (income)    |   | 69                                   |     | 250                                       |     | 2,323 |   | 362 |   |
| Other expense (income)       |   | 57                                   |     | (2                                        | )        | (116 | ) | 21 |   |
|                         |   |                                 |     |                                      |     |   |   |   |   |
| Income (loss) before taxes   |   | $                                    | (116     | )                                         | $        | (964 | ) | $ | (4,306 | ) | $ | (3,594 | ) |

 
| **Total Assets by Segment:**         |   | **September 30,  2003** |   |
|--------------------------------------|--------|------------------------------|--------|
|                                 |   | **(in  thousands)**          |   |
| Law Enforcement                      |   | $                            | 270    |   |
| Identification                       |   | 9,505                        |   |
| Digital Photography                  |   | 1,546                        |   |
| Total assets for reportable segments |   | 11,321                       |   |
| Corporate                            |   | 1,177                        |   |
| Total consolidated assets            |   | $                            | 12,498 |   |

 

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**NOTE4.  NOTES PAYABLE AND LINES OF CREDIT**

 

In May 2002, the Company issued a senior secured convertiblepromissory note for $2,000,000 at an interest rate of 12.5%, due May 22,2004 (the “Note”).  The Note initiallywas convertible into common shares of the Company at $4.31 per share.  In conjunction with the note, the Companyissued a warrant to purchase 150,000 shares of common stock at $4.74 pershare.  The Company recorded the notenet of a discount equal to the fair value allocated to the warrants issued ofapproximately $537,000.

 

The Note also contained abeneficial conversion feature, which resulted in additional debt discount of$537,000.  The beneficial conversionamount was measured using the accounting intrinsic value, i.e. the excess ofthe aggregate fair value of the common stock into which the debt is convertibleover the proceeds allocated to the security. The Company accreted thebeneficial conversion feature as interest expense over the life of thenote.  For the nine months endedSeptember 30, 2003, the Company recorded $1,519,000 as interest expensefrom the amortization of the discount related to fair value of the warrants andfrom the accretion of the beneficial conversion feature through the date ofextinguishment.  The Company allocated aportion of the reacquisition price to the beneficial conversion feature at thedate of extinguishment.  See notesbelow.  

 

InSeptember 2002, the Company issued a secured demand promissory note for$500,000 at an interest rate of 12.5% to the holder of the Note.  This note was due and payable upon demandgiven by the holder.

 

The issuance by the Companyof $600,000 in convertible subordinated promissory notes in March 2003(described below) triggered certain anti-dilution provisions contained in theNote.  This resulted in the conversionprice of the note being reduced to $1.90 per share.  Similar provisions also reduced the warrant exercise price to$4.65 per share.  These reductionsresulted in the recognition of an additional beneficial conversion feature inthe amount of $926,000 which has been recorded as additional debtdiscount.  The Company accreted thisadditional beneficial conversion feature as interest expense through the dateof extinguishment.  

 

In March 2003, the Company issued to certain accredited investorsconvertible subordinated promissory notes (“the Subordinated Notes”).  The Subordinated Notes have an aggregate principal amount of $600,000, bearan interest rate of 8.5% per annum, payable semi-annually in arrears, have amaturity date of April 15, 2005 and are convertible into shares of theCompany’s common stock at a conversion price of $1.90 per share.

 

TheSubordinated Notes contained an embedded beneficial conversion feature which resulted in debt discount of$111,000.  The beneficial conversionamount was measured using the accounting intrinsic value, i.e. the excess ofthe aggregate fair value of the common stock into which the debt is convertibleover the proceeds allocated to the security. The Company is accreting thebeneficial conversion feature as interest expense over the life of the note.  For the nine months ended September 30,2003, the Company recorded $28,000 as interest expense from the amortization ofthe discount related to the accretion of this beneficial conversion feature.

 

In June 2003, theCompany issued two senior secured convertible promissory notes for an aggregateof $4,150,000 and a third senior secured convertible promissory note for$106,000 (collectively “the New Notes”) in lieu of payment of financingfees.  The New Notes bear interest at12.5% per annum and are due on the earlier of May 22, 2005 or upon theoccurrence of various other events or conditions set forth in the New Notes,including but not limited to certain mergers, consolidations, reorganizationsor other business combinations involving the Company.  Under the terms of the New Notes, the holders retain the right,subject to certain exceptions, to convert all or any part of the principal andaccrued interest outstanding under the Notes into shares of our Common Stock ata conversion price per share equal to $2.11. The conversion price is subject to adjustment in the event we affect astock split, combination or like transaction.  The New Notes contain “full-ratchet” price anti-dilution provisions thatwould become effective if our shareholders approve the transaction.  In conjunction with the issuance of the NewNotes, the Company issued warrants to acquire 1,600,000 shares of the Company’sCommon stock at an exercise price of $2.11 per share.  The warrant price is subject to adjustment in the event of astock split, combination or like transaction. The warrants contain “full-ratchet” price and anti-dilution provisionsthat would become effective if our shareholders approve the transaction.  

 

12

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The Company recorded the NewNotes net of a discount equal to the fair value allocated to the warrantsissued of approximately $2,038,000.  TheNew Notes also contained a beneficial conversion feature, which resulted inadditional debt discount of $2,052,000. The beneficial conversion amount was measured using the accountingintrinsic value, i.e. the excess of the aggregate fair value of the commonstock into which the debt is convertible over the proceeds allocated to thesecurity. The Company is accreting the beneficial conversion feature asinterest expense over the life of the note. For the nine months ended September 30, 2003, the Company recorded$614,000 as interest expense from the amortization of the discount related tofair value of the warrants and from the accretion of the beneficial conversionfeature.  

 

The Company utilized aportion of the proceeds from the issuance of the New Notes to extinguish the$2,000,000 Senior Secured Convertible Note issued in May 2002 and the$500,000 secured demand promissory note issued in September 2002.  The Company has recorded additional interestexpense of $766,757 representing the unamortized debt discount at the date ofextinguishment.  The Company has also recordedadditional interest expense of $225,000 representing unamortized deferred financingfees at the date of extinguishment.  TheCompany allocated $516,000 of the reacquisition price to the beneficialconversion feature based on the intrinsic value of the conversion features onthe date of extinguishment.

 

A foreign subsidiary of the Companyhad two line of credit facilities with commercial banks totaling $606,000.  As of September 30, 2003, the Companyfully repaid all outstanding borrowings under these credit facilities upontheir termination.

 

In July 2003, theCompany converted $99,000 in trade accounts payable into promissory notes.  The notes bear interest between 6.50% to7.50% per annum, call for monthly payments between $1,000 to $2,000 until paidin full, with payments commencing August 1, 2003.

 

**NOTE 5.  WARRANTLIABILITY**

** **

In conjunction with the Company’s issuance ofthe New Notes, the Company agreed to register with the Securities and ExchangeCommission, the shares of common stock underlying the warrants issued as partof the New Notes.  In accordance withthe Financial Accounting Standards Board Emerging Issue Task Force 00-19, theCompany has recorded as long-term liability the relative fair value of thewarrant.  Accordingly, the Company isaccounting for the liability under fair value accounting and has recordedcurrent period interest income of $711,000 for the three months endedSeptember 30, 2003 and has recorded $390,000 in interest income for thenine month period ended September 30, 2003.  The following table sets forth the changes in fair value and theresulting interest income or expense of this liability as determined under fairvalue accounting:

 
|                                          |   | **($ in  thousands)** |   |
|-----------------------------------------------|--------|-----------------------|--------|
|                                          |   |                  |   |
| Warrant liability at date of inception        |   | 2,037                 |   |
|                                          |   |                  |   |
| Change in fair value of warrant liability     |   | 321                   |   |
|                                          |   |                  |   |
| Warrant liability at June 30, 2003       |   | 2,358                 |   |
|                                          |   |                  |   |
| Change in fair value of warrant liability     |   | (711                  | )      |
|                                          |   |                  |   |
| Warrant liability at September 30,  2003 |   | 1,647                 |   |

 

**NOTE6.  RECENTLY ISSUED ACCOUNTING STANDARDS**

 

InDecember 2002, the Financial Accounting Standards Board (“FASB”) issuedSFAS No. 148, *Accounting for Stock Based Compensation — Transition andDisclosure. *This statementprovides alternative methods of transition for a voluntary change to the fairvalue-based method of accounting for stock-based employee

 

13

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compensation.  In addition, thisstatement also amends the disclosure requirements of SFAS No. 123 to requiremore prominent and frequent disclosures in the financial statements about theeffects of stock-based compensation. The transitional guidance and annual disclosure provisions of thisstatement was effective for the December 31, 2002 financialstatements.  The interim reportingdisclosure requirements are effective for the Company’s September 30, 2003Form 10-QSB. Because the Company continues to account for employee stock-basedcompensation under APB Opinion No. 25, the transitional guidance of SFAS No.148 has no effect on the financial statements at this time. TheDecember 31, 2002 and September 30, 2003 financial statements haveincorporated the enhanced disclosure requirements of SFAS No. 148, as presentedbelow under the caption “Stock-Based Compensation.”

** **

InNovember 2002, the FASB issued FASB Interpretation No. 45 (“FIN 45”),*— “Guarantor’s Accounting and Disclosure Requirementsfor Guarantees, Including Indirect Guarantees of Indebtedness of Others.”*FIN45 requires that a liability be recorded in the guarantor’s balance sheet uponissuance of a guarantee. In addition, FIN 45 requires disclosures about theguarantees that an entity has issued, including a roll forward of the entity’sproduct warranty liabilities. The Company will apply the recognition provisionsof FIN 45 prospectively to guarantees issued after December 31, 2002. Thedisclosure provisions of FIN 45 are effective for the 2002 financialstatements; however no new disclosures were deemed necessary. The adoption ofFIN 45 did not have a material effect on the Company’s results of operations orfinancial condition.

