**U.S. SECURITIES AND EXCHANGE COMMISSION**

**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 June 30, 2003**

** **
| o |   | **TRANSITION  REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT** |
|---|--------|----------------------------------------------------------------------|

 

**For the transition periodfrom         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 RoadSan Diego, CA 92127**

(Addressof Principal Executive Offices)

 

**(858) 673-8600**(Issuer’s TelephoneNumber, Including Area Code)

 

Check whether the issuer (1)filed all reports required to be filed by Section 13 or 15(d) of the ExchangeAct during the past 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to such filingrequirements 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 August 12, 2003, the number of outstanding shares ofthe 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 June 30, 2003 and December 31, 2002                                             |   |
|       |                  | Condensed  Consolidated Statements of Operations for the three and six months ended June  30, 2003 and 2002                  |   |
|       |                  | Condensed  Consolidated Statements of Cash Flows for the three and six months ended June  30, 2003 and 2002                  |   |
|       |                  | Condensed  Consolidated Statements of Comprehensive Income (Loss) for the three and six  months ended June 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 I**

### **FINANCIAL INFORMATION**

 

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

 

**IMAGEWARE SYSTEMS, INC.**

**CONDENSED CONSOLIDATED BALANCESHEETS**

**ASSETS**

**(IN THOUSANDS)**

 
|                                                                                                                                                                                                                                                                                                              |                                                 | **June 30,  2003** |       | **December 31,  2002** |       |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------------------------------------------------|--------------------|------------|------------------------|------------|
|                                                                                                                                                                                                                                                                                                              |                                                 | **(Unaudited)**    |       |                   |       |
| Current Assets:                                                                                                                                                                                                                                                                                                   |                                                 |               |       |                   |       |
| Cash                                                                                                                                                                                                                                                                                                              |                                                 | $                  | 628        |                   | $          | 215 |   |
| Restricted cash and cash equivalents                                                                                                                                                                                                                                                                              |                                                 | 60                 |       | 60                     |       |
| Accounts receivable, net                                                                                                                                                                                                                                                                                          |                                                 | 2,262              |       | 3,295                  |       |
| Inventory                                                                                                                                                                                                                                                                                                         |                                                 | 1,800              |       | 1,882                  |       |
| Other current assets                                                                                                                                                                                                                                                                                              |                                                 | 442                |       | 422                    |       |
|                                                                                                                                                                                                                                                                                                              | Total Current Assets                                 |               | 5,192      |                   | 5,874      |   |
|                                                                                                                                                                                                                                                                                                              |                                                 |               |       |                   |       |
| Property and equipment, net                                                                                                                                                                                                                                                                                       |                                                 | 873                |       | 1,040                  |       |
| Other assets                                                                                                                                                                                                                                                                                                      |                                                 | 1,106              |       | 744                    |       |
| Intangible assets, net of accumulated  amortization                                                                                                                                                                                                                                                               |                                                 | 1,329              |       | 1,562                  |       |
| Goodwill                                                                                                                                                                                                                                                                                                          |                                                 | 5,298              |       | 5,298                  |       |
|                                                                                                                                                                                                                                                                                                              | **Total Assets**                                     |               | **$**      | **13,798**             | ** ** | **$** | **14,518** | ** ** |
|                                                                                                                                                                                                                                                                                                              |                                                 |               |       |                   |       |
| **LIABILITIES AND SHAREHOLDERS’  EQUITY**                                                                                                                                                                                                                                                                    |                                                 |               | ** ** |                   | ** ** |
|                                                                                                                                                                                                                                                                                                              |                                                 |               |       |                   |       |
| Current Liabilities:                                                                                                                                                                                                                                                                                              |                                                 |               |       |                   |       |
| Accounts payable                                                                                                                                                                                                                                                                                                  |                                                 | $                  | 2,540      |                   | $          | 3,233 |   |
| Deferred revenue                                                                                                                                                                                                                                                                                                  |                                                 | 1,022              |       | 976                    |       |
| Accrued expenses                                                                                                                                                                                                                                                                                                  |                                                 | 1,529              |       | 1,500                  |       |
| Accrued expenses - related parties                                                                                                                                                                                                                                                                                |                                                 | 0                  |       | 47                     |       |
| Accrued interest                                                                                                                                                                                                                                                                                                  |                                                 | 102                |       | 198                    |       |
| Notes & advances payable to bank and  third parties                                                                                                                                                                                                                                                           |                                                 | 472                |       | 786                    |       |
| Notes payable to related parties                                                                                                                                                                                                                                                                                  |                                                 | 134                |       | 218                    |       |
|                                                                                                                                                                                                                                                                                                              | Total Current Liabilities                            |               | 5,799      |                   | 6,958      |   |
|                                                                                                                                                                                                                                                                                                              |                                                 |               |       |                   |       |
| Convertible notes payable, net of discount                                                                                                                                                                                                                                                                        |                                                 | 759                |       | 1,252                  |       |
| Warrant liability                                                                                                                                                                                                                                                                                                 |                                                 | 2,358              |       | —                 |       |
| Pension obligation                                                                                                                                                                                                                                                                                                |                                                 | 452                |       | 406                    |       |
| Total Liabilities                                                                                                                                                                                                                                                                                                 |                                                 | 9,368              |       | 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 June  30, 2003 and December 31, 2002, liquidation preference $673,500 at June 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                                                                                                                                                                                                                                                                            |                                                 | 214                |       | 113                    |       |
| Accumulated deficit                                                                                                                                                                                                                                                                                               |                                                 | (39,517            | )          | (35,326                | )          |
|                                                                                                                                                                                                                                                                                                              | Total shareholders’ equity                      |               | 4,430      |                   | 5,902      |   |
|                                                                                                                                                                                                                                                                                                              |                                                 |               |       |                   |       |
|                                                                                                                                                                                                                                                                                                              | **Total Liabilities and  Shareholders’ Equity** |               | **$**      | **13,798**             | ** ** | **$** | **14,518** | ** ** |
|                                                                                                                                                                                                                                                                                                                   |                                                      |                    |            |                        |            |  |  |  |  |  |  |  |

 

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

 

3

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**IMAGEWARE SYSTEMS, INC.**

**CONDENSED CONSOLIDATED STATEMENTSOF OPERATIONS**

**(IN THOUSANDS, EXCEPT SHARE ANDPER SHARE AMOUNTS)**

**(UNAUDITED)**

 
|                                                    |   | **THREE MONTHS ENDED  June 30,** |   | **SIX MONTHS ENDED  June 30,** |   |
|---------------------------------------------------------|--------|----------------------------------|--------|--------------------------------|--------|
|                                                    |   | **2003**                         |   | **2002**                       |   | **2003** |   | **2002** |   |
|                                                    |   |                             |   |                           |   |   |   |   |   |
| **Revenues:**                                           |   |                             |   |                           |   |   |   |   |   |
| Product                                                 |   | $                                | 3,835  |                           | $      | 3,663 |   | $ | 6,469 |   | $ | 6,659 |   |
| Maintenance                                             |   | 792                              |   | 673                            |   | 1,590 |   | 1,345 |   |
|                                                    |   | 4,627                            |   | 4,336                          |   | 8,059 |   | 8,004 |   |
| **Cost of revenues:**                                   |   |                             |   |                           |   |   |   |   |   |
| Product                                                 |   | 1,840                            |   | 1,622                          |   | 3,077 |   | 2,924 |   |
| Maintenance                                             |   | 314                              |   | 263                            |   | 669 |   | 543 |   |
|                                                    |   |                             |   |                           |   |   |   |   |   |
| Gross profit                                            |   | 2,473                            |   | 2,451                          |   | 4,313 |   | 4,537 |   |
|                                                    |   |                             |   |                           |   |   |   |   |   |
| **Operating expenses:**                                 |   |                             |   |                           |   |   |   |   |   |
| General & administrative                            |   | 1,439                            |   | 1,675                          |   | 2,881 |   | 3,391 |   |
| Sales and marketing                                     |   | 1,048                            |   | 1,059                          |   | 2,137 |   | 2,201 |   |
| Research & development                              |   | 437                              |   | 510                            |   | 931 |   | 1,025 |   |
| Depreciation and amortization                           |   | 237                              |   | 197                            |   | 473 |   | 415 |   |
|                                                    |   | 3,161                            |   | 3,441                          |   | 6,422 |   | 7,032 |   |
|                                                    |   |                             |   |                           |   |   |   |   |   |
| Loss from operations                                    |   | (688                             | )      | (990                           | )      | (2,109 | ) | (2,495 | ) |
|                                                    |   |                             |   |                           |   |   |   |   |   |
| Interest (income) expense, net                          |   | 1,893                            |   | 108                            |   | 2,254 |   | 112 |   |
|                                                    |   |                             |   |                           |   |   |   |   |   |
| Other (income) expense, net                             |   | (92                              | )      | 43                             |   | (173 | ) | 23 |   |
|                                                    |   |                             |   |                           |   |   |   |   |   |
| Loss before income taxes                                |   | (2,489                           | )      | (1,141                         | )      | (4,190 | ) | (2,630 | ) |
|                                                    |   |                             |   |                           |   |   |   |   |   |
| Income tax  expense (benefit)                           |   | —                           |   | —                         |   | — |   | — |   |
|                                                    |   |                             |   |                           |   |   |   |   |   |
| Net loss                                                |   | $                                | (2,489 | )                              | $      | (1,141 | ) | $ | (4,190 | ) | $ | (2,630 | ) |
|                                                    |   |                             |   |                           |   |   |   |   |   |
| Basic and diluted (loss) per common share -  see note 2 |   | $                                | (0.46  | )                              | $      | (0.21 | ) | $ | (0.77 | ) | $ | (0.49 | ) |
| Weighted-average shares (basic and diluted)             |   | 5,489,390                        |   | 5,483,275                      |   | 5,489,390 |   | 5,482,299 |   |

 

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

 

