UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549





FORM 10-Q





(Mark One)





x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE


SECURITIES EXCHANGE ACT OF 1934





For the quarterly period ended March 31, 2009





o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE


EXCHANGE ACT





For the transition period from         to





Commission file number 001-15757





IMAGEWARE SYSTEMS, INC.


(Exact Name of Registrant as Specified in Its Charter)





Delaware

33-0224167(State or Other Jurisdiction of Incorporation or

(IRS Employer Identification No.)Organization)





10883 Thornmint Road


San Diego, CA 92127


(Address of Principal Executive Offices)





(858) 673-8600


(Registrant’s Telephone Number, Including Area Code)





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





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





Large accelerated filer o

Accelerated filer oNon-accelerated filer o

Smaller reporting company x(Do not check if a smaller reporting company)





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




The number of shares of Common Stock, with $0.01 par value, outstanding on April 27, 2010 was 22,785,911.














IMAGEWARE SYSTEMS, INC. INDEX





PART I.

FINANCIAL INFORMATION
3ITEM 1.

FINANCIAL STATEMENTS
3Condensed Consolidated Balance Sheets as of March 31, 2009 (unaudited) and December 31, 2008
3Condensed Consolidated Statements of Operations for the three months ended March 31, 2009 and 2008 (unaudited)
4Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2009 and 2008 (unaudited)
5Condensed Consolidated Statements of Comprehensive Loss for the three months ended March 31, 2009 and 2008 (unaudited)
6Notes to unaudited Condensed Consolidated Financial Statements
7ITEM 2.

Management’s Discussion and Analysis of Financial Condition and Results of

Operations
19ITEM 4.

Controls and Procedures
28PART II.

OTHER INFORMATION
29ITEM 1A.

Risk Factors
29ITEM 6.

Exhibits
31SIGNATURES
32





2


PART I





FINANCIAL INFORMATION





ITEM 1. FINANCIAL STATEMENTS





IMAGEWARE SYSTEMS, INC.


CONDENSED CONSOLIDATED BALANCE SHEETS


(In Thousands, except share amounts)





March 31,

2009


December 31,

2008(Unaudited)ASSETSCurrent Assets:Cash and cash equivalents

$
376


$
171Accounts receivable, net of allowance for doubtful accounts of $28 (unaudited) and $28 at March 31, 2009 and December 31, 2008, respectively


295



503Inventory, net


70



19Other current assets


163



191Total Current Assets


904



884Property and equipment, net


84



108Other assets


176



37Pension assets


654



682Intangible assets, net of accumulated amortization


106



110Goodwill


3,416



3,416Total Assets

$
5,340


$
5,237LIABILITIES AND SHAREHOLDERS’ EQUITY (DEFICIT)Current Liabilities:Accounts payable

$
2,319


$
2,388Deferred revenue


901



872Billings in excess of costs and estimated earnings on uncompleted contracts


153



279Accrued expenses


1,628



1,530Notes payable to related parties


110



98Total Current Liabilities


5,111



5167Secured note payable, net of discount


485



—Additional financing obligation, net of discount


440



—Pension obligation


1,073



1,102Total Liabilities


7,109



6,269Shareholders’ equity:Preferred stock, authorized 4,000,000 shares:Series B convertible redeemable preferred stock, $0.01 par value; designated 750,000 shares, 389,400 shares issued, and 239,400 shares outstanding at March 31, 2009 and December 31, 2008; liquidation preference $645 and $632 at March 31, 2009 and December 31, 2008, respectively


2



2Series C convertible non-redeemable preferred stock, $0.01 par value; designated 3,500 shares, 2,500 shares issued, and 2,200 shares outstanding at March 31, 2009 and December 31, 2008; liquidation preference $2,647 and $2,604 at March 31, 2009 and December 31, 2008, respectively


—



—Series D convertible non-redeemable preferred stock, $0.01 par value; designated 3,000 shares, 2,198 shares issued, and 2,198 shares outstanding at March 31, 2009 and December 31, 2008; liquidation preference $2,472 and $2,428 at March 31, 2009 and December 31, 2008, respectively