 

InNovember 2002, the Emerging Issues Task Force (EITF) issued IssueNo. 00-21, “Accounting for Revenue Arrangements with MultipleDeliverables.” This issue addresses determination of whether an arrangementinvolving more than one deliverable contains more than one unit of accountingand how arrangement consideration should be measured and allocated to theseparate units of accounting. EITF Issue No. 00-21 will be effective forrevenue arrangements entered into in fiscal periods beginning afterJune 15, 2003 or the Company may elect to report the change in accountingas a cumulative-effect adjustment. The Company is reviewing EITF IssueNo. 00-21 and has not yet determined the impact this issue will have onits results of operations and financial condition.

 

InApril 2003, the FASB issued Statement of Financial Accounting Standard No.149, (“SFAS 149”), “Amendment of Statement 133 on Derivative Instruments andHedging Activities,” which amends and clarifies financial accounting andreporting for derivative instruments, including certain derivative instrumentsembedded in other contracts and for hedging activities under SFAS 133.  SFAS 149 is effective for contracts enteredinto or modified after June 30, 2003 and for hedging relationshipsdesignated after June 30, except for the provisions that were cleared bythe FASB in prior pronouncements.  Theadoption of this statement is not expected to have a significant impact on theCompany’s consolidated financial statements. 

 

In May 2003, the FASBissued Statement of Financial Accounting Standard No. 150 (SFAS 150),“Accounting for Certain Financial Instruments with Characteristics of bothLiabilities and Equity.” SFAS 150 is effective for financial instrumentsentered into or modified after May 31, 2003, and otherwise is effective atthe beginning of the first interim period beginning after June 15, 2003.SFAS 150 establishes standards for how an issuer classifies and measures in itsstatement of financial position certain financial instruments withcharacteristics of both liabilities and equity. It requires that an issuerclassify a financial instrument that is within its scope as a liability becausethat financial instrument embodies an obligation of the issuer. The adoption ofthis statement is not expected to have a significant impact on the Company’sconsolidated financial statements.

 

In January 2003, theFinancial Accounting Standards Board (“FASB”) issued InterpretationNo. 46, “*Consolidation of VariableInterest Entities*” (“FIN 46”), an interpretation of AccountingResearch Bulletin No. 51, “*ConsolidatedFinancial Statements”*. FIN 46 explains how to identify variableinterest entities and how an enterprise assesses its interests in a variableinterest entity to decide whether to consolidate that entity. Thisinterpretation requires existing unconsolidated variable interest entities tobe consolidated by their primary beneficiaries if the primary beneficiary issubject to a majority of the risk of loss from the variable interest entity’sactivities or entitled to receive a majority of the entity’s residual returns,or both. FIN 46 is effective immediately for variable interest entities createdafter January 31, 2003, and to variable interest entities in which anenterprise obtains an interest after that date. The Interpretation applies inthe first fiscal year or interim period beginning after June 15, 2003, tovariable interest entities in which an enterprise holds a variable interestthat it acquired before February 1, 2003. The Company does not expect theadoption of FIN 46 to have a material impact on its consolidated financialposition or results of operations.

 

14

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In July 2003, the EITFreached a consensus on EITF 03-5, “*Applicabilityof AICPA SOP 97-2 to Non-Software Deliverables*.”  EITF 03-5provides accounting guidance on whether non-software deliverables (e.g.,non-software related equipment or services) included in an arrangement thatcontains software are within the scope of SOP 97-2.  In general, anynon-software deliverables are within the scope of SOP 97-2 if the softwaredeliverable is essential to the functionality of the non-softwaredeliverable.  Companies are required to adopt this consensus in the firstreporting period (annual or interim) beginning after ratification by the FASB,which is expected to be August 13, 2003.  The Company believes theadoption of EITF 03-5 will not have a material impact on the Company’sconsolidated financial position or results of operations.

 

** **

**ITEM2.  MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.**

 

This Quarterly Report onForm 10-QSB contains forward-looking statements within the meaning ofSection 27A of the Securities Act of 1933, and Section 21E of theSecurities Exchange Act of 1934. All forward-looking statements included inthis report are based on information available to us as of the date hereof andwe assume no obligation to update any forward-looking statements.Forward-looking statements involve known or unknown risks, uncertainties andother factors, which may cause our actual results, performance or achievements,or industry results to be materially different from any future results,performance or achievements expressed or implied by such forward-lookingstatements. Factors that could cause or contribute to such differences includebut are not limited to those items discussed under “Risk Factors” and elsewherein this Quarterly Report.

 

The following discussion ofthe financial condition and results of operations should be read in conjunctionwith the condensed consolidated financial statements included elsewhere withinthis quarterly report. Fluctuations in annual and quarterly results may occuras a result of factors affecting demand for the Company’s products such as thetiming of new product introductions by us and by our competitors and ourcustomers’ political and budgetary constraints. Due to such fluctuations,historical results and percentage relationships are not necessarily indicativeof the operating results for any future period.

 

**OVERVIEW**

 

ImageWare Systems, Inc. develops softwaresolutions for digital imaging, biometrics, law enforcement and securecredentials. Through its ID product line, ImageWare applies its core technologyto create secure identification systems for airports, universities, governmentagencies and private businesses. ImageWare’s law enforcement product lineempowers its customers to quickly capture, search, retrieve and share digitalphotographs and criminal history records on stand-alone, networked or Web-basedplatforms. ImageWare additionally leverages its imaging technology to createsoftware and Web-based solutions for professional photographers.

 

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** **

**RESULTS OFOPERATIONS**

 

***THREE MONTHS ENDED SEPTEMBER 30, 2003AND 2002.***

 
| **Net Product Revenues**                |   | **THREE MONTHS  ENDED  SEPTEMBER 30,** |   |     |   |            |   |
|-----------------------------------------|--------|---------------------------------------------|--------|----------|--------|-----------------|--------|
| **(dollars in thousands)**              |   | **2003**                                    |   | **2002** |   | **$****Change** |   | **%****Change** |   |
| **Product revenues:**                   |   |                                        |   |     |   |            |   |   |   |
| Law Enforcement                         |   | $                                           | 204    |     | $      | 381             |   | $ | (177 | ) | -46 | % |
| Percentage of total net product revenue |   | 5                                           | %      | 9        | %      |            |   |   |   |
| Identification                          |   | $                                           | 3,481  |     | $      | 3,174           |   | $ | 307 |   | 10 | % |
| Percentage of total net product revenue |   | 84                                          | %      | 81       | %      |            |   |   |   |
| Digital Photography                     |   | $                                           | 482    |     | $      | 387             |   | $ | 95 |   | 25 | % |
| Percentage of total net product revenue |   | 11                                          | %      | 10       | %      |            |   |   |   |
| Total net product revenues              |   | $                                           | 4,167  |     | $      | 3,942           |   | $ | 225 |   | 6 | % |

 

Product revenues increased6% from $3,942,000 for the three months ended September 30, 2002 to$4,167,000 for the corresponding period in 2003. Revenues related to lawenforcement systems and software decreased $177,000 or 46% for the three monthsended September 30, 2003 as compared to the corresponding period in 2002.We believe that the decrease in law enforcement product revenues is reflectiveof a decrease in state and local government procurement. We further believethat the increase in terrorism has created heightened interest in the abilityof law enforcement and other government agencies to be able to efficientlyretrieve, analyze and share information from their respective criminaldatabases.  We anticipate that thesefactors will increase overall demand for the Company’s law enforcementproducts, however, we cannot predict the timing of the shift in demand.

 

Identification productrevenues increased 10% from $3,174,000 for the three months endedSeptember 30, 2002 to $3,481,000 for the corresponding period in2003.  We believe that governmentagencies and private entities are reacting to increased terrorism byre-evaluating and upgrading their ability to positively identify and track theiremployees, consultants and visitors. We anticipate that these factors willincrease overall demand for the Company’s identification products, however, wecannot predict the timing of the shift in demand.  Also contributing to this increase was a change to ourdomestic distribution strategy with the establishment of Fargo Electronics,Inc. as a master distributor of our off-the-shelf photo ID badge design andmanagement software which resulted in higher software sales of identificationproducts in the quarter.

 

Digital Photography productrevenues increased 25% from $387,000 for the three months endedSeptember 30, 2002 to $482,000 for the corresponding period in 2003.  This increase is reflective of an increaseis custom software contracts completed during the third quarter of 2003 as wellas increased distribution through dealer networks.  

 

Our backlog of productorders as of September 30, 2003 was approximately $1,260,000.

 

16

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| **Maintenance Revenues**                    |   | **THREE MONTHS  ENDED  SEPTEMBER 30,** |   |     |   |            |   |
|---------------------------------------------|--------|---------------------------------------------|--------|----------|--------|-----------------|--------|
| **(dollars in thousands)**                  |   | **2003**                                    |   | **2002** |   | **$****Change** |   | **%****Change** |   |
| **Maintenance revenues:**                   |   |                                        |   |     |   |            |   |   |   |
| Law Enforcement                             |   | $                                           | 488    |     | $      | 560             |   | $ | (72 | ) | -13 | % |
| Percentage of total net maintenance revenue |   | 83                                          | %      | 77       | %      |            |   |   |   |
| Identification                              |   | $                                           | 102    |     | $      | 165             |   | $ | (63 | ) | -38 | % |
| Percentage of total net maintenance revenue |   | 17                                          | %      | 22       | %      |            |   |   |   |
| Digital Photography                         |   | $                                           | — |     | $      | 4               |   | $ | (4 | ) | -100 | % |
| Percentage of total net maintenance revenue |   | 0                                           | %      | 1        | %      |            |   |   |   |
| Total net maintenance revenues              |   | $                                           | 590    |     | $      | 729             |   | $ | (139 | ) | -19 | % |

 

Maintenance revenuesdecreased 19% from $729,000 for the three months ended September 30, 2002to $590,000 for the corresponding period in 2003. Law enforcement maintenancerevenues decreased 13% or $72,000 for the three months ended September 30,2003 from $560,000 for the three months ended September 30, 2002 to$488,000 for the corresponding period in 2003. This decrease reflectsthe expiration in the third quarter of 2003 of the service contract for the NewYork City Police Department, historically one of our larger service andmaintenance customers. 