4

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**IMAGEWARE SYSTEMS, INC.**

**CONDENSEDCONSOLIDATED STATEMENT OF CASH FLOWS**

**(IN THOUSANDS)**

**(UNAUDITED)**

 
|                                                                        |   | **Six Months Ended  June 30,** |       |
|-----------------------------------------------------------------------------|--------|--------------------------------|------------|
|                                                                        |   | **2003**                       |       | **2002** |   |
|                                                                        |   |                           | ** ** |   | ** ** |
| **Cash flows from operating  activities**                                   |   |                           |       |   |   |
| Net loss                                                                    |   | $                              | (4,190     | ) | $ | (2,630 | ) |
| Adjustments to reconcile net loss to net  cash used by operating activities |   |                           |       |   |   |
| Depreciation and amortization                                               |   | 476                            |       | 415 |   |
| Amortization of debt discount and debt  issuance costs                      |   | 1,551                          |       | 72 |   |
| Change in warrant liability                                                 |   | 321                            |       | — |   |
| Change in assets and liabilities                                            |   |                           |       |   |   |
| Accounts receivable, net                                                    |   | 1,032                          |       | 1,555 |   |
| Inventory                                                                   |   | 81                             |       | (148 | ) |
| Other current assets                                                        |   | (20                            | )          | 39 |   |
| Intangible and other assets                                                 |   | (54                            | )          | — |   |
| Accounts payable                                                            |   | (692                           | )          | (729 | ) |
| Accrued expenses                                                            |   | 25                             |       | 108 |   |
| Accrued interest                                                            |   | (96                            | )          | 30 |   |
| Deferred revenue                                                            |   | 46                             |       | (100 | ) |
| Pension obligation                                                          |   | 46                             |       | — |   |
| Total adjustments                                                           |   | 2,716                          |       | 1,242 |   |
|                                                                        |   |                           |       |   |   |
| Net cash used by operating activities                                       |   | (1,474                         | )          | (1,388 | ) |
|                                                                        |   |                           |       |   |   |
| **Cash flows from investing  activities**                                   |   |                           |       |   |   |
| Purchase of property and equipment                                          |   | (134                           | )          | (209 | ) |
| Payment on advances from related  stockholders                              |   | (128                           | )          | (90 | ) |
| Sale of property and equipment                                              |   | 59                             |       | — |   |
|                                                                        |   |                           |       |   |   |
| Net cash used by investing activities                                       |   | (203                           | )          | (299 | ) |
|                                                                        |   |                           |       |   |   |
| **Cash flows from financing  activities**                                   |   |                           |       |   |   |
| Proceeds from issuance of notes payable                                     |   | 4,856                          |       | 2,000 |   |
| Repayment of notes payable                                                  |   | (2,500                         | )          | (10 | ) |
| Debt issuance costs                                                         |   | (554                           | )          | (272 | ) |
| Proceeds from bank line of credit                                           |   | 186                            |       | 415 |   |
|                                                                        |   |                           |       |   |   |
| Net cash provided by financing activities                                   |   | 1,988                          |       | 2,133 |   |
| Effect of exchange rate changes on cash                                     |   | 102                            |       | 80 |   |
| Net increase in cash                                                        |   | 413                            |       | 526 |   |
|                                                                        |   |                           |       |   |   |
| Cash at beginning of period                                                 |   | 215                            |       | 388 |   |
|                                                                        |   |                           |       |   |   |
| Cash at end of period                                                       |   | $                              | 628        |   | $ | 914 |   |

 

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

 

5

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**IMAGEWARE SYSTEMS, INC.**

**CONDENSED CONSOLIDATED STATEMENTSOF COMPREHENSIVE (LOSS)**

**(IN THOUSANDS)**

**(UNAUDITED)**

 
|                                    |   | **THREE MONTHS ENDED  JUNE 30,** |       | **SIX MONTHS ENDED  JUNE 30,** |       |
|-----------------------------------------|--------|----------------------------------|------------|--------------------------------|------------|
|                                    |   | **2003**                         |       | **2002**                       |       | **2003** |   | **2002** |   |
|                                    |   |                             | ** ** |                           | ** ** |   | ** ** |   | ** ** |
| Net income (loss)                       |   | $                                | (2,489     | )                              | $          | (1,141 | ) | $ | (4,190 | ) | $ | (2,630 | ) |
| Other comprehensive (loss):             |   |                             |       |                           |       |   |   |   |   |
| Foreign currency translation adjustment |   | 70                               |       | 95                             |       | 102 |   | 80 |   |
| Comprehensive (loss)                    |   | $                                | (2,419     | )                              | $          | (1,046 | ) | $ | (4,088 | ) | $ | (2,550 | ) |

 

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

 

6

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**IMAGEWARE SYSTEMS, INC.**

 

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE1.  DESCRIPTION OF BUSINESS ANDOPERATIONS**

 

ImageWare Systems, Inc.(“we”, “our” or “the Company”), was incorporated in the State of California onFebruary 6, 1987. The Company utilizes its imaging technology to developsoftware used to create booking and investigative software, smart and secureidentification systems and documents, and software for professionalphotographers. Our software systems and associated hardware enable ourcustomers to quickly capture, archive, search, retrieve and share digitalphotographs and associated text records.

 

*Liquidity and Capital Resources*

 

The condensed consolidatedfinancial statements included in this report have been prepared assuming thatthe Company will be successful in obtaining the additional capital it needs tofund operations and implement its business plan. The Company used approximately$2,086,000 in operations during the year ended December 31, 2002 and $1,474,000in operations during the six months ended June 30, 2003, suffered recurringlosses from operations and has an accumulated deficit of approximately$39,517,000 at June 30, 2003 which raises substantial doubt about the Company’sability to continue as a going concern. The financial statements do not includeany adjustments that might result from the outcome of this uncertainty.

 

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 Company might berequired to sell certain of its assets or license its technologies to others.These actions, while necessary for the continuance of operations during a timeof cash constraints and a shortage of working capital, could adversely affectthe 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, 2002and notes thereto included in the Company’s Annual Report on Form 10-KSB, filedwith the SEC on April 15, 2003. In the opinion of management, the accompanyingcondensed consolidated financial statements contain all adjustments, consistingonly of adjustments of a normal recurring nature, necessary for a fairpresentation of the Company’s financial position as of June 30, 2003, and itsresults of operations for the periods presented. These condensed consolidatedunaudited financial statements are not necessarily indicative of the results tobe expected for the entire year.

 

*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, arerecorded at 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 six months ended June30, 2003 and 2002:

 
|                                                             |   | **THREE  MONTHS ENDED** |   | **SIX MONTHS  ENDED** |   |
|------------------------------------------------------------------|--------|-------------------------|--------|-----------------------|--------|
|                                                             |   | **JUNE 30,**            |   | **JUNE 30,**          |   |
|                                                             |   | **2003**                |   | **2002**              |   | **2003** |   | **2002** |   |
|                                                             |   |                    |   |                  |   |   |   |   |   |
| Net Loss:                                                        |   |                    |   |                  |   |   |   |   |   |
| As reported                                                      |   | $                       | (2,489 | )                     | $      | (1,141 | ) | $ | (4,190 | ) | $ | (2,630 | ) |
| Stock based compensation included in net  loss                   |   | —                  |   | —                |   | — |   | — |   |
| Stock based employee compensation under  fair value based method |   | (152                    | )      | (224                  | )      | (298 | ) | (448 | ) |
| Pro forma net loss                                               |   | $                       | (2,641 | )                     | $      | (1,365 | ) | $ | (4,488 | ) | $ | (3,078 | ) |
|                                                             |   |                    |   |                  |   |   |   |   |   |
| Basic loss per common share:                                     |   |                    |   |                  |   |   |   |   |   |
| As reported                                                      |   | $                       | (0.46  | )                     | $      | (0.21 | ) | $ | (0.77 | ) | $ | (0.49 | ) |
| Pro forma                                                        |   | $                       | (0.48  | )                     | $      | (0.25 | ) | $ | (0.82 | ) | $ | (0.57 | ) |

 

7

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Certain reclassificationshave been made to the prior period balances in order to conform to the currentperiod presentation.

 

**NOTE2.  NET LOSS PER COMMON SHARE**

 

Basic loss percommon share is calculated by dividing net loss available to commonshareholders for the period by the weighted-average number of common sharesoutstanding during the period. Diluted earnings per common share is calculatedby dividing net loss available to common shareholders for the period by theweighted-average number of common shares outstanding during the period, adjustedto include, if dilutive, potential dilutive shares consisting of convertiblepreferred stock, stock options, convertible notes payable and warrants,calculated using the treasury stock method. During the periods ended June 30,2003 and 2002, the Company has excluded all convertible preferred stock,outstanding stock options, convertible notes payable and warrants from thecalculation of diluted loss per share, as their effect would have beenantidilutive due to the Company’s net loss.

 

The following table setsforth the computation of basic and diluted loss per share for the three and sixmonth periods ended June 30, 2003 and 2002 (amounts in thousands except shareand per share amounts):

 
|                                      |   | **THREE MONTHS ENDED  June 30,** |   | **SIX MONTHS ENDED  June 30,** |   |
|-------------------------------------------|--------|----------------------------------|--------|--------------------------------|--------|
|                                      |   | **2003**                         |   | **2002**                       |   | **2003** |   | **2002** |   |
| Numerator                                 |   |                             |   |                           |   |   |   |   |   |
| Net loss                                  |   | $                                | (2,489 | )                              | $      | (1,141 | ) | $ | (4,190 | ) | $ | (2,630 | ) |
| Less Series B preferred dividends         |   | (15                              | )      | (20                            | )      | (31 | ) | (33 | ) |
| Net loss available to common shareholders |   | $                                | (2,504 | )                              | $      | (1,161 | ) | $ | (4,221 | ) | $ | (2,663 | ) |
|                                      |   |                             |   |                           |   |   |   |   |   |
| Denominator                               |   |                             |   |                           |   |   |   |   |   |
| Weighted-average shares outstanding       |   | 5,489,390                        |   | 5,483,275                      |   | 5,489,390 |   | 5,482,299 |   |
|                                      |   |                             |   |                           |   |   |   |   |   |
| Basic and diluted loss per share          |   | $                                | (0.46  | )                              | $      | (0.21 | ) | $ | (0.77 | ) | $ | (0.49 | ) |

 

8

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**NOTE3.  SEGMENT INFORMATION**

 

Prior to its acquisition ofG & A in March 2001, the Company operated in one business segment. During2002, the Company reorganized its reportable segments into geographical groups: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 South America.The Company’s International segment includes all geographic areas other thanNorth, Central and South America. The Company’s International segment develops,sells and supports software and designs systems utilizing digital imaging inthe production of photo identification cards, documents and identificationbadging systems. The Digital Photography segment develops digital imagingsoftware which enables professional photographers to quickly and easily takephotos and create a database of information that can be sent to photographylaboratories for processing.