—



—Common stock, $.01 par value, 50,000,000 shares authorized; 18,163,487 (unaudited) and 18,163,487 shares issued at March 31, 2009 and December 31, 2008, respectively, and 18,156,783 (unaudited) and 18,156,783 shares outstanding at March 31, 2009 and December 31, 2008, respectively


180



180Additional paid in capital


86,316



86,007Treasury stock, at cost - 6,704 shares


(64
)


(64
)Accumulated other comprehensive income


46



44Accumulated deficit


(88,249
)


(87,201
)Total Shareholders’ deficit


(1,769
)


(1,032
)Total Liabilities and Shareholders’ Equity (Deficit)

$
5,340


$
5,237





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


3


IMAGEWARE SYSTEMS, INC.





CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS


(In Thousands, except share and per share amounts)


(Unaudited)





THREE MONTHS ENDED

MARCH 31,2009


2008Revenues:Product

$
675


$
777Maintenance


638



6061,313



1,383Cost of revenues:Product


284



139Maintenance


209



315Gross profit


820



929Operating expenses:General & administrative


609



1,101Sales and marketing


429



667Research & development


587



897Depreciation and amortization


33



2011,658



2,866Loss from operations


(838
)


(1,937
)Interest expense (income), net


131



(5
)Change in fair value of financing obligation


90



—Other income, net


(11
)


(28
)Loss from operations before income taxes


(1,048
)


(1,904
)Income tax expense (benefit)


—



—Net loss

$
(1,048
)

$
(1,904
)Preferred dividends


(99
)


(84
)Amortization of beneficial conversion feature on preferred stocks


—



(1,794
)Net loss available to common shareholders

$
(1,147
)

$
(3,782
)Basic and diluted loss per common share — see Note 2:Continuing operations

$
(0.06
)

$
(0.11
)Preferred Dividends


—



—Beneficial conversion feature on preferred stocks


—



(0.11
)Basic and diluted loss per common share - see Note 2

$
(0.06
)

$
(0.22
)Weighted-average shares outstanding (basic and diluted)


18,156,783



17,836,698





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





4


IMAGEWARE SYSTEMS, INC.


CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


(In Thousands)


(Unaudited)





Three Months Ended

March 31,2009


2008Cash flows from operating activitiesNet loss

$
(1,048
)

$
(1,904
)Adjustments to reconcile net loss to net cash used in operating activitiesDepreciation and amortization


33



201Amortization of debt discount and debt issuance costs


105



—Change in fair value of additional financing obligation


90



—Stock based compensation


69



92Change in assets and liabilitiesAccounts receivable, net


208



(208
)Inventory, net


(51
)


(95
)Other assets


28



(53
)Pension assets


28



(63
)Accounts payable


(69
)


639Accrued expenses


99



(84
)Deferred revenue


29



352Billings in excess of costs and estimated earnings on uncompleted contracts


(127
)


—Pension obligation


(30
)


62Total adjustments


412



843Net cash used in operating activities


(636
)


(1,061
)Cash flows from investing activitiesPurchase of property and equipment


(5
)


(26
)Acquisition of business, net of cash acquired


—



(159
)Net cash used in investing activities


(5
)


(185
)Cash flows from financing activitiesProceeds from issuance of notes payable with warrants


1,000



—Financing issuance costs of notes payable


(155
)


—Proceeds from exercised stock purchase warrants


—



542Net cash provided by financing activities


845



542Effect of exchange rate changes on cash


1



(39
)Net increase (decrease) in cash and cash equivalents


205



(743
)Cash and cash equivalents at beginning of period


171



1,044Cash and cash equivalents at end of period

$
376


$
301Supplemental disclosure of cash flow information:Cash paid for interest

$
—


$
—Cash paid for income taxes

$
—


$
—Summary of non-cash investing and financing activities:Warrants issued with notes payable

$
241


$
—Discount on note payable

$
328


$
—Beneficial conversion feature of series C and D preferred stock

$
—


$
1,794





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





5


IMAGEWARE SYSTEMS, INC


CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS


(In Thousands)


(Unaudited)





THREE MONTHS ENDED

MARCH 31,2009


2008Net loss

$
(1,048
)