 

Identification maintenancerevenues decreased 38% or $63,000 for the three months ended September 30,2003 from $165,000 for the three months ended September 30, 2002 to$102,000 for the corresponding period in 2003. This decrease is due primarilyto the expiration of maintenance contracts for certain of our identificationcustomers.

 
| **Cost of product revenues**                        |   | **THREE MONTHS  ENDED  SEPTEMBER 30,** |   |     |   |            |   |
|-----------------------------------------------------|--------|---------------------------------------------|--------|----------|--------|-----------------|--------|
| **(dollars in thousands)**                          |   | **2003**                                    |   | **2002** |   | **$****Change** |   | **%****Change** |   |
| **Cost of Product Revenues:**                       |   |                                        |   |     |   |            |   |   |   |
| Law Enforcement                                     |   | $                                           | 128    |     | $      | 141             |   | $ | (13 | ) | -9 | % |
| Percentage of Law Enforcement  product revenue |   | 63                                          | %      | 37       | %      |            |   |   |   |
| Identification                                      |   | $                                           | 1,260  |     | $      | 1,504           |   | $ | (244 | ) | -16 | % |
| Percentage of Identification product  revenue       |   | 36                                          | %      | 47       | %      |            |   |   |   |
| Digital Photography                                 |   | $                                           | 17     |     | $      | 50              |   | $ | (33 | ) | -66 | % |
| Percentage of Digital Photography product  revenue  |   | 4                                           | %      | 13       | %      |            |   |   |   |
| Total product cost of revenues                      |   | $                                           | 1,405  |     | $      | 1,695           |   | $ | (290 | ) | -17 | % |
| Percentage of total product revenues                |   | 34                                          | %      | 43       | %      |            |   |   |   |

 

Cost of product revenues asa percentage of product revenues decreased from 43% for the three month periodended September 30, 2002 to 34% of product revenues for the correspondingperiod in 2003. This overall decrease is due primarily to anuncharacteristically high level of software only sales resulting in a lowercost of sales as a percentage of product revenues. 

 

 Cost of product revenues for our Law Enforcement segment decreased9%, or $13,000 from $141,000 or 37% of Law Enforcement product revenues for thethree months ended September 30, 2002 to $128,000, or 63% of productrevenues for the corresponding period in 2003. This percentage increase in Law Enforcement cost of product revenues asa percentage of Law Enforcement product revenues is due primarily to thesmaller revenue base to absorb fixed product costs.  Costs of products also can vary as a percentage of productrevenue from period to period depending upon product mix and the hardwarecontent, print media consumable content and software content included insystems installed during a given period.

 

17

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Cost of product revenues related to our Identification segmentdecreased 16% from $1,504,000, or 47% of Identification product revenues forthe three month period ended September 30, 2002 to 1,260,000 or 36% ofIdentification product revenues for the corresponding period in 2003.  This dollar decrease of $244,000 isreflective of higher sales of software. The percentage decrease of Identification cost of product revenues as apercentage of Identification revenues is also reflective of higher revenuesfrom the sale of software.  Costs ofproducts can vary as a percentage of product revenue from period to perioddepending upon product mix and the hardware content, print media consumable contentand software content included in products sold and systems installed during agiven period.

 

 Cost of product revenues related to ourDigital Photography segment decreased 66% from $50,000, or 13% of DigitalPhotography revenues for the three month period ended September 30, 2002to $17,000 or 4% of Digital Photography revenues for the corresponding periodin 2003.  This decrease of $33,000 isdue primarily to our elimination of costs related to our web hosting service, Picturemore.com,which was not operational during the 2003 period.

 
| **Maintenance cost of revenues**                       |   | **THREE MONTHS  ENDED  SEPTEMBER 30,** |       |     |       |            |       |
|--------------------------------------------------------|--------|---------------------------------------------|------------|----------|------------|-----------------|------------|
| **(dollars in thousands)**                             |   | **2003**                                    |       | **2002** |       | **$****Change** |       | **%****Change** |   |
| **Maintenance cost of  revenues:**                     |   |                                        | ** ** |     | ** ** |            | ** ** |   | ** ** |
| Law Enforcement                                        |   | $                                           | 185        |     | $          | 200             |       | $ | (15 | ) | -7 | % |
| Percentage of Law Enforcement maintenance  revenue     |   | 38                                          | %          | 36       | %          |            |       |   |   |
| Identification                                         |   | $                                           | 85         |     | $          | 106             |       | $ | (21 | ) | -21 | % |
| Percentage of Identification maintenance  revenue      |   | 83                                          | %          | 64       | %          |            |       |   |   |
| Digital Photography                                    |   | $                                           | —     |     | $          | —          |       | $ | — |   | N/A |   |
| Percentage of Digital Photography  maintenance revenue |   |                                        |       |     |       |            |       |   |   |
| Total maintenance cost of revenues                     |   | $                                           | 270        |     | $          | 306             |       | $ | (36 | ) | -12 | % |
| Percentage of total maintenance revenues               |   | 46                                          | %          | 42       | %          |            |       |   |   |

 

Costs of maintenancerevenues decreased 12% from $306,000, or 42% of maintenance revenues, for thethree months ended September 30, 2002 to $270,000, or 46% of maintenancerevenues, for the corresponding period in 2003. Cost of maintenance revenues inour Law Enforcement segment decreased 7%, from $200,000 or 36% of maintenancerevenues for the three months ended September 30, 2002 to $185,000 or 38%of maintenance revenues for the corresponding period in 2003. This decrease incosts of maintenance revenues is due primarily to lower costs necessary toservice the installed base due to the expiration in the third quarter ofthe service contract for the New York City Police Department.  Fixed costs totaling approximately $200,000per year associated with that contract were eliminated upon contractexpiration.  Identification maintenance cost of revenuesdecreased $21,000 for the three month period ended September 30, 2003 ascompared to the corresponding period in 2002 but increased as a percentage ofIdentification maintenance revenue from 64% for the three month period endedSeptember 30, 2002 to 83% for the corresponding period in 2003.  The dollar decrease is reflective ofdecreased maintenance revenues due to the expiration of certain maintenancecontracts.  The percentage increase isreflective of a lower maintenance revenue base to absorb fixed maintenancecosts.  

 

18

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| **Product gross profit**                          |   | **THREE MONTHS  ENDED  SEPTEMBER 30,** |   |     |   |            |   |
|---------------------------------------------------|--------|---------------------------------------------|--------|----------|--------|-----------------|--------|
| **(dollars in thousands)**                        |   | **2003**                                    |   | **2002** |   | **$****Change** |   | **%****Change** |   |
| Law Enforcement                                   |   | $                                           | 76     |     | $      | 240             |   | $ | (164 | ) | -68 | % |
| Percentage of Law Enforcement product  revenue    |   | 37                                          | %      | 63       | %      |            |   |   |   |
| Identification                                    |   | $                                           | 2,221  |     | $      | 1,670           |   | $ | 551 |   | 33 | % |
| Percentage of Identification product  revenue     |   | 64                                          | %      | 53       | %      |            |   |   |   |
| Digital Photography                               |   | $                                           | 465    |     | $      | 337             |   | $ | 128 |   | 38 | % |
| Percentage of Digital Photography product revenue |   | 96                                          | %      | 87       | %      |            |   |   |   |
| Total product gross profit                        |   | $                                           | 2,762  |     | $      | 2,247           |   | $ | 515 |   | 23 | % |
| Percentage of total product revenues              |   | 66                                          | %      | 57       | %      |            |   |   |   |

 

Total product gross marginsas a percentage of product revenues increased from 57% for the three monthperiod ended September 30, 2002 to 66% of product revenues for thecorresponding period in 2003. The overall increase is primarily due to a higherpercentage of total revenues coming from the sales of software only solutions.

 

Law Enforcement gross profitas a percentage of Law Enforcement product revenue decreased from 63% for thethree months ended September 30, 2002 to 37% for the corresponding periodof 2003. This decrease is due primarily to our product mix containing higherpercentages of hardware than the comparable period in 2002, as well as a lowerrevenue base to absorb fixed product costs. Costs of products can vary as a percentage of product revenue fromquarter to quarter depending upon product mix and hardware content and printmedia consumable content included in systems installed during a given period.

 

Identification gross profitas a percentage of Identification product revenue increased from 53% for thethree months ended September 30, 2002 to 64% for the corresponding periodof 2003.  This increase is reflective ofuncharacteristically high sales of software only solutions.  Costs of products can vary as a percentageof product revenue from period to period depending upon product mix and thehardware content, print media consumable content and software content includedin systems installed during a given period.