 

Subsequent to the nine months ended September30, 2002, the Company has re-evaluated its organizational and internalfinancial 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 tablebelow summarizes information about reportable segments for the three and sixmonths ended June 30, 2003 and 2002:

 

9

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|                         |   | **THREE MONTHS ENDED  June 30,** |   | **SIX MONTHS ENDED  June 30,** |       |
|------------------------------|--------|----------------------------------|--------|--------------------------------|------------|
|                         |   | **2003**                         |   | **2002**                       |       | **2003** |   | **2002** |   |
|                         |   | ***(in thousands)***             |   | ***(in thousands******)***     | ** ** |
|                         |   | ***(unaudited)***                |   | ***(unaudited)***              |       |
| Net Revenue:                 |   |                             |   |                           |       |
| Law Enforcement              |   | $                                | 1,149  |                           | $          | 1,270 |   | $ | 1,941 |   | $ | 2,291 |   |
| Identification               |   | 3,266                            |   | 2,942                          |       | 5,644 |   | 5,292 |   |
| Digital Photography          |   | 212                              |   | 124                            |       | 474 |   | 421 |   |
| Total consolidated net sales |   | $                                | 4,627  |                           | $          | 4,336 |   | $ | 8,059 |   | $ | 8,004 |   |
|                         |   |                             |   |                           |       |   |   |   |   |
| Operating income (loss):     |   |                             |   |                           |       |   |   |   |   |
| Law Enforcement              |   | $                                | 104    |                           | $          | 82 |   | $ | (76 | ) | $ | 156 |   |
| Identification               |   | (646                             | )      | (740                           | )          | (1,745 | ) | (2,080 | ) |
| Digital Photography          |   | (146                             | )      | (332                           | )          | (288 | ) | (571 | ) |
|                         |   |                             |   |                           |       |   |   |   |   |
| Other unallocated amounts:   |   |                             |   |                           |       |   |   |   |   |
| Interest expense (income)    |   | 1,893                            |   | 108                            |       | 2,254 |   | 112 |   |
| Other expense (income)       |   | (92                              | )      | 43                             |       | (173 | ) | 23 |   |
|                         |   |                             |   |                           |       |   |   |   |   |
| Income (loss) before taxes   |   | $                                | (2,489 | )                              | $          | (1,141 | ) | $ | (4,190 | ) | $ | (2,630 | ) |

 
| **Total Assets by Segment:**         |   | **June 30,  2003**   |   |
|--------------------------------------|--------|----------------------|--------|
|                                 |   | ***(in thousands)*** |   |
|                                 |   | ***(unaudited)***    |   |
| Law Enforcement                      |   | $                    | 924    |   |
| Identification                       |   | 9,765                |   |
| Digital Photography                  |   | 1,631                |   |
| Total assets for reportable segments |   | 12,320               |   |
| Corporate                            |   | 1,478                |   |
| Total consolidated assets            |   | $                    | 13,798 |   |

 

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

 

In May 2002, the Companyissued a senior secured convertible promissory note for $2,000,000 at aninterest rate of 12.5%, due May 22, 2004 (the “Note”).  The Note initially was convertible intocommon shares of the Company at $4.31 per share.  In conjunction with the note, the Company issued a warrant topurchase 150,000 shares of common stock at $4.74 per share.  The Company recorded the note net of adiscount 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 six months ended June 30,2003, the Company recorded $767,000 as interest expense from the amortizationof the discount related to fair value of the warrants and from the accretion ofthe beneficial conversion feature through the date of extinguishment. TheCompany allocated a portion of the reacquisition price to the beneficialconversion feature at the date of extinguishment. See notes below.

 

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 is accreting thisadditional beneficial conversion feature as interest expense over the remaininglife of the note.

 

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 conversion amountwas measured using the accounting intrinsic value, i.e. the excess of theaggregate 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 thenote.  For the six months ended June 30,2003, the Company recorded $15,000 as interest expense from the amortization ofthe discount related to the accretion of this beneficial conversion feature.

 

In June 2003, the Companyissued two senior secured convertible promissory notes (“the New Notes”) for anaggregate of $4,150,000 and a third senior secured convertible promissory notefor $106,000 in lieu of payment of financing fees.  The New Notes bear interest at 12.5% per annum and are due on theearlier of May 22, 2005 or upon the occurrence of various other events orconditions set for the in the New Notes, including but not limited to certainmergers, consolidations, reorganizations or other business combinationsinvolving the Company.  Under the termsof the New Notes, the holders retain the right, subject to certain exceptions,to convert all or any part of the principal and accrued interest outstandingunder the Notes into shares of our Common Stock at a conversion price per shareequal to $2.11.  The conversion price issubject to adjustment in the event we affect a stock split, combination or liketransaction.  The New Notes contain“full-ratchet” price anti-dilution provisions that would become effective if ourshareholders approve the transaction. In conjunction with the issuance of the New Notes, the Company issuedwarrants to acquire 1,600,000 shares of the Company’s Common stock at anexercise price of $2.11 per share.  Thewarrant price is subject to adjustment in the event of a stock split,combination or like transaction.  Thewarrants contain “full-ratchet” price and anti-dilution provisions that wouldbecome effective if our shareholders approve the transaction.

 

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 six months ended June 30, 2003, the Company recorded $102,000 asinterest expense from the amortization of the discount related to fair value ofthe warrants and from the accretion of the beneficial conversion feature.

 

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 $500,000secured 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 alsorecorded additional interest expense of $225,000 representing unamortizeddeferred financing fees at the date of extinguishment. The Company allocated$516,000 of the reacquisition price to the beneficial conversion feature basedon the intrinsic value of the conversion features on the date ofextinguishment.

 

A foreign subsidiary of theCompany has two line of credit facilities with commercial banks totaling$606,000.  As of June 30, 2003, theCompany had utilized $352,000 of these facilities.  Borrowings under these line of credit facilities bear interest atbetween 8.0% and 8.4% per annum and are collateralized by the subsidiary’saccounts receivable and inventories.

 

**NOTE5.  WARRANT LIABILITY**

 

In conjunctionwith the Company’s issuance of the New Notes, the Company agreed to registerwith the Securities and Exchange Commission, the shares of common stockunderlying the warrants issued as part of the New Notes.  In accordance with the Financial AccountingStandard Board Emerging Issue Task Force 00-19, the Company has recorded aslong-term liability the $2,037,000 relative fair market value of the warrant.  Accordingly, the Company is accounting forthe liability under fair value accounting and has recorded a current periodexpense of $321,000 for the three months ended June 30, 2003.

 

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**NOTE6.  RECENTLY ISSUED ACCOUNTING STANDARDS**

 

In December2002, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 148, *Accountingfor Stock Based Compensation — Transition and Disclosure. *This statement providesalternative methods of transition for a voluntary change to the fairvalue-based method of accounting for stock-based employee compensation.  In addition, this statement also amends thedisclosure requirements of SFAS No. 123 to require more prominent and frequentdisclosures in the financial statements about the effects of stock-basedcompensation.  The transitional guidanceand annual disclosure provisions of this statement was effective for theDecember 31, 2002 financial statements. The interim reporting disclosure requirements are effective for theCompany’s June 30, 2003 Form 10-QSB. Because the Company continues to accountfor employee stock-based compensation under APB Opinion No. 25, thetransitional guidance of SFAS No. 148 has no effect on the financial statementsat this time. The December 31, 2002 and June 30, 2003 financial statements haveincorporated the enhanced disclosure requirements of SFAS No. 148, as presentedbelow under the caption “Stock-Based Compensation.”

 

In November2002, 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.

 

In November2002, the Emerging Issues Task Force (EITF) issued Issue No. 00-21,“Accounting for Revenue Arrangements with Multiple Deliverables.” This issueaddresses determination of whether an arrangement involving more than onedeliverable contains more than one unit of accounting and how arrangementconsideration should be measured and allocated to the separate units ofaccounting. EITF Issue No. 00-21 will be effective for revenuearrangements entered into in fiscal periods beginning after June 15, 2003or the Company may elect to report the change in accounting as acumulative-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.

 

In April 2003,the FASB issued Statement of Financial Accounting Standard No. 149, (“SFAS149”), “Amendment of Statement 133 on Derivative Instruments and HedgingActivities,” which amends and clarifies financial accounting and reporting for derivativeinstruments, including certain derivative instruments embedded in othercontracts and for hedging activities under SFAS 133.  SFAS 149 is effective for contracts entered into or modifiedafter June 30, 2003 and for hedging relationships designated after June 30,except for the provisions that were cleared by the FASB in priorpronouncements.  The adoption of thisstatement is not expected to have a significant impact on the Company’sconsolidated 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 with characteristicsof both liabilities and equity. It requires that an issuer classify a financialinstrument that is within its scope as a liability because that financialinstrument embodies an obligation of the issuer. The adoption of this statementis not expected to have a significant impact on the Company’s consolidatedfinancial statements.

 

**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 of Section27A of the Securities Act of 1933, and Section 21E of the Securities ExchangeAct of 1934. All forward-looking statements included in this report are basedon information available to us as of the date hereof and we assume noobligation to update any forward-looking statements. Forward-looking statementsinvolve known or unknown risks, uncertainties and other factors, which maycause our actual results, performance or achievements, or industry results tobe materially different from any future results, performance or achievementsexpressed or implied by such forward-looking statements. Factors that couldcause or contribute to such differences include but are not limited to thoseitems discussed under “Risk Factors” and elsewhere in 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

 

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such fluctuations, historical results andpercentage relationships are not necessarily indicative of the operatingresults for any future period.

 

**OVERVIEW**

 

ImageWare Systems, Inc.utilizes its imaging technology to develop software used to create booking andinvestigative software, smart and secure identification systems and documents,and software for professional photographers. Our software systems andassociated hardware enable our customers to quickly capture, archive, search,retrieve and share digital photographs and associated text records.