$
(1,904
)Other comprehensive loss:Foreign currency translation adjustment


2



(39
)Comprehensive loss

$
(1,046
)

$
(1,943
)





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





6


IMAGEWARE SYSTEMS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





NOTE 1.  DESCRIPTION OF BUSINESS AND OPERATIONS





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





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





The Company recently added next generation voice recognition, multilingual speech translation and voice analytics capabilities to our suite of biometric identity management solutions, enabling users to facilitate and improve communication across major language groups globally. The ImageWare Mediator products are offered stand-alone or integrated with our Biometric Engine platform providing an advanced multilingual communications capability. Government, intelligence, defense, public safety and border control customers are able to realize language translation and voice recognition capabilities whereby an English-speaking user can understand and be understood in numerous languages including Spanish, German, French, Korean, Arabic and Polish, among others. ImageWare Mediator products support speech to speech translation, multilingual collaboration, conversational environments, which are represented for both voice and text and include biometric functionality for speaker identification and voice analytics.





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





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





7


Our enterprise authentication software includes the IWS Desktop Security product which is a comprehensive authentication management infrastructure solution providing added layers of security to workstations, networks and systems through advanced encryption and authentication technologies. IWS Desktop Security is optimized to enhance network security and usability, and uses multi-factor authentication methods to protect access, verify identity and help secure the computing environment without sacrificing ease-of-use features such as quick login. Additionally, IWS Desktop Security provides an easy integration with various smart card-based credentials including the Common Access Card (CAC), Homeland Security Presidential Directive 12 (HSPD-12), Personal Identity Verification (PIV) credential, and Transportation Worker Identification Credential (TWIC) with an organization’s access control process. IWS Desktop Security provides the crucial end-point component of a Logical Access Control System (LACS), and when combined with a Physical Access Control System (PACS), organizations benefit from a complete door to desktop access control and security model.





Basis of Presentation





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





The accompanying condensed consolidated balance sheet as of December 31, 2008 has been derived from the Company’s audited balance sheet included in the 2008 Annual Report on Form 10-K and the condensed consolidated unaudited financial statements of ImageWare have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) regarding interim financial reporting. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for annual financial statements and should be read in conjunction with the consolidated financial statements for the year ended December 31, 2008, and notes thereto included in the Company’s Annual Report on Form 10-K, filed with the SEC on February 24, 2010. In the opinion of management, the accompanying condensed consolidated financial statements contain all adjustments, consisting only of adjustments of a normal recurring nature, necessary for a fair presentation of the Company’s financial position as of March 31, 2009, and its results of operations for the periods presented. These condensed consolidated unaudited financial statements for the period ended March 31, 2009 are not necessarily indicative of the results to be expected for the entire year.





Going Concern





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





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





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





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





8


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





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





Recently Issued Accounting Standards




In February 2008, the FASB issued FASB Staff Position FAS 157-2, Partial Deferral of the Effective Date of Statement 157(“FSP FAS 157-2”). FSP FAS 157-2 delayed the effective date of SFAS No. 157 for nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually) to fiscal years beginning after November 15, 2008.  The provisions of FSP FAS 157-2 did not have an impact on our results of operations or financial position.





In December 2007, the FASB issued SFAS No. 141(R), “Business Combinations” and SFAS No. 160, “Non-controlling Interests in Consolidated Financial Statements”. The standards are intended to improve, simplify, and converge internationally the accounting for business combinations and the reporting of non-controlling interests in consolidated financial statements. SFAS No. 141(R) requires the acquiring entity in a business combination to recognize all (and only) the assets acquired and liabilities assumed in the transaction; establishes the acquisition-date fair value as the measurement objective for all assets acquired and liabilities assumed; and requires the acquirer to disclose to investors and other users all of the information they need to evaluate and understand the nature and financial effect of the business combination. SFAS No. 141(R) is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. SFAS No. 141(R) applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Earlier adoption is prohibited. The Company will apply SFAS 141(R) to business combinations occurring after the effective date.