 

Digital Photography grossprofit as a percentage of Digital Photography product revenue increased from87% for the three months ended June 30, 2002 to 96% for the correspondingperiod in 2003. This increase is due to higher revenues related to customsoftware contracts combined with our elimination of costs related to our web hosting service, Picturemore.com,which was not operational during the 2003 period.

 
| **Maintenance gross profit**                           |   | **THREE MONTHS  ENDED  SEPTEMBER 30,** |   |     |   |            |   |
|--------------------------------------------------------|--------|---------------------------------------------|--------|----------|--------|-----------------|--------|
| **(dollars in thousands)**                             |   | **2003**                                    |   | **2002** |   | **$****Change** |   | **%****Change** |   |
| **Maintenance gross profit**                           |   |                                        |   |     |   |            |   |   |   |
| Law Enforcement                                        |   | $                                           | 303    |     | $      | 360             |   | $ | (57 | ) | -16 | % |
| Percentage of Law Enforcement maintenance  revenue     |   | 62                                          | %      | 64       | %      |            |   |   |   |
| Identification                                         |   | $                                           | 17     |     | $      | 59              |   | $ | (42 | ) | -71 | % |
| Percentage of Identification maintenance  revenue      |   | 17                                          | %      | 36       | %      |            |   |   |   |
| Digital Photography                                    |   | $                                           | — |     | $      | 4               |   | $ | (4 | ) | 100 | % |
| Percentage of Digital Photography  maintenance revenue |   | N/A                                         |   | 100      | %      |            |   |   |   |
| Total maintenance gross profit                         |   | $                                           | 320    |     | $      | 423             |   | $ | (103 | ) | -24 | % |
| Percentage of total maintenance revenues               |   | 54                                          | %      | 58       | %      |            |   |   |   |

 

Gross margins related tomaintenance revenues decreased $103,000, or 24% from $423,000, or 58% of 

 

19

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maintenancerevenues for the three months ended September 30, 2002 to $320,000, or 54%of maintenance revenues for the corresponding period in 2003. This dollardecrease is due primarily to reduced revenues resulting from the expiration inthe third quarter of 2003 of the New York City Police Department servicecontract and the expiration of certain Identification maintenance contracts.

 
| **Operating expenses**          |   | **THREE MONTHS  ENDED  SEPTEMBER 30,** |   |     |   |            |   |
|---------------------------------|--------|---------------------------------------------|--------|----------|--------|-----------------|--------|
| **(dollars in thousands)**      |   | **2003**                                    |   | **2002** |   | **$****Change** |   | **%****Change** |   |
|                            |   |                                        |   |     |   |            |   |   |   |
| General & administrative    |   | $                                           | 1,461  |     | $      | 1,646           |   | $ | (185 | ) | -11 | % |
| Percentage of total net revenue |   | 31                                          | %      | 35       | %      |            |   |   |   |
| Sales and marketing             |   | $                                           | 883    |     | $      | 957             |   | $ | (74 | ) | -8 | % |
| Percentage of total net revenue |   | 19                                          | %      | 20       | %      |            |   |   |   |
| Research & development      |   | $                                           | 509    |     | $      | 538             |   | $ | (29 | ) | -5 | % |
| Percentage of total net revenue |   | 11                                          | %      | 12       | %      |            |   |   |   |
| Depreciation and amortization   |   | $                                           | 219    |     | $      | 245             |   | $ | (26 | ) | -11 | % |
| Percentage of total net revenue |   | 5                                           | %      | 5        | %      |            |   |   |   |

 

*GENERAL AND ADMINISTRATIVE EXPENSES.* General and administrative expenses are comprised primarily of salariesand other employee-related costs for executive, financial, and otherinfrastructure personnel. General legal, accounting and consulting services,insurance, occupancy and communication costs are also included with general andadministrative expenses. Such expenses decreased 11%, or $185,000 from$1,646,000 for the three months ended September 30, 2002 to $1,461,000 forthe corresponding period in 2003.  Suchexpenses, as a percentage of total net revenues, decreased from 35% for the threemonths ended September 30, 2002 to 31% for the corresponding period in2003.  We are continuing to focus ourefforts on achieving additional future operating efficiencies by reviewing andimproving upon existing business processes and evaluating our cost structure.We believe these efforts will allow us to decrease our level of general andadministrative expenses expressed as a percentage of total revenues.

 

*SALES AND MARKETING.* Sales and marketing expenses consist primarily of the salaries,commissions, other incentive compensation, employee benefits and travelexpenses of our sales force. Such expenses decreased 8%, or $74,000 from$957,000 for the three months ended September 30, 2002 to $883,000 for thecorresponding period in 2003.  Suchexpenses, as a percentage of total net revenues, decreased from 20% for thethree months ended September 30, 2002 to 19% for the corresponding periodin 2003.  

 

*RESEARCH AND DEVELOPMENT.* Research and development costs consist primarily of salaries, employeebenefits and outside contractors for new product development, productenhancements and custom integration work. Such expenses decreased 5% or $29,000from $538,000 for the three months ended September 30, 2002 to $509,000for the corresponding period in 2003.  Thisdecrease is due to a reduction in contract programming expenditures.  Our level of expenditures in research anddevelopment reflects our belief that to maintain our competitive position inmarkets characterized by rapid rates of technological advancement, we mustcontinue to invest significant resources in the development of new systems andsoftware as well as continue to enhance existing products.

 

*DEPRECIATION AND AMORTIZATION.* Depreciation and amortization decreased $26,000 from $245,000 for thethree months ended September 30, 2002 to $219,000 for the correspondingperiod in 2003. This decrease is due primarily to certain fixed assets andintangibles being fully depreciated or amortized.

 

*INTEREST EXPENSE, NET.*  Forthe three months ended September 30, 2003, we recognized interest incomeof $713,000 and interest expense of $782,000. For the three months endedSeptember 30, 2002, we recognized interest income of $18,000 and interestexpense of $268,000.  Interest incomefor the three months ended September 30, 2003 contains $711,000 ofinterest income related to fair value accounting for our warrant liability

 

20

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due to the registration rights agreement associated with the underlyingshares of the Company’s common stock to be issued upon conversion of thewarrants.  Interest expense in the threemonths ended September 30, 2003 increased due to our issuance of seniorsecured and subordinated convertible promissory notes payable, short-termdemand notes payable and short-term borrowings under banking lines ofcredit.  Interest expense for the threemonths ended September 30, 2003 includes approximately of $619,000 of debtdiscount and deferred financing fee amortization classified as interestexpense. The following table sets forth the components of net interestexpense for the three months ended September 30, 2003:

 
|                                                                                                                                                                        |   | **THREE  MONTHS ENDED  September30,** |       |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------|------------|
| **Components of net interest  expense (income):**                                                                                                                           |   | **2003**                              |       | **2002** |   |
|                                                                                                                                                                        |   | **(in  thousands)**                   | ** ** |
| Senior secured convertible promissory note  issued May 22, 2002, interest rate 12.5% due May 22, 2004; Principal amount  $2,000,000 (the “Note):                       |   |                                  |       |   |   |
| Coupon interest rate expense                                                                                                                                                |   | $                                     | —     |   | $ | 62 |   |
| Amortization to interest expense of note  discount related to fair value of warrants                                                                                        |   |                                  |       | 67 |   |
| Amortization to interest expense of note  discount related to beneficial conversion feature                                                                                 |   |                                  |       | 67 |   |
| Interest expense from amortization of  deferred financing fees                                                                                                              |   |                                  |       | 34 |   |
|                                                                                                                                                                        |   |                                  |       |   |   |
| Secured demand promissory note issued  September, 2002, interest rate 12.5%, due upon demand                                                                                |   | —                                |       | 2 |   |
|                                                                                                                                                                        |   |                                  |       |   |   |
| Subordinated convertible promissory notes  issued March 13, 2003, interest rate 8.5%, due April 15, 2005; Principal  amount $600,000, (“the Subordinated Notes”): |   |                                  |       |   |   |
| Coupon interest rate expense                                                                                                                                                |   | 13                                    |       | — |   |
| Amortization to interest expense of note  discount related to beneficial conversion feature                                                                                 |   | 13                                    |       | — |   |
| Interest expense from amortization of  deferred financing fees                                                                                                              |   | 7                                     |       | — |   |
|                                                                                                                                                                        |   |                                  |       |   |   |
| Senior secured convertible promissory notes  issued June 2003, interest rate 12.5% due May 22, 2005, Principal amount  $4,256,000; (“the New Notes):                   |   |                                  |       |   |   |
| Coupon interest rate expense                                                                                                                                                |   | 136                                   |       | — |   |
| Amortization to interest expense of note  discount related to fair value of warrants                                                                                        |   | 262                                   |       | — |   |
| Amortization to interest expense of note discount  related to beneficial conversion feature                                                                                 |   | 264                                   |       | — |   |
| Interest expense from amortization of  deferred financing fees                                                                                                              |   | 73                                    |       | — |   |
|                                                                                                                                                                        |   |                                  |       |   |   |
| Other notes payable interest expense                                                                                                                                        |   | 14                                    |       | 36 |   |
|                                                                                                                                                                        |   |                                  |       |   |   |
| Change in warrant liability classified as  interest (income) or expense                                                                                                     |   | (711                                  | )          | — |   |
|                                                                                                                                                                        |   |                                  |       |   |   |
| Interest income                                                                                                                                                             |   | (2                                    | )          | (18 | ) |
|                                                                                                                                                                        |   |                                  |       |   |   |
| Net interest (income) expense                                                                                                                                               |   | $                                     | 69         |   | $ | 250 |   |

 

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***NINE MONTHS ENDED SEPTEMBER 30,2003 AND 2002.***