 

**RESULTS OFOPERATIONS**

 

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

 
| **Net  Product Revenues****(dollars  in thousands)** |     | **THREE MONTHS  ENDED  JUNE 30,** |     |   |            |   |            |
|------------------------------------------------------|----------|-----------------------------------|----------|--------|-----------------|--------|-----------------|
|                                                 | **2003** |                              | **2002** |   | **$****Change** |   | **%****Change** |   |
|                                                 |     |                              |     |   |            |   |            |   |   |
| **Product revenues:**                                |     |                              |     |   |            |   |            |   |   |
| Law Enforcement                                      |     | $                                 | 556      |   | $               | 726    |            | $ | (170 | ) | -23 | % |
| Percentage of total net product revenue              |     | 14                                | %        | 20     | %               |   |            |   |   |
| Identification                                       |     | $                                 | 3,067    |   | $               | 2,824  |            | $ | 243 |   | 9 | % |
| Percentage of total net product revenue              |     | 80                                | %        | 77     | %               |   |            |   |   |
| Digital Photography                                  |     | $                                 | 212      |   | $               | 113    |            | $ | 99 |   | 87 | % |
| Percentage of total net product revenue              |     | 6                                 | %        | 3      | %               |   |            |   |   |
| Total net product revenues                           |     | $                                 | 3,835    |   | $               | 3,663  |            | $ | 172 |   | 5 | % |

 

Product revenues increased5% from $3,663,000 for the three months ended June 30, 2002 to $3,835,000 forthe corresponding period in 2003. Revenues related to law enforcement systemsand software decreased $170,000 for the three months ended June 30, 2003 ascompared to the corresponding period in 2002. We believe that the decrease inlaw enforcement product revenues is reflective of a decrease in governmentprocurement. We believe that the increase in terrorism has created heightenedinterest in the ability of law enforcement and other government agencies to beable to efficiently retrieve, analyze and share information from theirrespective criminal databases.  Weanticipate that these factors will increase overall demand for the Company’slaw enforcement products, however, we cannot predict the timing of the shift indemand.

 

Identification productrevenues increased 9% from $2,824,000 for the three months ended June 30, 2002to $3,067,000 for the corresponding period in 2003.  We believe that government agencies and private entities arereacting to increased terrorism by re-evaluating and upgrading their ability topositively identify and track their employees, consultants and visitors. Weanticipate that these factors will increase overall demand for the Company’sidentification products, however, we cannot predict the timing of the shift indemand.

 

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Digital Photography productrevenues increased 87% from $113,000 for the three months ended June 30, 2002to $212,000 for the corresponding period in 2003.  This increase is reflective of an increase is custom softwarecontracts completed during the second quarter of 2003 as well as increaseddistribution through dealer networks.

 

Our backlog of productorders as of June 30, 2003 was approximately $1,314,000.

 
| **Maintenance  Revenues****(dollars  in thousands)** |     | **THREE MONTHS  ENDED  JUNE 30,** |     |   |            |   |            |
|------------------------------------------------------|----------|-----------------------------------|----------|--------|-----------------|--------|-----------------|
|                                                 | **2003** |                              | **2002** |   | **$****Change** |   | **%****Change** |   |
| **Maintenance revenues:**                            |     |                              |     |   |            |   |            |   |   |
| Law Enforcement                                      |     | $                                 | 593      |   | $               | 544    |            | $ | 49 |   | 9 | % |
| Percentage of total net maintenenance  revenue       |     | 75                                | %        | 81     | %               |   |            |   |   |
| Identification                                       |     | $                                 | 198      |   | $               | 119    |            | $ | 79 |   | 67 | % |
| Percentage of total net maintenenance  revenue       |     | 25                                | %        | 18     | %               |   |            |   |   |
| Digital Photography                                  |     | $                                 | 1        |   | $               | 10     |            | $ | (9 | ) | -90 | % |
| Percentage of total net maintenenance  revenue       |     | 0                                 | %        | 1      | %               |   |            |   |   |
| Total net maintenance revenues                       |     | $                                 | 792      |   | $               | 673    |            | $ | 119 |   | 18 | % |

 

Maintenance revenuesincreased 18% from $673,000 for the three months ended June 30, 2002 to$792,000 for the corresponding period in 2003. This increase is due to theexpansion of our installed base of both law enforcement and identification systems.  Law enforcement maintenance revenuesincreased 9% or $49,000 for the three months ended June 30, 2003 from $544,000for the three months ended June 30, 2002 to $593,000 for the correspondingperiod in 2003. This increase is due primarily to the expansion of ourinstalled base of law enforcement systems.

 

Identification maintenancerevenues increased 67% or $79,000 for the three months ended June 30, 2003 from$119,000 for the three months ended June 30, 2002 to $198,000 for thecorresponding period in 2003. This increase is due primarily to the expansionof our installed base of identification systems.

 

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| **Cost of product revenues****(dollars in thousands)** |     | **THREE MONTHS  ENDED  JUNE 30,** |       |   |            |   |            |
|--------------------------------------------------------|----------|-----------------------------------|------------|--------|-----------------|--------|-----------------|
|                                                   | **2003** |                              | **2002**   |   | **$****Change** |   | **%****Change** |   |
| **Cost of Product Revenues:**                          |     |                              | ** ** |   | ** **      |   | ** **      |   | ** ** |
| Law Enforcement                                        |     | $                                 | 252        |   | $               | 281    |            | $ | (29 | ) | -10 | % |
| Percentage of Law Enforcement product  revenue         |     | 45                                | %          | 39     | %               |   |            |   |   |
| Identification                                         |     | $                                 | 1,579      |   | $               | 1,289  |            | $ | 290 |   | 23 | % |
| Percentage of Identification product  revenue          |     | 51                                | %          | 46     | %               |   |            |   |   |
| Digital Photography                                    |     | $                                 | 9          |   | $               | 52     |            | $ | (43 | ) | -82 | % |
| Percentage of Digital Photography product  revenue     |     | 4                                 | %          | 46     | %               |   |            |   |   |
| Total product cost of revenues                         |     | $                                 | 1,840      |   | $               | 1,622  |            | $ | 218 |   | 13 | % |
| Percentage of total product revenues                   |     | 48                                | %          | 44     | %               |   |            |   |   |

 

Cost of product revenues asa percentage of product revenues increased from 44% for the three month periodended June 30, 2002 to 48% of product revenues for the corresponding period in2003. This increase is due primarily to higher sales of hardware and relatedprint media consumables resulting in higher cost of sales as a percentage ofproduct revenues. Cost of product revenues for our Law Enforcement segmentdecreased 10%, or $29,000 from $281,000 or 39% of Law Enforcement productrevenues for the three months ended June 30, 2002 to $252,000, or 45% ofproduct revenues for the corresponding period in 2003.  This percentage increase in Law Enforcementcost of product revenues as a percentage of Law Enforcement product revenues isdue primarily 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 revenuesrelated to our Identification segment increased 23% from $1,289,000, or 46% ofIdentification product revenues for the three month period ended June 30, 2002to 1,579,000 or 51% of Identification product revenues for the correspondingperiod in 2003.  This increase of$290,000 is reflective of higher product revenues and higher sales of hardwareand print media consumables.  Thepercentage increase of Identification cost of product revenues as a percentageof Identification revenues is reflective of higher revenues from the sale ofhardware and print media consumables. Costs of products can vary as a percentage of product revenue fromperiod to period depending upon product mix and the hardware content, printmedia consumable content and software content included in products sold andsystems installed during a given period.

 

 Cost of product revenues related to our Digital Photographysegment decreased 82% from $52,000, or 46% of Digital Photography revenues forthe three month period ended June 30, 2002 to $9,000 or 4% of DigitalPhotography revenues for the corresponding period in 2003.  This decrease of $43,000 is reflective ofour decision to sell software only solutions beginning late in the firstquarter of 2002 as compared to our selling of software only solutions for theentire three month ended June 30, 2003.

 
| **Maintenance  cost of revenues****(dollars  in thousands)** |     | **THREE MONTHS  ENDED  JUNE 30,** |       |   |            |   |            |
|--------------------------------------------------------------|----------|-----------------------------------|------------|--------|-----------------|--------|-----------------|
|                                                         | **2003** |                              | **2002**   |   | **$****Change** |   | **%****Change** |   |
| **Maintenance cost of  revenues:**                           |     |                              | ** ** |   | ** **      |   | ** **      |   | ** ** |
| Law Enforcement                                              |     | $                                 | 215        |   | $               | 196    |            | $ | 19 |   | 9 | % |
| Percentage of Law Enforcement maintenance  revenue           |     | 36                                | %          | 36     | %               |   |            |   |   |
| Identification                                               |     | $                                 | 99         |   | $               | 67     |            | $ | 32 |   | 47 | % |
| Percentage of Identification maintenance  revenue            |     | 50                                | %          | 56     | %               |   |            |   |   |
| Digital Photography                                          |     | $                                 | —     |   | $               | — |            | $ | — |   | N/A |   |
| Percentage of Digital Photography  maintenance revenue       |     |                              |       |   |            |   |            |   |   |
| Total maintenance cost of revenues                           |     | $                                 | 314        |   | $               | 263    |            | $ | 51 |   | 20 | % |
| Percentage of total maintenance revenues                     |     | 40                                | %          | 39     | %               |   |            |   |   |

 

Costs of maintenancerevenues increased 20% from $263,000, or 39% of maintenance revenues, for thethree months ended June 30, 2002 to $314,000, or 40% of maintenance revenues,for the corresponding period in 2003. Cost of maintenance revenues in our Law Enforcementsegment increased 9%, from $196,000 or 36% of maintenance revenues for thethree months ended June 30, 2002 to $215,000 or 36% of maintenance revenues forthe corresponding period in 2003. This increase in costs of maintenancerevenues is due primarily to higher costs necessary to service the expandinginstalled base. Identification maintenance cost of revenues increased $32,000for the three month period ended June 30, 2003 as compared to the correspondingperiod in 2002 but decreased as a percentage of Identification maintenancerevenue from 56% for the three month period ended June 30, 2002 to 50% for thecorresponding period in 2003.  Thedollar increase is reflective of increased maintenance revenues due to theexpanding installed base.  The percentagedecrease is reflective of a higher maintenance revenue base to absorb fixedmaintenance costs.