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





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





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





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





9


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





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





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





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





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





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





10


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




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




In June 2009 the FASB issued SFAS No. 168, The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting. SFAS No. 168 represents the last numbered standard to be issued by FASB under the old (pre-Codification) numbering system, and amends the GAAP hierarchy established under SFAS No. 162. On July 1, 2009 the FASB launched FASB's new Codification entitled The FASB Accounting Standards Codification, or FASB ASC.





The Codification will supersede all existing non-SEC accounting and reporting standards. SFAS No. 168 is effective in the first interim and annual periods ending after September 15, 2009. This pronouncement will have no effect on the Company’s consolidated financial statements upon adoption other than current references to GAAP which will be replaced with references to the applicable codification paragraphs.





In August 2009, the FASB issued an amendment to the accounting standards related to the measurement of liabilities that are recognized or disclosed at fair value on a recurring basis. This standard clarifies how a company should measure the fair value of liabilities and that restrictions preventing the transfer of a liability should not be considered as a factor in the measurement of liabilities within the scope of this standard. This standard was effective on October 1, 2009. We do not expect the impact of its adoption to be material to our financial statements.





In October 2009, the Financial Accounting Standards Board (“FASB”) issued new revenue recognition standards for arrangements with multiple deliverables, where certain of those deliverables are non-software related. The new standards permit entities to initially use management’s best estimate of selling price to value individual deliverables when those deliverables do not have VSOE of fair value or when third-party evidence is not available. Additionally, these new standards modify the manner in which the transaction consideration is allocated across the separately identified deliverables by no longer permitting the residual method of allocating arrangement consideration. These new standards are effective for annual periods ending after June 15, 2010 and are effective for the Company beginning in the first quarter of fiscal 2011, however early adoption is permitted. The Company is currently evaluating the impact of adopting these new standards on its consolidated financial position, results of operations and cash flows, including possible early adoption.




In October 2009, the FASB issued new standards for the accounting for certain revenue arrangements that include software elements. These new standards amend the scope of pre-existing software revenue guidance by removing from the guidance non-software components of tangible products and certain software components of tangible products. These new standards are required to be adopted in the first quarter of 2011; however, early adoption is permitted. The Company does not expect these new standards to significantly impact the financial statements.
 
 In January 2010, the FASB issued amended standards that require additional fair value disclosures. These amended standards require disclosures about inputs and valuation techniques used to measure fair value as well as disclosures about significant transfers, beginning in the first quarter of 2010. Additionally, these amended standards require presentation of disaggregated activity within the reconciliation for fair value measurements using significant unobservable inputs (Level 3), beginning in the first quarter of 2011. The Company does not expect these new standards to significantly impact the financial statements.


A variety of proposed or otherwise potential accounting standards are currently under study by standard setting organizations and various regulatory agencies. Due to the tentative and preliminary nature of those proposed standards, management has not determined whether implementation of such proposed standards would be material to the consolidated financial statements.





11




Reclassifications





Certain reclassifications have been made to the prior period balances in order to conform to the current period presentation.





NOTE 2.  NET LOSS PER COMMON SHARE





Basic loss per common share is calculated by dividing net loss available to common shareholders for the period by the weighted-average number of common shares outstanding during the period. Diluted earnings per common share is calculated by dividing net loss available to common shareholders for the period by the weighted-average number of common shares outstanding during the period, adjusted to include, if dilutive, potential dilutive shares consisting of convertible preferred stock, stock options and warrants, calculated using the treasury stock method. During the periods ended March 31, 2009 and 2008, the Company has excluded the following securities from the calculation of diluted loss per share, as their effect would have been antidilutive due to the Company’s net loss:





Potential Dilutive Securities:

Number of

Common Shares

Convertible into at

March 31, 2009


Number of

Common Shares

Convertible into at

March 31, 2008Restricted stock grants


180,000



—Convertible notes payable


205,255



—Convertible preferred stock


10,213,156



3,633,384Stock options


2,306,288



2,127,954Warrants


14,971,167



6,721,385





The table below presents the computation of basic and diluted earnings (loss) per share:





(Amounts in thousands, except  share and per share amounts)

Three Months Ended

March 31,2009


2008Numerator for basic and diluted earnings per share:Net loss from operations

$
(1,048
)

$
(1,904
)Preferred dividends


(99
)