* *
| **Net Product Revenues**                |   | **NINE MONTHS  ENDED  SEPTEMBER 30,** |   |     |   |            |   |
|-----------------------------------------|--------|--------------------------------------------|--------|----------|--------|-----------------|--------|
| **(dollars in thousands)**              |   | **2003**                                   |   | **2002** |   | **$****Change** |   | **%****Change** |   |
| **Product revenues:**                   |   |                                       |   |     |   |            |   |   |   |
| Law Enforcement                         |   | $                                          | 964    |     | $      | 1,620           |   | $ | (656 | ) | -40 | % |
| Percentage of total net product revenue |   | 9                                          | %      | 15       | %      |            |   |   |   |
| Identification Group                    |   | $                                          | 8,716  |     | $      | 8,196           |   | $ | 520 |   | 6 | % |
| Percentage of total net product revenue |   | 82                                         | %      | 77       | %      |            |   |   |   |
| Digital Photography                     |   | $                                          | 956    |     | $      | 785             |   | $ | 171 |   | 22 | % |
| Percentage of total net product revenue |   | 9                                          | %      | 7        | %      |            |   |   |   |
| Total net product revenues              |   | $                                          | 10,636 |     | $      | 10,601          |   | $ | 35 |   | 0 | % |

 

Product revenues increasedless than 1% from $10,601,000 for the nine months ended September 30, 2002to $10,636,000 for the corresponding period in 2003. Revenues related to lawenforcement systems and software decreased $656,000 for the nine months endedSeptember 30, 2003 as compared to the corresponding period in 2002. Webelieve that the decrease in law enforcement product revenues is reflective ofa decrease in government procurement. We believe that the increase in terrorismhas created heightened interest in the ability of law enforcement and othergovernment agencies to be able to efficiently retrieve, analyze and shareinformation from their respective criminal databases.  We anticipate that these factors will increase overall demand forthe Company’s law enforcement products, however, we cannot predict the timingof the shift in demand.

 

Identification productrevenues increased 6% from $8,196,000 for the nine months endedSeptember 30, 2002 to $8,716,000 for the corresponding period in2003.  We believe that governmentagencies and private entities are reacting to increased terrorism byre-evaluating and upgrading their ability to positively identify and tracktheir employees, consultants and visitors. We anticipate that these factorswill continue to increase overall demand for the Company’s identificationproducts, however, we cannot predict the timing of the shift in demand.  Also contributing to this increase was achange to our domestic distribution strategy with the establishment ofFargo Electronics, Inc. as a master distributor of our off-the-shelf photo IDbadge design and management software which resulted in higher software sales ofidentification products.

 

Digital Photography productrevenues increased 22% from $785,000 for the nine months endedSeptember 30, 2002 to $956,000 for the corresponding period in 2003.  This increase is reflective of an increaseis custom software contracts completed during the nine months endedSeptember 30, 2003 as well as increased distribution through dealer networks.  

 
| **Maintenance Revenues**                    |   | **NINE MONTHS  ENDED  SEPTEMBER 30,** |   |     |   |            |   |
|---------------------------------------------|--------|--------------------------------------------|--------|----------|--------|-----------------|--------|
| **(dollars in thousands)**                  |   | **2003**                                   |   | **2002** |   | **$****Change** |   | **%****Change** |   |
| **Maintenance revenues:**                   |   |                                       |   |     |   |            |   |   |   |
| Law Enforcement                             |   | $                                          | 1,668  |     | $      | 1,613           |   | $ | 55 |   | 3 | % |
| Percentage of total net maintenance revenue |   | 77                                         | %      | 78       | %      |            |   |   |   |
| Identification Group                        |   | $                                          | 511    |     | $      | 435             |   | $ | 76 |   | 17 | % |
| Percentage of total net maintenance revenue |   | 23                                         | %      | 21       | %      |            |   |   |   |
| Digital Photography                         |   | $                                          | 1      |     | $      | 26              |   | $ | (25 | ) | -98 | % |
| Percentage of total net maintenance revenue |   | 0                                          | %      | 1        | %      |            |   |   |   |
| Total net maintenance revenues              |   | $                                          | 2,180  |     | $      | 2,074           |   | $ | 106 |   | 5 | % |

 

22

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Maintenance revenuesincreased 5% from $2,074,000 for the nine months ended September 30, 2002to $2,180,000 for the corresponding period in 2003. This increase is due to theexpansion of our installed base of both law enforcement and identificationsystems.  Law enforcement maintenancerevenues increased 3% or $55,000 for the nine months ended September 30, 2003from $1,613,000 for the nine months ended September 30, 2002 to $1,668,000for the corresponding period in 2003. This increase is due primarily to theexpansion of our installed base of law enforcement systems and is offset by theexpiration of the New York City Police Department service and maintenanceagreement during the third quarter of 2003.

 

Identification maintenance revenues increased17% or $76,000 for the nine months ended September 30, 2003 from $435,000for the nine months ended September 30, 2002 to $511,000 for thecorresponding period in 2003. This increase is due primarily to the expansionof our installed base of identification systems offset by the expiration ofcertain maintenance contracts.

 
| **Cost of product revenues**                        |   | **NINE MONTHS  ENDED  SEPTEMBER 30,** |   |     |   |            |   |
|-----------------------------------------------------|--------|--------------------------------------------|--------|----------|--------|-----------------|--------|
| **(dollars in thousands)**                          |   | **2003**                                   |   | **2002** |   | **$****Change** |   | **%****Change** |   |
| **Cost of Product Revenues:**                       |   |                                       |   |     |   |            |   |   |   |
| Law Enforcement                                     |   | $                                          | 544    |     | $      | 553             |   | $ | (9 | ) | -2 | % |
| Percentage of Law Enforcement product  revenue      |   | 56                                         | %      | 34       | %      |            |   |   |   |
| Identification Group                                |   | $                                          | 3,892  |     | $      | 3,849           |   | $ | 43 |   | 1 | % |
| Percentage of Identification Group product  revenue |   | 45                                         | %      | 47       | %      |            |   |   |   |
| Digital Photography                                 |   | $                                          | 46     |     | $      | 218             |   | $ | (172 | ) | -79 | % |
| Percentage of Digital Photography product  revenue  |   | 5                                          | %      | 28       | %      |            |   |   |   |
| Total product cost of revenues                      |   | $                                          | 4,482  |     | $      | 4,620           |   | $ | (138 | ) | -3 | % |
| Percentage of total product revenues                |   | 42                                         | %      | 44       | %      |            |   |   |   |

 

Cost of product revenues as a percentage of product revenues decreasedfrom 44% for the nine month period ended September 30, 2002 to 42% ofproduct revenues for the corresponding period in 2003. This decrease is dueprimarily to higher sales of software only solutions resulting in lower cost ofsales as a percentage of product revenues. Cost of product revenues for our LawEnforcement segment decreased 2%, or $9,000 from $553,000 or 34% of LawEnforcement product revenues for the nine months ended September 30, 2002to $544,000, or 56% of product revenues for the corresponding period in2003.  This percentage increase is dueprimarily to the smaller revenue base to absorb fixed product costs.  Costs of products also can vary as apercentage of product revenue from period to period depending upon product mixand the hardware content, print media consumable content and software contentincluded in systems installed during a given period.

 

Cost of product revenues related to our Identification segmentincreased 1% from $3,849,000, or 47% of Identification product revenues for thenine month period ended September 30, 2003 to $3,892,000 or 45% ofIdentification product revenues for the corresponding period in 2003.  The percentage decrease of Identificationcost of product revenues as a percentage of Identification revenues isreflective of higher revenues from the sale of software only solutions.  Costs of products also can vary as a percentageof product revenue from period to period depending upon product mix and thehardware content, print media consumable content and software content includedin systems installed during a given period.

 

Cost of product revenues related to our Digital Photography segmentdecreased 79% from $218,000, or  28% ofDigital Photography revenues for the nine month period ended September 30,2002 to $46,000 or 5% of Digital Photography revenues for the correspondingperiod in 2003.  This decrease of$172,000 is reflective of our

 

23

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decision to sell software only solutions beginning late in the firstquarter of 2002 as compared to our selling of software only solutions for theentire nine month period in 2003.

 
| **Maintenance cost of revenues**                       |   | **NINE MONTHS  ENDED  SEPTEMBER 30,** |   |     |   |            |   |
|--------------------------------------------------------|--------|--------------------------------------------|--------|----------|--------|-----------------|--------|
| **(dollars in thousands)**                             |   | **2003**                                   |   | **2002** |   | **$****Change** |   | **%****Change** |   |
| **Maintenance cost of  revenues:**                     |   |                                       |   |     |   |            |   |   |   |
| Law Enforcement                                        |   | $                                          | 622    |     | $      | 581             |   | $ | 41 |   | 7 | % |
| Percentage of Law Enforcement maintenance  revenue     |   | 37                                         | %      | 36       | %      |            |   |   |   |
| Identification Group                                   |   | $                                          | 317    |     | $      | 267             |   | $ | 50 |   | 19 | % |
| Percentage of Identification maintenance  revenue      |   | 62                                         | %      | 61       | %      |            |   |   |   |
| Digital Photography                                    |   | $                                          | — |     | $      | —          |   | $ | — |   | N/A |   |
| Percentage of Digital Photography  maintenance revenue |   |                                       |   |     |   |            |   |   |   |
| Total maintenance cost of revenues                     |   | $                                          | 939    |     | $      | 848             |   | $ | 91 |   | 11 | % |
| Percentage of total maintenance revenues               |   | 43                                         | %      | 41       | %      |            |   |   |   |

 

Costs of maintenance revenues increased 11% from $848,000, or 41% ofmaintenance revenues, for the nine months ended September 30, 2002 to$939,000, or 43% of maintenance revenues, for the corresponding period in 2003.Cost of maintenance revenues in our Law Enforcement segment increased 7%, from$581,000 or 36% of maintenance revenues for the nine months endedSeptember 30, 2002 to $622,000 or 37% of maintenance revenues for thecorresponding period in 2003. This increase in costs of maintenance revenues isdue primarily to higher costs necessary to service the expanding installedbase. Identification maintenance cost of revenues increased 19% or $50,000 from$267,000or 61% of identification maintenance revenues for the nine month periodended September 30, 2002 to $317,000 or 62% of maintenance revenues forcorresponding period in 2003.  Thedollar increase is reflective of increased maintenance revenues due to theexpanding installed base.  