 

14

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| **Product gross profit****(dollars in thousands)** |     | **THREE  MONTHS  ENDED  JUNE 30,** | ** ** |       | ** **      |   | ** **      |
|----------------------------------------------------|----------|------------------------------------|------------|------------|-----------------|--------|-----------------|
|                                               | **2003** | ** **                         | **2002**   | ** ** | **$****Change** |   | **%****Change** | ** ** |
| Law Enforcement                                    |     | $                                  | 304        |       | $               | 445    |            | $ | (141 | ) | -32 | % |
| Percentage of Law Enforcement product  revenue     |     | 55                                 | %          | 61         | %               |   |            |   |   |
| Identification                                     |     | $                                  | 1,488      |       | $               | 1,535  |            | $ | (47 | ) | -3 | % |
| Percentage of Identification product  revenue      |     | 49                                 | %          | 54         | %               |   |            |   |   |
| Digital Photography                                |     | $                                  | 203        |       | $               | 61     |            | $ | 142 |   | 231 | % |
| Percentage of Digital Photography product  revenue |     | 96                                 | %          | 54         | %               |   |            |   |   |
| Total product gross profit                         |     | $                                  | 1,995      |       | $               | 2,041  |            | $ | (46 | ) | -2 | % |
| Percentage of total product revenues               |     | 52                                 | %          | 56         | %               |   |            |   |   |

 

Total product gross marginsas a percentage of product revenues decreased from 56% for the three monthperiod ended June 30, 2002 to 52% of product revenues for the correspondingperiod in 2003. The overall decrease is primarily due to a higher percentage oftotal revenues coming from the sales of hardware and print media consumables.

 

Law Enforcement gross profitas a percentage of Law Enforcement product revenue decreased from 61% for thethree months ended June 30, 2002 to 55% for the corresponding period of 2003.This decrease is due primarily to our product mix containing higher percentagesof hardware than the comparable period in 2002, as well as a lower revenue baseto absorb fixed product costs.  Costs ofproducts can vary as a percentage of product revenue from quarter to quarterdepending upon product mix and hardware content and print media consumablecontent included in systems installed during a given period.

 

Identification gross profitas a percentage of Identification product revenue decreased from 54% for thethree months ended June 30, 2002 to 49% for the corresponding period of2003.  This decrease is reflective ofhigher product sales of hardware and print media consumables.  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.

 

Digital Photography grossprofit as a percentage of Digital Photography product revenue increased from54% for the three months ended June 30, 2002 to 96% for the correspondingperiod in 2003. This increase is reflective of our selling of software onlysolutions during the three months ended June 30, 2003 as compared to thecorresponding period of 2002 which contained both hardware and softwarecomponents.

 
| **Maintenance gross profit****(dollars in thousands)** |     | **THREE  MONTHS  ENDED  JUNE 30,** | ** ** |       | ** **      |   | ** **      |
|--------------------------------------------------------|----------|------------------------------------|------------|------------|-----------------|--------|-----------------|
|                                                   | **2003** | ** **                         | **2002**   | ** ** | **$****Change** |   | **%****Change** | ** ** |
|                                                   |     |                               | ** ** |       | ** **      |   | ** **      |   | ** ** |
| **Maintenance gross profit**                           |     |                               |       |       |            |   |            |   |   |
| Law Enforcement                                        |     | $                                  | 379        |       | $               | 348    |            | $ | 31 |   | 9 | % |
| Percentage of Law Enforcement maintenance  revenue     |     | 64                                 | %          | 64         | %               |   |            |   |   |
| Identification                                         |     | $                                  | 99         |       | $               | 52     |            | $ | 47 |   | 90 | % |
| Percentage of Identification maintenance  revenue      |     | 50                                 | %          | 44         | %               |   |            |   |   |
| Digital Photography                                    |     | $                                  | 1          |       | $               | 10     |            | $ | (9 | ) | 100 | % |
| Percentage of Digital Photography  maintenance revenue |     | N/A                                |       | 100        | %               |   |            |   |   |
| Total maintenance gross profit                         |     | $                                  | 479        |       | $               | 410    |            | $ | 69 |   | 17 | % |
| Percentage of total maintenance revenues               |     | 60                                 | %          | 61         | %               |   |            |   |   |

 

Gross margins related tomaintenance revenues increased $69,000, or 17% from $410,000, or 61% ofmaintenance revenues for the three months ended June 30, 2002 to $479,000, or60% of maintenance revenues for the corresponding period in 2003. This increaseis due primarily to increased revenues resulting from our expanding installedbase.

 

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| **Operating expenses****(dollars in thousands)** |     | **THREE  MONTHS  ENDED  JUNE 30,** | ** ** |       | ** **      |   | ** **      |
|--------------------------------------------------|----------|------------------------------------|------------|------------|-----------------|--------|-----------------|
|                                             | **2003** | ** **                         | **2002**   | ** ** | **$****Change** |   | **%****Change** | ** ** |
|                                             |     |                               |       |       |            |   |            |   |   |
| General & administrative                     |     | $                                  | 1,439      |       | $               | 1,675  |            | $ | (236 | ) | -14 | % |
| Percentage of total net revenue                  |     | 31                                 | %          | 39         | %               |   |            |   |   |
| Sales and marketing                              |     | $                                  | 1,048      |       | $               | 1,059  |            | $ | (11 | ) | -1 | % |
| Percentage of total net revenue                  |     | 23                                 | %          | 24         | %               |   |            |   |   |
| Research & development                       |     | $                                  | 437        |       | $               | 510    |            | $ | (73 | ) | -14 | % |
| Percentage of total net revenue                  |     | 9                                  | %          | 12         | %               |   |            |   |   |
| Depreciation and amortization                    |     | $                                  | 237        |       | $               | 197    |            | $ | 40 |   | 21 | % |
| 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 $236,000 from$1,675,000 for the three months ended June 30, 2002 to $1,439,000 for thecorresponding period in 2003.  Suchexpenses, as a percentage of total net revenues, decreased from 39% for thethree months ended June 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 gradually decrease our level ofgeneral and administrative expenses expressed as a percentage of totalrevenues.

 

*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 1%, or $11,000 from$1,059,000 for the three months ended June 30, 2002 to $1,048,000 for thecorresponding period in 2003.  Suchexpenses, as a percentage of total net revenues, decreased from 24% for thethree months ended June 30, 2002 to 23% for the corresponding period in 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 14% or$73,000 from $510,000 for the three months ended June 30, 2002 to $437,000 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 $40,000 from $197,000 for thethree months ended June 30, 2002 to $237,000 for the corresponding period in2003. This increase is due primarily to higher amortization of intangibleassets.

 

*INTEREST EXPENSE, NET.*  Forthe three months ended June 30, 2003, we recognized interest income of $1,000and interest expense of $1,894,000. For the three months ended June 30, 2002,we recognized interest income of $10,000 and interest expense of $118,000.  Interest expense in the three months endedJune 30, 2003 increased due to our issuance of senior secured and subordinatedconvertible promissory notes payable, short-term demand notes payable andshort-term borrowings under banking lines of credit.  Interest expense for the three months ended June 30, 2003 alsoincludes approximately $1,409,000 of debt discount and deferred financing feeamortization classified as interest expense. Interest expense for the threemonths ended June 30, 2003 also contains $321,000 of interest expense relatedto fair value accounting for our warrant liability due to the registrationrights agreement associated with the underlying shares of the Company's commonstock to be issued upon conversion of the warrants.

 

16

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***SIX MONTHS ENDED JUNE 30, 2003 AND 2002.***

* *
| **Net Product Revenues****(dollars in thousands)** |     | **SIX  MONTHS  ENDED  JUNE 30,** | ** ** |       | ** **      |   | ** **      |
|----------------------------------------------------|----------|----------------------------------|------------|------------|-----------------|--------|-----------------|
|                                               | **2003** | ** **                       | **2002**   | ** ** | **$****Change** |   | **%****Change** | ** ** |
|                                               |     |                             | ** ** |       | ** **      |   | ** **      |   | ** ** |
| **Product revenues:**                              |     |                             |       |       |            |   |            |   |   |
| Law Enforcement                                    |     | $                                | 760        |       | $               | 1,239  |            | $ | (479 | ) | -39 | % |
| Percentage of total net product revenue            |     | 11                               | %          | 19         | %               |   |            |   |   |
| Identification Group                               |     | $                                | 5,236      |       | $               | 5,021  |            | $ | 215 |   | 4 | % |
| Percentage of total net product revenue            |     | 81                               | %          | 75         | %               |   |            |   |   |
| Digital Photography                                |     | $                                | 473        |       | $               | 399    |            | $ | 74 |   | 19 | % |
| Percentage of total net product revenue            |     | 7                                | %          | 6          | %               |   |            |   |   |
| Total net product revenues                         |     | $                                | 6,469      |       | $               | 6,659  |            | $ | (190 | ) | -3 | % |

 

Product revenues decreased3% from $6,659,000 for the six months ended June 30, 2002 to $6,469,000 for thecorresponding period in 2003. Revenues related to law enforcement systems andsoftware decreased $479,000 for the six months ended June 30, 2003 as comparedto the corresponding period in 2002. We believe that the decrease in lawenforcement product revenues is reflective of a decrease in governmentprocurement. We believe that the increase in terrorism has created heightenedinterest in the ability of law enforcement and other government agencies to beable to efficiently retrieve, analyze and share information from theirrespective criminal databases.  Weanticipate that these factors will increase overall demand for the Company’slaw enforcement products, however, we cannot predict the timing of the shift indemand.

 

Identification productrevenues increased 4% from $5,021,000 for the six months ended June 30, 2002 to$5,236,000 for the corresponding period in 2003.  We believe that government agencies and private entities are reactingto increased terrorism by re-evaluating and upgrading their abilityto positively identify and track their employees, consultants and visitors. Weanticipate that these factors will continue to increase overall demand for theCompany’s identification products, however, we cannot predict the timing of theshift in demand.