(84
)Beneficial conversion feature on preferred stocks


—



(1,794
)Net loss from operations available to common shareholders

$
(1,147
)

$
(3,782
)Denominator for basic and diluted earnings per share — weighted-average shares outstanding


18,156,783



17,836,698Basic and diluted income (loss) per share:Loss from operations

$
(0.06
)

$
(0.11
)Preferred dividends


—



—Beneficial conversion feature on preferred stocks


—



(0.11
)Net loss available to common shareholders

$
(0.06
)

$
(0.22
)





Preferred stock dividends for the three months ended March 31, 2009 and 2008 were $99,000 and $1,878,000, respectively.  Preferred stock dividends for the three months ended March 31, 2008 contains approximately $1,794,000 in preferred dividends attributable to an embedded beneficial conversion feature recognized in conjunction with the issuance of common stock pursuant to the Company’s warrant financing transaction consummated in March 2008.





NOTE 3. INVENTORY





Inventories at March 31, 2009 were comprised of work in process of $20,000 representing direct labor costs on in-process projects and finished goods of $50,000 net of reserves for obsolete and slow-moving items of $93,000.  Inventories at December 31, 2008 were comprised of work in process of $9,000 representing direct labor costs on in-process projects and finished goods of $10,000 net of reserves for obsolete and slow-moving items of $93,000.  Appropriate consideration is given to obsolescence, excessive levels, deterioration, and other factors in evaluating net realizable value and required reserve levels.





12


NOTE 4. FAIR VALUE ACCOUNTING





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





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





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





Level 2
Level 2 applies to assets or liabilities for which there are inputs other than quoted prices included within Level 1 that are observable for the asset or liability such as quoted prices for similar assets or liabilities in active markets; quoted prices for identical assets or liabilities in markets with insufficient volume or infrequent transactions (less active markets); or model-derived valuations in which significant inputs are observable or can be derived principally from, or corroborated by, observable market data.





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





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





Fair Value at March 31, 2009($ in thousands)

Total


Level 1


Level 2


Level 3Assets:Pension assets

$
654


$
654


$
—


$
—Totals

$
654


$
654


$
—


$
—Liabilities:Secured promissory note

$
485


$
—


$
—


$
485Additional financing obligation

$
440


$
—


$
—


$
440Totals

$
925


$
—


$
—


$
925





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





The fair value of the Company’s secured notes payable and additional financing obligation are classified within Level 3 of the fair value hierarchy because they are valued using pricing models that incorporate management assumptions that cannot be corroborated with observable market data.  The Company obtains pricing information from an independent pricing vendor.  The pricing vendor uses various pricing models that are consistent with what other market participants would use.  The inputs and assumptions to the models used by the pricing vendor include the following: benchmark yields, issuer spreads, benchmark securities, bids, offers and other market-related data.  The methodology of the pricing vendor uses available information applicable such as benchmark curves, benchmarking of like securities, sector groupings and matrix pricing.  The application of such methodologies include the computation of market yield, credit risk return and illiquidity return used as inputs to the pricing models.





13
 
 The fair value of the Company’s secured notes payable and additional financing obligation are classified within Level 3 of the fair value hierarchy because they are valued using pricing models that incorporate management assumptions that cannot be corroborated with observable market data.  The Company uses various pricing models that are consistent with what other market participants would use.  The inputs and assumptions to the models include the following: benchmark yields, issuer spreads, benchmark securities, bids, offers and other market-related data.  The methodology uses available information applicable such as benchmark curves, benchmarking of like securities, sector groupings and matrix pricing.  The application of such methodologies includes the computation of market yield, credit risk return and illiquidity return used as inputs to the pricing models.


Other significant assumptions used in calculating the fair value of the note and the additional financing obligation include the application of the Black-Scholes option pricing model used to value the warrants issued to the Lender.  The determination of fair value of the warrants issued to the lender using the Black-Scholes option-pricing model is affected by our stock price as well as assumptions regarding the expected stock price volatility over the term of the warrants. The Company calculated the expected volatility assumption required in the Black-Scholes model based on the historical volatility of the Company’s stock.