 
| **Product gross profit**                           |   | **NINE MONTHS  ENDED  SEPTEMBER 30,** |   |     |   |            |   |
|----------------------------------------------------|--------|--------------------------------------------|--------|----------|--------|-----------------|--------|
| **(dollars in thousands)**                         |   | **2003**                                   |   | **2002** |   | **$****Change** |   | **%****Change** |   |
| Law Enforcement                                    |   | $                                          | 420    |     | $      | 1,067           |   | $ | (647 | ) | -61 | % |
| Percentage of Law Enforcement product  revenue     |   | 44                                         | %      | 66       | %      |            |   |   |   |
| Identification Group                               |   | $                                          | 4,825  |     | $      | 4,347           |   | $ | 478 |   | 11 | % |
| Percentage of Identification product  revenue      |   | 55                                         | %      | 53       | %      |            |   |   |   |
| Digital Photography                                |   | $                                          | 909    |     | $      | 567             |   | $ | 342 |   | 60 | % |
| Percentage of Digital Photography product  revenue |   | 95                                         | %      | 72       | %      |            |   |   |   |
| Total product gross profit                         |   | $                                          | 6,154  |     | $      | 5,981           |   | $ | 173 |   | 3 | % |
| Percentage of total product revenues               |   | 58                                         | %      | 56       | %      |            |   |   |   |

 

Total product gross margins as a percentage of product revenuesincreased from 56% for the nine month period ended September 30, 2002 to58% of product revenues for the corresponding period in 2003. The overallincrease is primarily due to a higher percentage of total revenues coming fromthe sales of software only solutions.

 

Law Enforcement gross profitas a percentage of Law Enforcement product revenue decreased from 66% for thenine months ended September 30, 2002 to 44% for the corresponding periodof 2003. This decrease is due primarily to our product mix containing higherpercentages of hardware than the comparable period in 2002, as well as a lowerrevenue base to absorb fixed product costs. Costs of products can vary as a percentage of product revenue fromquarter to quarter depending upon product mix and hardware content and printmedia consumable content

 

24

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includedin systems installed during a given period.

 

Identification gross profitas a percentage of Identification product revenue increased from 53% for thenine months ended September 30, 2002 to 55% for the corresponding periodof 2003.  This increase is reflective ofhigher product sales of software only solutions.  Costs of products also can vary as a percentage of productrevenue from period to period depending upon product mix and the hardwarecontent, print media consumable content and software content included insystems installed during a given period.

 

Digital Photography gross profit as a percentage of Digital Photographyproduct revenue increased from 72% for the nine months ended September 30,2002 to 95% for the corresponding period in 2003. This increase is reflectiveof our selling of software only solutions during the nine months endedSeptember 30, 2003 as compared to the corresponding period of 2002 whichcontained both hardware and software components.

 
| **Maintenance gross profit**                           |   | **NINE MONTHS  ENDED  SEPTEMBER 30,** |   |     |   |            |   |
|--------------------------------------------------------|--------|--------------------------------------------|--------|----------|--------|-----------------|--------|
| **(dollars in thousands)**                             |   | **2003**                                   |   | **2002** |   | **$****Change** |   | **%****Change** |   |
| **Maintenance gross profit**                           |   |                                       |   |     |   |            |   |   |   |
| Law Enforcement                                        |   | $                                          | 1,046  |     | $      | 1,031           |   | $ | 15 |   | 1 | % |
| Percentage of Law Enforcement maintenance  revenue     |   | 63                                         | %      | 64       | %      |            |   |   |   |
| Identification Group                                   |   | $                                          | 194    |     | $      | 168             |   | $ | 26 |   | 16 | % |
| Percentage of Identification maintenance  revenue      |   | 38                                         | %      | 39       | %      |            |   |   |   |
| Digital Photography                                    |   | $                                          | 1      |     | $      | 26              |   | $ | (25 | ) |   |   |
| Percentage of Digital Photography  maintenance revenue |   | 100                                        | %      | 100      | %      |            |   |   |   |
| Total maintenance gross profit                         |   | $                                          | 1,241  |     | $      | 1,225           |   | $ | 16 |   | 1 | % |
| Percentage of total maintenance revenues               |   | 57                                         | %      | 59       | %      |            |   |   |   |

 

Gross margins related to maintenance revenues increased $16,000, or 1%from $1,225,000, or 59% of maintenance revenues for the nine months endedSeptember 30, 2002 to $1,241,000, or 57% of maintenance revenues for thecorresponding period in 2003. This increase is due primarily to increasedrevenues resulting from our expanding installed base.

 
| **Operating expenses**          |   | **NINE MONTHS  ENDED  SEPTEMBER 30,** |   |     |   |            |   |
|---------------------------------|--------|--------------------------------------------|--------|----------|--------|-----------------|--------|
| **(dollars in thousands)**      |   | **2003**                                   |   | **2002** |   | **$****Change** |   | **%****Change** |   |
|                            |   |                                       |   |     |   |            |   |   |   |
| General & administrative    |   | $                                          | 4,343  |     | $      | 5,037           |   | $ | (694 | ) | -14 | % |
| Percentage of total net revenue |   | 34                                         | %      | 40       | %      |            |   |   |   |
| Sales and marketing             |   | $                                          | 3,020  |     | $      | 3,158           |   | $ | (138 | ) | -4 | % |
| Percentage of total net revenue |   | 24                                         | %      | 25       | %      |            |   |   |   |
| Research & development      |   | $                                          | 1,439  |     | $      | 1,563           |   | $ | (124 | ) | -8 | % |
| Percentage of total net revenue |   | 11                                         | %      | 12       | %      |            |   |   |   |
| Depreciation and amortization   |   | $                                          | 692    |     | $      | 660             |   | $ | 32 |   | 5 | % |
| Percentage of total net revenue |   | 5                                          | %      | 5        | %      |            |   |   |   |

 

*GENERAL AND ADMINISTRATIVE EXPENSES.* General and administrative expenses are comprised primarily of salariesand other employee-related costs for executive, financial, and otherinfrastructure personnel. General legal, accounting and consulting services,insurance, occupancy and communication costs are also included with general andadministrative expenses. Such expenses decreased 14%, or $694,000 from$5,037,000 for the nine

 

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months ended September 30, 2002 to $4,343,000 for thecorresponding period in 2003.  Suchexpenses, as a percentage of total net revenues, decreased from 40% for thenine months ended September 30, 2002 to 34% for the corresponding periodin 2003.  We are continuing to focus ourefforts on achieving additional future operating efficiencies by reviewing andimproving upon existing business processes and evaluating our cost structure.We believe these efforts will allow us to decrease our level of general andadministrative expenses expressed as a percentage of total revenues.

 

*SALES AND MARKETING.* Sales and marketing expenses consist primarily of the salaries,commissions, other incentive compensation, employee benefits and travelexpenses of our sales force. Such expenses decreased 4%, or $138,000 from$3,158,000 for the nine months ended September 30, 2002 to $3,020,000 forthe corresponding period in 2003.  Suchexpenses, as a percentage of total net revenues, decreased from 25% for thenine months ended September 30, 2002 to 24% for the corresponding periodin 2003.  The dollar decrease is dueprimarily to reduced headcount.

 

*RESEARCH AND DEVELOPMENT.* Research and development costs consist primarily of salaries, employeebenefits and outside contractors for new product development, product enhancementsand custom integration work. Such expenses decreased 8% or $124,000 from$1,563,000 for the nine months ended September 30, 2002 to $1,439,000 forthe corresponding period in 2003.  Thisdecrease is due to a reduction in contract programming expenditures and reducedheadcount.  Our level of expenditures inresearch and development reflects our belief that to maintain our competitiveposition in markets characterized by rapid rates of technological advancement,we must continue to invest significant resources in new systems and software aswell as continue to enhance existing products.

 

*DEPRECIATION AND AMORTIZATION.* Depreciation and amortization increased $32,000 from $660,000 for thenine months ended September 30, 2002 to $692,000 for the correspondingperiod in 2003. This increase is due primarily to higher amortization ofintangible assets.