 

Digital Photography productrevenues increased 19% from $399,000 for the six months ended June 30, 2002 to$473,000 for the corresponding period in 2003. This increase is reflective of an increase is custom software contractscompleted during the six months ended June 30, 2003 as well as increaseddistribution through dealer networks.

 
| **Maintenance Revenues****(dollars in thousands)** |     | **SIX  MONTHS  ENDED  JUNE 30,** | ** ** |       | ** **      |   | ** **      |
|----------------------------------------------------|----------|----------------------------------|------------|------------|-----------------|--------|-----------------|
|                                               | **2003** | ** **                       | **2002**   | ** ** | **$****Change** |   | **%****Change** | ** ** |
|                                               |     |                             | ** ** |       | ** **      |   | ** **      |   | ** ** |
| **Maintenance revenues:**                          |     |                             |       |       |            |   |            |   |   |
| Law Enforcement                                    |     | $                                | 1,181      |       | $               | 1,052  |            | $ | 129 |   | 12 | % |
| Percentage of total net maintenenance  revenue     |     | 74                               | %          | 78         | %               |   |            |   |   |
| Identification Group                               |     | $                                | 408        |       | $               | 271    |            | $ | 137 |   | 51 | % |
| Percentage of total net maintenenance  revenue     |     | 26                               | %          | 20         | %               |   |            |   |   |
| Digital Photography                                |     | $                                | 1          |       | $               | 22     |            | $ | (21 | ) | -95 | % |
| Percentage of total net maintenenance  revenue     |     | 0                                | %          | 2          | %               |   |            |   |   |
| Total net maintenance revenues                     |     | $                                | 1,590      |       | $               | 1,345  |            | $ | 245 |   | 18 | % |

 

Maintenance revenuesincreased 18% from $1,345,000 for the six months ended June 30, 2002 to$1,590,000 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 12% or $129,000 for the six months ended June 30, 2003 from$1,052,000 for the six months ended June 30, 2002 to $1,181,000 for thecorresponding period in 2003. This increase is due primarily to the expansionof our installed base of law enforcement systems.

 

17

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Identification maintenancerevenues increased 51% or $137,000 for the six months ended June 30, 2003 from$271,000 for the six months ended June 30, 2002 to $409,000 for thecorresponding period in 2003. This increase is due primarily to the expansionof our installed base of identification systems.

 
| **Cost of product revenues  (dollars in thousands)** |     | **SIX  MONTHS  ENDED  JUNE 30,** | ** ** |       | ** **      |   | ** **      |
|------------------------------------------------------|----------|----------------------------------|------------|------------|-----------------|--------|-----------------|
|                                                 | **2003** | ** **                       | **2002**   | ** ** | **$****Change** |   | **%****Change** | ** ** |
|                                                 |     |                             | ** ** |       | ** **      |   | ** **      |   | ** ** |
| **Cost of Product Revenues:**                        |     |                             | ** ** |       | ** **      |   | ** **      |   | ** ** |
| Law Enforcement                                      |     | $                                | 416        |       | $               | 412    |            | $ | 4 |   | 1 | % |
| Percentage of Law Enforcement product  revenue       |     | 55                               | %          | 33         | %               |   |            |   |   |
| Identification Group                                 |     | $                                | 2,632      |       | $               | 2,344  |            | $ | 288 |   | 12 | % |
| Percentage of Identification Group product  revenue  |     | 50                               | %          | 47         | %               |   |            |   |   |
| Digital Photography                                  |     | $                                | 29         |       | $               | 168    |            | $ | (139 | ) | -83 | % |
| Percentage of digital photography product  revenue   |     | 6                                | %          | 42         | %               |   |            |   |   |
| Total product cost of revenues                       |     | $                                | 3,077      |       | $               | 2,924  |            | $ | 153 |   | 5 | % |
| Percentage of total product revenues                 |     | 48                               | %          | 44         | %               |   |            |   |   |

 

Cost of product revenues asa percentage of product revenues increased from 44% for the six month periodended June 30, 2002 to 48% of product revenues for the corresponding period in2003. This increase is due primarily to higher sales of hardware and relatedprint media consumables resulting in higher cost of sales as a percentage ofproduct revenues. Cost of product revenues for our Law Enforcement segmentincreased 1%, or $4,000 from $412,000 or 33% of Law Enforcement productrevenues for the six months ended June 30, 2002 to $416,000, or 55% of productrevenues for the corresponding period in 2003. This increase is due primarily to the smaller revenue base to absorbfixed product costs.  Costs of productsalso can vary as a percentage of product revenue from period to perioddepending upon product mix and the hardware content, print media consumablecontent and software content included in systems installed during a givenperiod.

 

Cost of product revenuesrelated to our Identification segment increased 12% from $2,344,000, or 47% ofIdentification product revenues for the six month period ended June 30, 2003 to$2,632,000 or 50% of Identification product revenues for the correspondingperiod in 2003.  This increase of$288,000 is reflective of higher product revenues and higher sales of hardwareand print media consumables.  Thepercentage increase of Identification cost of product revenues as a percentageof Identification revenues is reflective of higher revenues from the sale ofhardware and print media consumables. Costs of products also can vary as a percentage of product revenue fromperiod to period depending upon product mix and the hardware content, printmedia consumable content and software content included in systems installedduring a given period.

 

Cost of product revenuesrelated to our Digital Photography segment decreased 83% from $168,000, or 42%of Digital Photography revenues for the six month period ended June 30, 2002 to$29,000 or 6% of Digital Photography revenues for the corresponding period in2003.  This decrease of $139,000 isreflective of our decision to sell software only solutions beginning late inthe first quarter of 2002 as compared to our selling of software only solutionsfor the entire six month period in 2003.

 
| **Maintenance cost of revenues  (dollars in thousands)** |     | **SIX MONTHS  ENDED  JUNE 30,** | ** ** |       | ** **      |   | ** **      |
|----------------------------------------------------------|----------|---------------------------------|------------|------------|-----------------|--------|-----------------|
|                                                     | **2003** | ** **                      | **2002**   | ** ** | **$****Change** |   | **%****Change** | ** ** |
|                                                     |     |                            |       |       |            |   |            |   |   |
| **Maintenance cost of  revenues:**                       |     |                            | ** ** |       | ** **      |   | ** **      |   | ** ** |
| Law Enforcement                                          |     | $                               | 438        |       | $               | 381    |            | $ | 57 |   | 15 | % |
| Percentage of Law Enforcement maintenance  revenue       |     | 37                              | %          | 36         | %               |   |            |   |   |
| Identification Group                                     |     | $                               | 231        |       | $               | 162    |            | $ | 69 |   | 43 | % |
| Percentage of Identification maintenance  revenue        |     | 57                              | %          | 60         | %               |   |            |   |   |
| Digital Photography                                      |     | $                               | —     |       | $               | — |            | $ | — |   | N/A |   |
| Percentage of digital photography  maintenance revenue   |     |                            |       |       |            |   |            |   |   |
| Total maintenance cost of revenues                       |     | $                               | 669        |       | $               | 543    |            | $ | 126 |   | 23 | % |
| Percentage of total maintenance revenues                 |     | 42                              | %          | 40         | %               |   |            |   |   |

 

Costs of maintenancerevenues increased 23% from $543,000, or 40% of maintenance revenues, for thesix months ended June 30, 2002 to $669,000, or 42% of maintenance revenues, forthe corresponding period in 2003. Cost of maintenance revenues in

 

18

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our Law Enforcement segment increased 15%,from $381,000 or 36% of maintenance revenues for the six months ended June 30,2002 to $438,000 or 37% of maintenance revenues for the corresponding period in2003. This increase in costs of maintenance revenues is due primarily to highercosts necessary to service the expanding installed base. Identificationmaintenance cost of revenues increased $69,000 for the six month period endedJune 30, 2003 as compared to the corresponding period in 2002 but decreased asa percentage of identification maintenance revenue from 60% for the six monthperiod ended June 30, 2002 to 57% for the corresponding period in 2003.  The dollar increase is reflective ofincreased maintenance revenues due to the expanding installed base.  The percentage decrease is reflective of ahigher maintenance revenue base to absorb fixed maintenance costs.

 
| **Product gross profit****(dollars  in thousands)** |     | **SIX  MONTHS  ENDED  JUNE 30,** | ** ** |       | ** **      |   | ** **      |
|-----------------------------------------------------|----------|----------------------------------|------------|------------|-----------------|--------|-----------------|
|                                                | **2003** | ** **                       | **2002**   | ** ** | **$****Change** |   | **%****Change** | ** ** |
|                                                |     |                             | ** ** |       | ** **      |   | ** **      |   | ** ** |
| Law Enforcement                                     |     | $                                | 344        |       | $               | 827    |            | $ | (483 | ) | -58 | % |
| Percentage of Law Enforcement product  revenue      |     | 45                               | %          | 67         | %               |   |            |   |   |
| Identification Group                                |     | $                                | 2,604      |       | $               | 2,677  |            | $ | (73 | ) | -3 | % |
| Percentage of Identification product  revenue       |     | 50                               | %          | 53         | %               |   |            |   |   |
| Digital Photography                                 |     | $                                | 444        |       | $               | 231    |            | $ | 213 |   | 93 | % |
| Percentage of digital photography product  revenue  |     | 94                               | %          | 58         | %               |   |            |   |   |
| Total product gross profit                          |     | $                                | 3,392      |       | $               | 3,735  |            | $ | (343 | ) | -9 | % |
| Percentage of total product revenues                |     | 52                               | %          | 56         | %               |   |            |   |   |

 

Total product gross marginsas a percentage of product revenues decreased from 56% for the six month periodended June 30, 2002 to 52% of product revenues for the corresponding period in2003. The overall decrease is primarily due to a higher percentage of totalrevenues coming from the sales of hardware and print media consumables.

 

Law Enforcement gross profitas a percentage of Law Enforcement product revenue decreased from 67% for thesix months ended June 30, 2002 to 45% for the corresponding period of 2003.This decrease is due primarily to our product mix containing higher percentagesof hardware than the comparable period in 2002, as well as a lower revenue baseto absorb fixed product costs.  Costs ofproducts can vary as a percentage of product revenue from quarter to quarterdepending upon product mix and hardware content and print media consumablecontent included in systems installed during a given period.

 

Identification gross profitas a percentage of Identification product revenue decreased from 53% for thesix months ended June 30, 2002 to 50% for the corresponding period of2003.  This decrease is reflective of higherproduct sales of hardware and print media consumables.  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.