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





NOTE 5. INTANGIBLE ASSETS AND GOODWILL





The following table presents certain information about the Company’s acquired intangible assets as of March 31, 2009 and December 31, 2008. All intangible assets are being amortized over their estimated useful lives, as indicated below, with no estimated residual values.





Pro Rata

ImpairmentReduction of

Charge on



AmortizationSol Logic Assets

Sol Logic



RecordedFrom Purchase

Intangible



During ThreeNet Balance at

Amortization

Accounting

Assets Recorded

Net Balance at

Months Ended

Net Balance atAmortization

December 31,

Recorded

Contingency

at December 31,

December 31,

March 31,

March 31,($ in thousands)

Period

2007

During 2008

Resolution

2008

2008

2009

2009Technology

5 years

$
2,018

$
(420
)
$
(940
)
$
(658
)
$
-

$
-

$
-Trademark and Trade names

14.5 years

$
126

$
(16
)
$
-

$
-

$
110

$
(4
)
$
106Customer relationship

5 years

$
93

$
(19
)
$
(43
)
$
(30
)
$
-

$
-

$
-Non-Compete Agreement

3 years

$
200

$
(69
)
$
(77
)
$
(54
)
$
-

$
-

$
-Patents

4 years

$
-

$
-

$
-

$


$
-




$
-Totals



$
2,437

$
(525
)
$
(1,060
)
$
(742
)
$
110

$
(4
)
$
106





In December 2007, the Company completed the acquisition of substantially all the assets of Sol Logic, Inc. resulting in acquired intangible assets of approximately $2,311,000.  Based on fair value methodologies, the Company recorded approximately $2,018,000 in intangibles assets for developed technology, $93,000 in customer relationship intangible assets and $200,000 for a non-compete agreement.





14


In 2008, the Company recorded an impairment charge of approximately $742,000 related to our intangible assets related to the acquisition of Sol Logic in 2007.  This charge reflects the amount by which the carrying value of this asset exceeded its estimated fair value determined by the assets’ future discounted cash flows.  The impairment charge was recorded as a component of Operating expenses in the consolidated Statement of Operations for 2008.  We recorded no impairment losses for long-lived or intangible assets during the three months ended March 31, 2009. At March 31, 2009, the EPI trademark and trade name is the Company’s only remaining definite-lived intangible asset.





The changes in the carrying amount of goodwill for the year ended December 31, 2008 and the three months ended March 31, 2009 are as follows:





($ in thousands)

TotalBBa Balance of Goodwill as of January 1, 2008

$
4,452Goo Goodwill acquired


—Don Derecognition of goodwill resulting from amended purchase accounting agreement


(1,036
)Bala Balance of Goodwill as of December 31, 2008

$
3,416De-  Goodwill acquired


—Im    Impairment losses


—Bala Balance of Goodwill as of March 31, 2009

$
3,416





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





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




NOTE 6. COSTS AND ESTIMATED EARNINGS ON UNCOMPLETED CONTRACTS





The Company recognizes revenues and cost of revenues on long-term, fixed price contracts involving significant amounts of customization using the percentage of completion method based on costs incurred to date compared to total estimated costs at completion.  Such amounts are included in the accompanying consolidated balance sheets at March 31, 2009 and December 31, 2008 under the caption “Billings in excess of costs and estimated earnings on uncompleted contract”.





Costs and estimated billings on uncompleted contracts and related amounts billed as of March 31, 2009 and December 31, 2008 are as follows:





($ in thousands)

March 31,

2009


December 31,

2008Costs incurred on uncompleted contract

$
138


$
108Estimated earnings


493



397631



505Less: Billings to date


(784
)


(784
)Billings in excess of costs and estimated earnings on uncompleted contract

$
(153
)

$
(279
)





15




NOTE 7. NOTES PAYABLE AND ADDITIONAL INTEREST OBLIGATION





Notes payable consist of the following:





($ in thousands)

March 31,


December 31,2009


2008Secured Promissory Note5% Secured promissory note. Face value of note $1,000. Discount on note at March 31, 2009 is $515. Note due June 30, 2010.