 

*INTEREST EXPENSE, NET.*  Forthe nine months ended September 30, 2003, we recognized interest income of$714,000 and interest expense of $3,037,000. For the nine months endedSeptember 30, 2002, we recognized interest income of $35,000 and interestexpense of $397,000.  Interest incomefor the nine months ended September 30, 2003 contains $711,000 of interestincome related to fair value accounting for our warrant liability due to theregistration rights agreement associated with the underlying shares of theCompany’s common stock to be issued upon conversion of the warrants.  Interest expense in the nine months endedSeptember 30, 2003 increased due to our issuance of senior secured andsubordinated convertible promissory notes payable, short-term demand notespayable and short-term borrowings under banking lines of credit.  Interest expense for the nine months endedSeptember 30, 2003 also includes approximately of $2,264,000 of debtdiscount and deferred financing fee amortization classified as interestexpense.  The following tablesets forth the components of net interest expense for the nine months endedSeptember 30, 2003:

 
|                                                                                                                                                                             |   | **NINE  MONTHS ENDED  September 30,** |       |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------|------------|
| **Components of net interest  expense (income):**                                                                                                                                |   | **2003**                              |       | **2002** |   |
|                                                                                                                                                                             |   | **(in  thousands)**                   | ** ** |
| Senior secured convertible promissory note  issued May 22, 2002, interest rate 12.5% due May 22, 2004; Principal amount  $2,000,000 (the “Note):                            |   |                                  |       |   |   |
| Coupon interest rate expense                                                                                                                                                     |   | $                                     | 199        |   | $ | 69 |   |
| Amortization to interest expense of note  discount related to fair value of warrants                                                                                             |   | 374                                   |       | 106 |   |
| Amortization to interest expense of note  discount related to beneficial conversion feature                                                                                      |   | 878                                   |       | 106 |   |
| Interest expense from amortization of  deferred financing fees                                                                                                                   |   | 267                                   |       | 49 |   |
|                                                                                                                                                                             |   |                                  |       |   |   |
| Secured demand promissory note issued  September, 2002, interest rate 12.5%, due upon demand                                                                                     |   | 27                                    |       | 2 |   |
|                                                                                                                                                                             |   |                                  |       |   |   |
| Subordinated convertible promissory notes  issued March 13, 2003, interest rate 8.5%, due April 15, 2005; Principal  amount $600,000, (“the Subordinated Notes”): |   |                                  |       |   |   |
| Coupon interest rate expense                                                                                                                                                     |   | 26                                    |       | — |   |
| Amortization to interest expense of note  discount related to beneficial conversion feature                                                                                      |   | 28                                    |       | — |   |
| Interest expense from amortization of  deferred financing fees                                                                                                                   |   | 15                                    |       | — |   |
|                                                                                                                                                                             |   |                                  |       |   |   |
| Senior secured convertible promissory notes  issued June 2003, interest rate 12.5% due May 22, 2005, Principal amount  $4,256,000; (“the New Notes):                        |   |                                  |       |   |   |
| Coupon interest rate expense                                                                                                                                                     |   | 158                                   |       | — |   |
| Amortization to interest expense of note  discount related to fair value of warrants                                                                                             |   | 306                                   |       | — |   |
| Amortization to interest expense of note  discount related to beneficial conversion feature                                                                                      |   | 308                                   |       | — |   |
| Interest expense from amortization of  deferred financing fees                                                                                                                   |   | 88                                    |       | — |   |
|                                                                                                                                                                             |   |                                  |       |   |   |
| Other notes payable interest expense                                                                                                                                             |   | 41                                    |       | 65 |   |
|                                                                                                                                                                             |   |                                  |       |   |   |
| Change in warrant liability classified as  interest (income) or expense                                                                                                          |   | (390                                  | )          | — |   |
|                                                                                                                                                                             |   |                                  |       |   |   |
| Interest income                                                                                                                                                                  |   | (2                                    | )          | (35 | ) |
|                                                                                                                                                                             |   |                                  |       |   |   |
| Net interest (income) expense                                                                                                                                                    |   | $                                     | 2,323      |   | $ | 362 |   |

 

*LIQUIDITY AND CAPITAL RESOURCES*

 

As of September 30, 2003, we had total current assets of$4,151,000 and total current liabilities of $4,747,000, or negative workingcapital of $596,000. At September 30, 2003, we had available cash of$634,000. 

 

Net cash used in operating activities was $1,144,000 for the nine monthperiod ended September 30, 2003 as compared to $1,967,000 for thecorresponding period in 2002. We used cash to fund net losses of $1,831,000,excluding non-cash expenses (depreciation and amortization) of $2,475,000 forthe nine months ended September 30, 2003. We used cash to fund net losses of $2,693,000, excluding non-cashexpenses (depreciation and amortization) of $901,000 for the corresponding periodin 2002. For the nine months ended September 30, 2003, we generated cashof $2,017,000 from reductions in current, intangible and other assets and usedcash of $1,330,000 for reductions in current liabilities, excluding debt. In2002, we used cash of  $55,000 to fundincreases in current, intangible and other assets and generated cash of$781,000 through increases in current liabilities and deferred revenues,excluding debt.

 

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Net cash used by investing activities was $201,000 for the nine monthsended September 30, 2003 as compared to $394,000 for the correspondingperiod in 2002. For the nine months ended September 30, 2003, we used cashto fund capital expenditures of computer equipment and software, furniture andfixtures and leasehold improvements of approximately $162,000. The level ofequipment purchases resulted primarily from continued growth of the businessand replacement of older equipment. For the nine months endedSeptember 30, 2003, we also used cash of approximately $158,000 to repay notespayable to related stockholders. For the nine months ended September 30,2003, we generated cash of $60,000 through reductions in restricted cash andgenerated cash of  $59,000 from the saleof assets.  For the nine months endedSeptember 30, 2002, we used cash of $289,000 to fund capital expendituresof computer equipment, software, furniture and fixtures. We used cash of$135,000 to repay notes payable to related stockholders and generated cash of$30,000 through reductions in restricted cash. 

 

Net cash provided by financing activities was $1,636,000 for the ninemonth period ended September 30, 2003 as compared to net cash provided byfinancing activities of $2,609,000 for the corresponding period in 2002. Forthe nine months ended September 30, 2003, we generated cash of $4,856,000from our issuance of senior and subordinated convertible promissory notespayable offset by $554,000 in debt issuance costs and $2,500,000 for therepayment of notes payable.  We alsoused cash of $166,000 for the repayment of short-term borrowings under bankline of credit agreements. For the corresponding period in 2002, we generatedcash of $2,000,000 from our issuance of senior secured convertible promissorynotes offset by $272,000 in debt issuance costs and generated cash of $500,000from our issuance of a demand promissory note. We also generated cash of $398,000 from short-term borrowings under bankline of credits.  We used cash of $17,000for the repayment of various capital lease obligations.

 

We conduct operations in leased facilitiesunder operating leases expiring at various dates through 2006. Additionally, wehave acquired certain equipment under capital leases which expire at variousdates through 2006.  We also havevarious short-term notes payable and capital lease obligations due at varioustimes during the next twelve months.

 

The report of the Company’s independent accountants included with ourmost recent Annual Report filed on Form 10-KSB on April 15, 2003 includesan explanatory paragraph as to the uncertainty that the Company will continueas a going concern. The Company is seeking additional financing that we believeis necessary to fund our working capital requirements for at least the nexttwelve months, assuming the successful implementation of our

 

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business plan. Our businessplan includes, among other things, significant increases in revenues in futureperiods, the monitoring and controlling of operating expenses, collection ofsignificant trade and other accounts receivables, and controlling of capitalexpenditures. If we are unable to secure additional financing or successfullyimplement our business plan, we will be required to seek funding from alternatesources and/or institute significant cost reduction plans. We may seek to sellequity or debt securities, secure a bank line of credit, or consider strategicalliances. The sale of equity or equity related securities could result inadditional dilution to our shareholders. There can be no assurance thatadditional financing, in any form, will be available at all or, if available,will be on terms acceptable to the Company. In addition, our ability to raiseadditional capital may be dependent upon the Company’s Common Stock beingquoted on the American Stock Exchange. There can be no assurance that theCompany will be able to satisfy the criteria for continued listing on theAmerican Stock Exchange. Insufficient funds may require us to delay, scale backor eliminate some or all of our activities, and if we are unable to obtainadditional funding there is substantial doubt about our ability to continue asa going concern.

 

**RISK FACTORS**

 

**WE CURRENTLY HAVE LIMITED CASH RESOURCES ANDNEED ADDITIONAL FUNDING TO FINANCE OUR WORKING CAPITAL REQUIREMENTS DURING THENEXT TWELVE MONTHS.**

 

We currently require financingto fund our anticipated working capital requirements during the next twelvemonths. We anticipate that our existing resources will not be sufficient toenable us to maintain our current and planned operations for the next twelvemonths and the report of our independent accountants included with our mostrecent report on Form 10-KSB includes an explanatory paragraph regarding ourability to continue as a going concern. We are seeking additional fundingthrough public or private equity or debt financing. There can be no assurancethat additional financing will be available on acceptable terms, or at all. Ifwe are required to sell equity to raise additional funds, our existingshareholders may incur substantial dilution and any shares so issued may haverights, preferences and privileges superior to the rights, preferences andprivileges of our outstanding Common Stock. Also, we may be required to obtainfunds through arrangements with third parties that require us to relinquishrights to certain of our technologies or products that we would seek to developor commercialize ourselves. In addition, our ability to raise additionalcapital may be dependent upon the Company’s Common Stock being listed on theAmerican Stock Exchange. We cannot guarantee that the Company will be able tosatisfy the criteria for continued listing on the American Stock Exchange.

 

**WE HAVE A HISTORY OF SIGNIFICANT RECURRINGLOSSES TOTALING APPROXIMATELY $39.6 MILLION, AND THESE LOSSES MAY CONTINUEIN THE FUTURE.**

 

As of September 30, 2003,we had an accumulated deficit of $39.6 million, and these losses maycontinue in the future. We may need to raise capital to cover these losses, andfinancing may not be available to us on favorable terms. We expect to continueto incur significant sales and marketing, research and development, and generaland administrative expenses. As a result, we will need to generate significantrevenues to achieve profitability and may never achieve profitability.

 

**THE HOLDERS OF OUR PREFERRED STOCK HAVECERTAIN RIGHTS AND PRIVILEGES THAT ARE SENIOR TO THE COMMON STOCK AND WEMAY ISSUE ADDITIONAL SHARES OF PREFERRED STOCK WITHOUT SHAREHOLDERAPPROVAL THAT COULD HAVE A MATERIAL ADVERSE EFFECT ON THE MARKET VALUE OF THECOMMON STOCK.**

 

Our Board of Directors has theauthority to issue a total of up to 4,000,000 shares of preferred stock and tofix the rights, preferences, privileges, and restrictions, including votingrights, of the preferred stock, which typically are

 

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senior to the rights of thecommon shareholders, without any further vote or action by you and the othercommon shareholders. Your rights will be subject to, and may be adverselyaffected by, the rights of the holders of the preferred stock that have beenissued, or might be issued in the future. Preferred stock also could have theeffect of making it more difficult for a third party to acquire a majority ofthe outstanding voting stock of ImageWare. This could delay, defer, or preventa change in control. Furthermore, holders of preferred stock may have otherrights, including economic rights, senior to the common stock. As a result,their existence and issuance could have a material adverse effect on the marketvalue of the common stock. We have in the past issued, and, may from time totime in the future issue, preferred stock for financing or other purposes withrights, preferences, or privileges senior to the common stock.