 

Digital Photography grossprofit as a percentage of Digital Photography product revenue increased from58% for the six months ended June 30, 2002 to 94% for the corresponding periodin 2003. This increase is reflective of our selling of software only solutionsduring the six months ended June 30, 2003 as compared to the correspondingperiod of 2002 which contained both hardware and software components.

 
| **Maintenance gross profit  (dollars in thousands)**   |     | **SIX MONTHS****ENDED****JUNE 30,** |       |       |            |   |            |
|--------------------------------------------------------|----------|-------------------------------------|------------|------------|-----------------|--------|-----------------|
|                                                   | **2003** | ** **                          | **2002**   | ** ** | **$****Change** |   | **%****Change** | ** ** |
|                                                   |     |                                | ** ** |       | ** **      |   | ** **      |   | ** ** |
| **Maintenance gross profit**                           |     |                                |       |       |            |   |            |   |   |
| Law Enforcement                                        |     | $                                   | 743        |       | $               | 672    |            | $ | 71 |   | 11 | % |
| Percentage of Law Enforcement maintenance  revenue     |     | 63                                  | %          | 64         | %               |   |            |   |   |
| Identification Group                                   |     | $                                   | 177        |       | $               | 108    |            | $ | 69 |   | 63 | % |
| Percentage of Identification maintenance  revenue      |     | 43                                  | %          | 40         | %               |   |            |   |   |
| Digital Photography                                    |     | $                                   | 1          |       | $               | 22     |            | $ | (21 | ) | 95 | % |
| Percentage of digital photography  maintenance revenue |     | 100                                 | %          | 100        | %               |   |            |   |   |
| Total maintenance gross profit                         |     | $                                   | 921        |       | $               | 802    |            | $ | 119 |   | 15 | % |
| Percentage of total maintenance revenues               |     | 58                                  | %          | 60         | %               |   |            |   |   |

 

19

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Gross margins related tomaintenance revenues increased $119,000, or 15% from $802,000, or 60% ofmaintenance revenues for the six months ended June 30, 2002 to $921,000, or 58%of maintenance revenues for the corresponding period in 2003. This increase isdue primarily to increased revenues resulting from our expanding installedbase.

 

 
| **Operating  expenses****(dollars  in thousands)** |     | **SIX MONTHS  ENDED  JUNE 30,** |       |       |            |   |            |
|----------------------------------------------------|----------|---------------------------------|------------|------------|-----------------|--------|-----------------|
|                                               | **2003** | ** **                      | **2002**   | ** ** | **$****Change** |   | **%****Change** | ** ** |
|                                               |     |                            | ** ** |       | ** **      |   | ** **      |   | ** ** |
| General & administrative                       |     | $                               | 2,881      |       | $               | 3,391  |            | $ | (510 | ) | -15 | % |
| Percentage of total net revenue                    |     | 36                              | %          | 42         | %               |   |            |   |   |
| Sales and marketing                                |     | $                               | 2,137      |       | $               | 2,201  |            | $ | (64 | ) | -3 | % |
| Percentage of total net revenue                    |     | 27                              | %          | 27         | %               |   |            |   |   |
| Research & development                         |     | $                               | 931        |       | $               | 1,025  |            | $ | (94 | ) | -9 | % |
| Percentage of total net revenue                    |     | 12                              | %          | 13         | %               |   |            |   |   |
| Depreciation and amortization                      |     | $                               | 473        |       | $               | 415    |            | $ | 58 |   | 14 | % |
| Percentage of total net revenue                    |     | 6                               | %          | 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 15%, or $510,000 from$3,391,000 for the six months ended June 30, 2002 to $2,881,000 for thecorresponding period in 2003.  Suchexpenses, as a percentage of total net revenues, decreased from 42% for the sixmonths ended June 30, 2002 to 36% for the corresponding period in 2003.  We are continuing to focus our efforts onachieving additional future operating efficiencies by reviewing and improvingupon existing business processes and evaluating our cost structure. We believethese efforts will allow us to gradually decrease our level of general andadministrative expenses expressed as a percentage of total revenues.

 

*SALES AND MARKETING*.  Sales and marketing expensesconsist primarily of the salaries, commissions, other incentive compensation,employee benefits and travel expenses of our sales force. Such expensesdecreased 3%, or $64,000 from $2,201,000 for the six months ended June 30, 2002to $2,137,000 for the corresponding period in 2003.  Such expenses, as a percentage of total net revenues, were 27%for the six months ended June 30, 2002 and for the corresponding period in2003.

 

*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 9% or $94,000from $1,025,000  for the six monthsended June 30, 2002 to $931,000 for the corresponding period in 2003.  This decrease is due to a reduction incontract programming expenditures and reduced headcount.  Our level of expenditures in research anddevelopment reflects our belief that to maintain our competitive position inmarkets characterized by rapid rates of technological advancement, we mustcontinue to invest significant resources in new systems and software as well ascontinue to enhance existing products.

 

*DEPRECIATION AND AMORTIZATION.* Depreciation and amortization increased $58,000 from $415,000 for thesix months ended June 30, 2002 to $473,000 for the corresponding period in2003. This increase is due primarily to higher amortization of intangibleassets.

 

*INTEREST EXPENSE, NET.*  Forthe six months ended June 30, 2003, we recognized interest income of $1,000 andinterest expense of $2,255,000. For the six months ended June 30, 2002, werecognized interest income of $18,000 and interest expense of $130,000.  Interest expense in the six months ended June30, 2003 increased due to our issuance of senior secured and subordinatedconvertible promissory notes payable, short-term demand notes payable andshort-term borrowings under banking lines of credit.  Interest expense for the six months ended June 30, 2003 alsoincludes approximately of $1,645,000 of debt discount and deferred financingfee amortization classified as interest expense. Interest expense for the sixmonths ended June 30, 2003 also contains $321,000 interest expense related tofair value accounting for our warrant liabilites due to the registration rightsagreement associated with the underlying shares of the Company's common stockto be issued upon conversion of the warrants.

 

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*LIQUIDITYAND CAPITAL RESOURCES*

 

As of June 30, 2003, we hadtotal current assets of $5,192,000 and total current liabilities of $5,799,000,or negative working capital of $607,000. At June 30, 2003, we had availablecash of $628,000 and $60,000 in restricted cash securing our San Diego,California facility lease.

 

Net cash used in operatingactivities was $1,474,000 for the six month period ended June 30, 2003 ascompared to $1,388,000 for the corresponding period in 2002. We used cash tofund net losses of $1,842,000, excluding non-cash expenses (depreciation,amortization and change in warrant liability) of $2,348,000 for the six monthsended June 30, 2003.  We used cash tofund net losses of $2,143,000, excluding non-cash expenses (depreciation andamortization) of $487,000 for the corresponding period in 2002. For the sixmonths ended June 30, 2003, we generated cash of $1,039,000 from reductions incurrent, intangible and other assets and used cash of $671,000 for reductionsin current liabilities, excluding debt. In 2002, we generated cash of$1,446,000 from reductions in current, intangible and other assets and usedcash of $691,000 from reductions in current liabilities, excluding debt.

 

Net cash used by investingactivities was $203,000 for the six months ended June 30, 2003 as compared to$299,000 for the corresponding period in 2002. For the six months ended June30, 2003, we used cash to fund capital expenditures of computer equipment andsoftware, furniture and fixtures and leasehold improvements of approximately$134,000. The level of equipment purchases resulted primarily from continuedgrowth of the business and replacement of older equipment. For the six monthsended June 30, 2003, we also used cash of approximately $128,000 to repayadvances from related stockholders and generated cash of $59,000 from the saleof equipment. For the six months ended June 30, 2002, we used cash of $209,000to fund capital expenditures of computer equipment, software, furniture andfixtures. We used cash of $90,000 to repay advances from related stockholders.

 

Net cash provided byfinancing activities was $1,988,000 for the six month period ended June 30,2003 as compared to net cash provided by financing activities of $2,133,000 forthe corresponding period in 2002. For the six months ended June 30, 2003, wegenerated cash of $4,856,000 from our issuance of senior and subordinatedconvertible promissory notes payable offset by $554,000 in debt issuance costsand $2,500,000 for the repayment of notes payable.  We also generated cash of $186,000 from short-term borrowingsunder bank line of credit agreements. For the corresponding period in 2002, wegenerated cash of $2,000,000 from our issuance of senior secured convertiblepromissory notes offset by $272,000 in debt issuance costs.  We also generated cash of $415,000 fromshort-term borrowings under bank line of credits.  We used cash of $10,000 for the repayment of capital leaseobligations.

 

We conductoperations in leased facilities under operating leases expiring at variousdates through 2006. Additionally, we have acquired certain equipment undercapital leases which expire at various dates through 2006. In conjunction withour San Diego, California leased facility, we are contingently liable under anirrevocable letter of credit in the amount of $30,000. The letter of creditexpires July 31, 2003 provided there are no drawings against the outstandingbalance. We also have various short-term notes payable and capital leaseobligations due at various times during the next twelve months.

 

The report of the Company’sindependent accountants included with our most recent Annual Report filed onForm 10-KSB on April 15, 2003 includes an explanatory paragraph as to theuncertainty that the Company will continue as a going concern. The Company isseeking additional financing that we believe is necessary to fund our workingcapital requirements for at least the next twelve months, assuming thesuccessful 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 the Companywill be able to satisfy the criteria for continued listing on the AmericanStock Exchange. Insufficient funds may require us to delay, scale back oreliminate 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 financing to fund our anticipated working capitalrequirements during the next twelve months. We anticipate that our existingresources will not be sufficient to enable us to maintain our current andplanned operations for the next twelve months and the report of our independentaccountants included with our most recent report on Form 10-KSB includes anexplanatory paragraph regarding our ability to continue as a going concern. Weare seeking additional funding through public or private equity or debtfinancing. There can be no assurance that additional financing will beavailable on acceptable terms, or at all. If we are required to sell equity toraise additional funds, our existing shareholders may incur substantialdilution and any shares so issued may have rights, preferences and privilegessuperior to the rights, preferences and privileges of our outstanding CommonStock. Also, we may be required to obtain funds through arrangements with thirdparties that require us to relinquish rights to certain of our technologies orproducts that we would seek to develop or commercialize ourselves. In addition,our ability to raise additional capital may be dependent upon the Company’sCommon Stock being listed on the American Stock Exchange. We cannot guaranteethat the Company will be able to satisfy the criteria for continued listing onthe American Stock Exchange.