$
485



—Total secured notes payable


485



—Notes payable to related parties:7% Convertible promissory notes. Face value of note $110. Discount on notes at March 31, 2009 and December 31, 2008 is $0 and $12, respectively. Notes were due February 14, 2009

$
110


$
98Total notes payable to related parties


110



98Total notes payable

$
595


$
98Less current portion


(110
)


(98
)Long-term notes payable

$
485


$
—





On November 14, 2008, the Company entered in to a series of convertible promissory notes (the” Convertible Notes”), aggregating $110,000 with certain officers and members of the Company’s Board of Directors. The Convertible Notes bear interest at 7.0% per annum and are due February 14, 2009. The principal amount of the Convertible Notes plus accrued but unpaid interest is convertible at the option of the holder into Common Stock of the Company. The number of shares into which the Convertible Notes are convertible shall be calculated by dividing the outstanding principle and accrued but unpaid interest by $0.55 (the “Conversion Price”).





In conjunction with the issuance of the Convertible Notes, the Company issued an aggregate of 149,996 warrants to the note holders to purchase Common Stock of the Company. The warrants have an exercise price $0.55 per share and may be exercised at any time from November 14, 2008 until November 14, 2013.





The Company initially recorded the convertible notes net of a discount equal to the fair value allocated to the warrants using the relative fair value method of approximately $13,000.  The Company estimated the fair value of the warrants using the Black-Scholes option pricing model using the following assumptions: term of 5 years, a risk free interest rate of 2.53%, a dividend yield of 0%, and volatility of 96%.  The convertible notes also contained a beneficial conversion feature, which resulted in additional debt discount of $12,000.  The beneficial conversion amount was measured using the accounting intrinsic value, i.e. the excess of the aggregate fair value of the common stock into which the debt is convertible over the proceeds allocated to the security.  The Company has accreted the beneficial conversion feature over the life of the note.  For the three months ended March 31, 2009 the Company recorded $12,000 as interest expense from the amortization of the discount related to the fair value of the warrants and from the accretion of the beneficial conversion feature.




The Company did not repay the Convertible Notes on the due date. In August 2009, the Company received from the Convertible Note holders a waiver of default and extension to January 31, 2010 of the maturity date of the Convertible Notes.  As consideration for the waiver and note extension, the Company issued to the Convertible Note holders an aggregate of 150,000 warrants to purchase shares of the Company’s common stock.  The warrants have an exercise price of $0.54 per share and expire on August 25, 2014. The Company did not repay the notes on January 31, 2010 and is currently seeking an additional waiver of default from the holders of the Convertible Notes.





In February 2009, the Company entered in to a secured promissory note (the ‘Note”), for $5,000,000 with a third-party lender (“the Lender”). The Note secures a credit facility for a total of up to Five Million Dollars ($5,000,000). The initial advance under the Note was One Million Dollars ($1,000,000). Subsequent advances are subject to the discretion of the Lender. The note shall bear interest at 5.0% per annum on the outstanding principal and principal and interest are due on June 30, 2010. The Company will also pay the Lender additional financing fees (the “Additional Financing Obligation”) on the maturity date or such earlier date as may be required under the terms of the note equal to the greater of Four Hundred Thousand Dollars ($400,000) or an amount equal to 2,000,000 multiplied by the average of the Closing prices for the Common Stock of the Company for the ten (10) trading day period immediately preceding the date of the payment of such interest payment.




16




In conjunction with the issuance of the Note, the Company issued a warrant to purchase 4,500,000 shares of Common Stock of the Company. The warrant has an exercise price $0.50 per share and may be exercised at any time from February 12, 2009 until February 12, 2014. Additionally, the Company entered into a Registration Rights Agreement requiring the Company to provide certain registration rights to the Lender relative to the 4,500,000 shares of Common Stock of the Company issuable pursuant to the warrant.