 

The provisions of ouroutstanding Series B Preferred Stock prohibit the payment of dividends onthe common stock unless the dividends on those preferred shares are first paid.In addition, upon a liquidation, dissolution or sale of ImageWare’s business,the holders of the Series B Preferred Stock will be entitled to receive,in preference to any distribution to the holders of common stock, initialdistributions of $2.50 per share, plus all accrued but unpaid dividends.

 

Pursuant to the terms of ourSeries B Preferred Stock we are obligated to pay cumulative cash dividends onshares of Series B Preferred Stock from legally available funds at the annualrate of $0.2125 per share, payable in two semi-annual installments of $0.10625each, which cumulative dividends must be paid prior to payment of any dividendon our Common Stock.  As ofSeptember 30, 2003, the Company had cumulative undeclared dividends of$192,000.

 

**WE DEPEND UPON ASMALL NUMBER OF LARGE SYSTEM SALES COSTING FROM $300,000 TO $1,000,000, AND WEMAY FAIL TO ACHIEVE ONE OR MORE LARGE SYSTEM SALES IN THE FUTURE.**

 

In the past three years we havederived a substantial portion of our revenues from a small number of sales oflarge, relatively expensive systems, typically ranging in price from $300,000to $1,000,000. As a result, if we fail to receive orders for these largesystems in a given sales cycle on a consistent basis, our business could besignificantly harmed. Further, our quarterly results are difficult to predictbecause we cannot predict in which quarter, if any, large system sales willoccur in a given year. As a result, we believe that quarter-to-quartercomparisons of our results of operations are not a good indication of ourfuture performance. In some future quarters our operating results may be below theexpectations of securities analysts and investors, in which case the marketprice of our common stock may decrease significantly.

 

**OUR LENGTHY SALES CYCLE MAY CAUSE US TOEXPEND SIGNIFICANT RESOURCES FOR AS LONG AS ONE YEAR IN ANTICIPATION OF A SALE,YET WE STILL MAY FAIL TO COMPLETE THE SALE.**

 

When considering the purchase ofa large computerized booking or identification system, a government agency maytake as long as a year to evaluate different systems and obtain approval forthe purchase. If we fail to complete a sale, we will have expended significantresources and received no revenue in return. Generally, agencies consider awide range of issues before committing to purchase our products, includingproduct benefits, ability to operate with their current systems, productreliability and their own budgetary constraints. While potential customers areevaluating our products and before they place an order with us, we may incursubstantial selling costs and expend significant management effort to accomplisha sale.

 

**A SIGNIFICANT NUMBER OF OUR CUSTOMERS AREGOVERNMENT AGENCIES THAT ARE SUBJECT TO UNIQUE POLITICAL AND BUDGETARYCONSTRAINTS AND HAVE SPECIAL CONTRACTING REQUIREMENTS WHICH MAY AFFECT OURABILITY TO OBTAIN NEW GOVERNMENT CUSTOMERS.**

 

A significant number of ourcustomers are government agencies. These agencies often do not set their ownbudgets and therefore have little control over the amount of money they canspend. In addition, these agencies

 

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experience political pressure that maydictate the manner in which they spend money. Due to political and budgetaryprocesses and other scheduling delays that may frequently occur relating to thecontract or bidding process, some government agency orders may becanceled or substantially delayed, and the receipt of revenues or payments maybe substantially delayed. In addition, future sales to government agencies willdepend on our ability to meet government contracting requirements, certain ofwhich may be onerous or impossible to meet, resulting in our inability toobtain a particular contract. Common requirements in government contractsinclude bonding requirements, provisions permitting the purchasing agency tomodify or terminate at will the contract without penalty, and provisionspermitting the agency to perform investigations or audits of our businesspractices.

 

**WE MAY FAIL TO CREATE NEW APPLICATIONSFOR OUR PRODUCTS AND ENTER NEW MARKETS, WHICH MAY AFFECT OUR FUTURESUCCESS.**

 

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

 

**WE OCCASIONALLY RELYON SYSTEMS INTEGRATORS TO MANAGE OUR LARGE PROJECTS, AND IF THESE COMPANIES DONOT PERFORM ADEQUATELY, WE MAY LOSE BUSINESS.**

 

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

 

**WE DO NOT HAVE U.S. OR FOREIGN PATENTPROTECTION FOR OUR PRODUCTS, AND A COMPETITOR MAY BE ABLE TO REPLICATE OURTECHNOLOGY.**

 

Our business is based in largepart on our technology, and our success depends in part on our ability andefforts to protect our intellectual property rights. If we do not adequatelyprotect our intellectual property through copyrights and various trade secretprotections afforded to us by law, our business will be seriously harmed. We donot have patent protection for our products.

 

We license certain elements ofour trademarks, trade dress, copyright and other intellectual property to thirdparties. We attempt to ensure that our rights in our trade names and thequality of third party uses of our names are maintained by these third parties.However, these third parties may take actions that could significantly impairthe value of our intellectual property and our reputation and goodwill.

 

In addition, internationalintellectual property laws differ from country to country. Any foreign rightswe have in our technology are limited by what has been afforded to us under theapplicable foreign intellectual property laws.

 

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Also, under the laws of certain foreignjurisdictions, in order to have recognizable intellectual property rights, wemay be required to file applications with various foreign agencies or officialsto register our intellectual property. Accordingly, our ability to operate andexploit our technology overseas could be significantly hindered.

 

**WE HAVE ACQUIRED SEVERAL BUSINESSES AND FACERISKS ASSOCIATED WITH INTEGRATING THESE BUSINESSES AND POTENTIAL FUTUREBUSINESSES THAT WE MAY ACQUIRE.**

 

We have completed theacquisitions of several companies and we plan to continue to review potentialacquisition candidates, and our business and our strategy includes building ourbusiness through acquisitions. However, acceptable acquisition candidates maynot be available in the future or may not be available on terms and conditionsacceptable to us.

 

Acquisitions involve numerousrisks, including among others, difficulties and expenses incurred in theconsummation of acquisitions and assimilation of the operations, personnel andservices and products of the acquired companies. Additional risks associatedwith acquisitions include the difficulties of operating new businesses, the diversionof management’s attention from other business concerns and the potential lossof key employees of the acquired company. If we do not successfully integratethe businesses we may acquire in the future, our business will suffer.

 

**WE OPERATE IN FOREIGNCOUNTRIES AND ARE EXPOSED TO RISKS ASSOCIATED WITH FOREIGN POLITICAL, ECONOMICAND LEGAL ENVIRONMENTS AND WITH FOREIGN CURRENCY EXCHANGE RATES.**

 

With our acquisition ofG & A, we have significant foreign operations and are accordinglyexposed to risks, including among others, risks associated with foreignpolitical, economic and legal environments and with foreign currency exchangerates. Our results may be adversely affected by, among other things, changes ingovernment policies with respect to laws and regulations, anti-inflationmeasures, currency conversions, remittance abroad and rates and methods oftaxation.

 

**Item3.  Controlsand Procedures**

 

*Evaluation of disclosure controls and procedures. *ImageWare’s chiefexecutive officer and its chief financial officer, after evaluating theeffectiveness of ImageWare’s disclosure controls and procedures (as defined inExchange Act Rule 13a-15(e) as of September 30, 2003, have concluded that,as of such date, ImageWare’s disclosure controls and procedures were adequateand sufficient to ensure that information required to be disclosed by ImageWarein the reports that it files under the Securities Exchange Act of 1934 isrecorded, processed, summarized and reported within the time period specifiedin the Commission’s rules and forms.

 

*Changes in internal controls. *There has been no change in our internalcontrol over financial reporting during the fiscal quarter endedSeptember 30, 2003 that has materially affected, or is reasonably likelyto materially affect, our internal control over financial reporting.

 

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**PART II**

 

**ITEM 6. EXHIBITSAND REPORTS ON FORM 8-K**

 

**(a)****                                 ****EXHIBITS**

 

10.1                           Leasebetween Thornmint I and the Company dated September 26, 2003

 

31.1                           Certificationof Chief Executive Officer pursuant to Section 302 of the Sarbanes-OxleyAct.

 

31.2                           Certificationof Chief Financial Officer pursuant to Section 302 of the Sarbanes-OxleyAct.

 

32.1                           Certificationof Chief Executive Officer and Chief Financial Officer pursuant toSection 906 of the Sarbanes-Oxley Act.

** **

**(b)****                                  Reportson Form 8-K**

 

During thethree months ended September 30, 2003, we filed one report on Form 8-K

 

We filed areport on Form 8-K on August 5, 2003 to report and disclose achange in our certifying accountant.

 

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**SIGNATURES**

 

In accordance with the requirements of the Exchange Act, the registrantcaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.

 
|                          | IMAGEWARE  SYSTEMS, INC. |
|-------------------------------|--------------------------|
|                          |                     |   |
|                          |                     |   |
| Date:  November 14, 2003 | By:                      | /s/ Wayne Wetherell |   |
|                          |                     | Wayne Wetherell, Chief Financial Officer  (on behalf of the Registrant and as Registrant’s  Principal Financial and Accounting Officer) |   |

 

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