 

**WE HAVE A HISTORY OF SIGNIFICANT RECURRINGLOSSES TOTALING APPROXIMATELY $39.5 MILLION, AND THESE LOSSES MAY CONTINUE INTHE FUTURE.**

 

As of June 30, 2003, we had an accumulated deficit of$39.5 million, and these losses may continue in the future. We may need toraise capital to cover these losses, and financing may not be available to uson favorable terms. We expect to continue to incur significant sales andmarketing, research and development, and general and administrative expenses.As a result, we will need to generate significant revenues to achieveprofitability and may never achieve profitability.

 

**THE HOLDERS OF OUR PREFERRED STOCK HAVECERTAIN RIGHTS AND PRIVILEGES THAT ARE SENIOR TO THE COMMON STOCK AND WE MAYISSUE ADDITIONAL SHARES OF PREFERRED STOCK WITHOUT SHAREHOLDER APPROVAL THATCOULD HAVE A MATERIAL ADVERSE EFFECT ON THE MARKET VALUE OF THE COMMON STOCK.**

 

Our Board of Directors has the authority to issue a total of up to4,000,000 shares of preferred stock and to fix the rights, preferences,privileges, and restrictions, including voting rights, of the preferred stock,which typically are

 

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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 been issued,or might be issued in the future. Preferred stock also could have the effect ofmaking it more difficult for a third party to acquire a majority of theoutstanding voting stock of ImageWare. This could delay, defer, or prevent achange in control. Furthermore, holders of preferred stock may have otherrights, including economic rights, senior to the common stock. As a result,their existence and issuance could have a material adverse effect on the marketvalue of the common stock. We have in the past issued, and, may from time totime in the future issue, preferred stock for financing or other purposes withrights, preferences, or privileges senior to the common stock.

 

The provisions of our outstanding Series B Preferred Stockprohibit the payment of dividends on the common stock unless the dividends onthose preferred shares are first paid. In addition, upon a liquidation,dissolution or sale of ImageWare’s business, the holders of the Series BPreferred Stock will be entitled to receive, in preference to any distributionto the holders of common stock, initial distributions of $2.50 per share, plusall accrued but unpaid dividends.

 

Pursuant to the terms of our Series B Preferred Stock we are obligatedto pay cumulative cash dividends on shares of Series B Preferred Stock fromlegally available funds at the annual rate of $0.2125 per share, payable in twosemi-annual installments of $0.10625 each, which cumulative dividends must bepaid prior to payment of any dividend on our Common Stock.  As of June 30, 2003, the Company hadcumulative undeclared dividends of $177,000.

 

**WE DEPEND UPON A SMALL NUMBER OF LARGE SYSTEMSALES COSTING FROM $300,000 TO $600,000, AND WE MAY FAIL TO ACHIEVE ONE OR MORELARGE SYSTEM SALES IN THE FUTURE.**

 

In the past three years we have derived a substantial portion of ourrevenues from a small number of sales of large, relatively expensive systems,typically ranging in price from $300,000 to $600,000. As a result, if we failto receive orders for these large systems in a given sales cycle on aconsistent basis, our business could be significantly harmed. Further, ourquarterly results are difficult to predict because we cannot predict in whichquarter, if any, large system sales will occur in a given year. As a result, webelieve that quarter-to-quarter comparisons of our results of operations arenot a good indication of our future performance. In some future quarters ouroperating results may be below the expectations of securities analysts andinvestors, in which case the market price of our common stock may decreasesignificantly.

 

**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 of a large computerized booking oridentification system, a government agency may take as long as a year toevaluate different systems and obtain approval for the purchase. If we fail tocomplete a sale, we will have expended significant resources and received norevenue in return. Generally, agencies consider a wide range of issues beforecommitting to purchase our products, including product benefits, ability tooperate with their current systems, product reliability and their own budgetaryconstraints. While potential customers are evaluating our products and beforethey place an order with us, we may incur substantial selling costs and expendsignificant management effort to accomplish a 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 our customers are government agencies. Theseagencies often do not set their own budgets and therefore have little controlover the amount of money they can spend. In addition, these agencies experiencepolitical pressure that may dictate the manner in which they spend money. Dueto political and budgetary processes and other scheduling delays that mayfrequently occur relating to the contract or bidding process, some

 

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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 APPLICATIONS FOROUR PRODUCTS AND ENTER NEW MARKETS, WHICH MAY AFFECT OUR FUTURE SUCCESS.**

 

We believe our future success depends in part on our ability to developand market our technology for applications other than booking systems for thelaw enforcement market. If we fail in these goals, our business strategy andability to generate revenues and cash flow would be significantly impaired. Weintend to expend significant resources to develop new technology, but thesuccessful development of new technology cannot be predicted and we cannotguarantee we will succeed in these goals.

 

**WE OCCASIONALLY RELY ON SYSTEMS INTEGRATORSTO MANAGE OUR LARGE PROJECTS, AND IF THESE COMPANIES DO NOT PERFORM ADEQUATELY,WE MAY LOSE BUSINESS.**

 

We are occasionally a subcontractor to systems integrators who managelarge projects that incorporate our systems, particularly in foreign countries.We cannot control these companies, and they may decide not to promote ourproducts, or they may price their services in such a way as to make itunprofitable for us to continue our relationship with them. Further, they mayfail to perform under agreements with their customers, in which case we mightlose sales to these customers. If we lose our relationships with thesecompanies, our business may suffer.

 

**WE RELY ON A LICENSE OF TECHNOLOGY FROMIDENTIX, INC., AND THIS LICENSE MAY BE TERMINATED IN THE FUTURE.**

 

We depend on a licensing arrangement with Identix for technology relatedto the search engine used in our systems. Our current licensing arrangementwith Identix terminates October 1, 2003. If Identix becomes unable orunwilling to continue to license us this technology or to renew the terms ofthis license, we will have to identify or develop acceptable alternativesources of this technology, which could take up to three months or longer. Anysignificant interruption in our ability to identify and contract withalternative providers of similar technology or to develop our own search enginewould result in delivery delays, which could harm our customer relationshipsand our business and reputation.  We arecurrently in discussions with Identix regarding the extension and/or renewal ofthis licensing arrangement and we are also continuing to explore alternativesources of this technology.

 

**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 large part on our technology, and our successdepends in part on our ability and efforts to protect our intellectual propertyrights. If we do not adequately protect our intellectual property throughcopyrights and various trade secret protections afforded to us by law, ourbusiness will be seriously harmed. We do not have patent protection for ourproducts.

 

We license certain elements of our trademarks, trade dress, copyrightand other intellectual property to third parties. We attempt to ensure that ourrights in our trade names and the quality of third party uses of our names aremaintained by these third parties. However, these third parties may takeactions that could significantly impair the value of our intellectual propertyand our reputation and goodwill.

 

In addition, international intellectual property laws differ fromcountry to country. Any foreign rights we have in our technology are limited bywhat has been afforded to us under the applicable foreign intellectual propertylaws. Also, under the laws of certain foreign jurisdictions, in order to haverecognizable intellectual property rights, we may be required to fileapplications with various foreign agencies or officials to register ourintellectual property. Accordingly, our ability to operate and exploit ourtechnology overseas could be significantly hindered.

 

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

 

We have completed the acquisitions of several companies and we plan tocontinue to review potential acquisition candidates, and our business and ourstrategy includes building our business through acquisitions. However,acceptable acquisition candidates may not be available in the future or may notbe available on terms and conditions acceptable to us.

 

Acquisitions involve numerous risks, including among others,difficulties and expenses incurred in the consummation of acquisitions andassimilation of the operations, personnel and services and products of theacquired companies. Additional risks associated with acquisitions include thedifficulties of operating new businesses, the diversion of management’sattention from other business concerns and the potential loss of key employeesof the acquired company. If we do not successfully integrate the businesses wemay acquire in the future, our business will suffer.

 

**WE OPERATE IN FOREIGN COUNTRIES AND AREEXPOSED TO RISKS ASSOCIATED WITH FOREIGN POLITICAL, ECONOMIC AND LEGAL ENVIRONMENTSAND WITH FOREIGN CURRENCY EXCHANGE RATES.**

 

With our acquisition of G & A, we have significant foreignoperations and are accordingly exposed to risks, including among others, risksassociated with foreign political, economic and legal environments and withforeign currency exchange rates. Our results may be adversely affected by,among other things, changes in government policies with respect to laws andregulations, anti-inflation measures, currency conversions, remittance abroadand rates and methods of taxation.

 

**Item 3****.  Controls andProcedures**

 

*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 June 30, 2003, have concluded that as of suchdate, ImageWare’s disclosure controls and procedures were adequate andsufficient to ensure that information required to be disclosed by ImageWare inthe 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. *Therehas been no change in our internal control over financial reporting during thefiscal quarter ended June 30, 2003 that has materially affected, or isreasonably likely to materially affect, our internal control over financialreporting.

 

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**PART II**

 

**ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K**

 

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

 

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

 

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

 

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

 

(b)                         Reportson Form 8-K

 

During the three months ended June 30, 2003, we filed three reports onForm 8-K

 

We filed a report on Form 8-K on April 24, 2003 to report and disclosefinancial information for the fourth quarter and year ended December 31, 2002.

 

Wefiled a report on Form 8-K on May 23, 2003 to report and disclose financialinformation for the first quarter of 2003.

 

Wefiled a report on Form 8-K on June 20, 2003 to report the issuance of SeniorSecured Convertible Promissory Notes.

 

 

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**SIGNATURES**

 

In accordance with therequirements of the Exchange Act, the registrant caused this report to besigned on its behalf by the undersigned, thereunto duly authorized.

 
|                  | IMAGEWARE SYSTEMS, INC. |
|-----------------------|-------------------------|
|                  |                    |
|                  |                    |
| Date: August 19, 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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INDEX TO EXHIBITS

 

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

 

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

 

32.1                           Certificationby Chief Executive Officer and Chief Financial Officer pursuant to Section 906of the Sarbanes-Oxley Act.

 

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