The Company recorded the Note and Additional Financing Obligation net of a discount equal to the fair values allocated to the various financial instruments issued to the Lender.  The Company estimated the fair value of the warrants using the Black-Scholes option pricing model and the following assumptions: term of 5 years, a risk free interest rate of 1.49%, a dividend yield of 0%, and volatility of 96% which resulted in note discount from the issuance of the warrants of approximately $241,000.  The Company recorded the Note and Additional Financing Obligation net of a discount equal to the fair values of the note instrument and the additional financing component as determined by an independent valuation specialist resulting in additional note discount of approximately $569,000.  The Company is accreting the note discount and the Additional Financing Obligation discount using the effective interest rate method over the life of the Note.  During the three months ended March 31, 2009, the Company recorded approximately $53,000 in note discount amortization and $23,000 in Additional Financing Obligation discount amortization.  Such amounts are classified as a component of interest expense in the Company’s Statement of Operations under the caption “Interest expense, net”.




The Note is secured by all of the assets of the Company. Under the terms of the Note, the entire outstanding balance together with all accrued interest shall be payable on (i) the maturity date (June 30, 2010), (ii) a change of control transaction, (iii) receipt by the Company of proceeds form the sale of equity or equity linked securities of the Company in excess of $2,500,000, (iv) receipt by the Company of proceeds from the issuance by the Company of any type of additional debt instruments, or upon the occurrence of an event of default under the terms of the Note.





NOTE 8. REGISTRATION PAYMENT ARRANGEMENTS





On September 25, 2007, the Company sold to certain accredited investors a total of 2,016,666 shares of the Company’s common stock, par value $0.01 per share, at a purchase price of $1.50 per share for aggregate gross proceeds of $3,025,003 (the “Common Stock Financing”). As part of the Common Stock Financing, the Company entered into a Registration Payment Arrangement as defined by FASB Staff Position No. EITF 00-19-2, “Accounting for Registration Payment Arrangements” (“EITF 00-19-2”). EITF 00-19-2 specifies that the contingent obligation to make future payments or otherwise transfer consideration under a registration payment arrangement should be separately recognized and measured in accordance with SFAS No. 5 “Accounting for Contingencies” (“SFAS No. 5”). EITF 00-19-2 is effective for registration payment arrangements entered into after December 21, 2006 or for the fiscal year beginning after December 15, 2006.





As part of the September 25, 2007 Common Stock registration payment arrangement, the Company agreed to register the shares of common stock issued in the financing and the shares of common stock underlying the warrants issued to the investors in the Common Stock Financing with the SEC within certain contractually specified time periods. The Company also agreed to use its best efforts to keep the registration statement continuously effective until the earlier of either the second year after the date the registration statement is declared effective by the SEC or the date when all the common stock, including the common stock underlying the warrants have been sold or may be sold without volume limitations. If the Company is unable to register the shares of common stock with the SEC or keep the registration statement continuously effective in accordance with the Securities Purchase Agreement dated September 25, 2007, between the Company and certain accredited investors, the Company is subject to a liquidated damages penalty equal to 1% of the aggregate purchase price paid for each month the registration statement is not effective, provided that such liquidated damages shall not exceed 12% of the aggregate purchase price.





The maximum exposure at March 31, 2009 is approximately $363,000. The Company initially met the requirements of the Common Stock Financing registration payment arrangement by filing the required registration statement with the SEC within the time frame specified by the agreement. During the third quarter of 2008, the Company was faced with limited funds for operations and was compelled to suspend SEC filings. The Company has determined that approximately $18,000 of  loss contingency related to the Common Stock Financing registration payment arrangement is required to be recorded as of March 31, 2009.  Such loss contingency is included as a component of “Accrued expenses” in the Company’s unaudited Condensed Consolidated Balance Sheet at March 31, 2009 and as a component of “Interest expense, net” in the Company unaudited Condensed Consolidated Statement of Operations for the three months ended March 31, 2009.





17


NOTE 9. COMMON STOCK AND WARRANTS





The following table summarizes warrant activity for the following periods:





WarrantsBalance at December 31, 2008


10,471,167Granted


4,500,000Expired / Canceled


—Exercised


—Balance at March 31, 2009


14,971,167





In conjunction with the issuance of the Note in February 2009, the Company issued a warrant to the lender to purchase 4,500,000 shares on Common Stock of the Company.  The warrant has an exercise price of $0.50 per share and may be exercised at any time from February 12, 2009 until February 12, 2014.  Additionally, the Company entered into a Registration Rights Agreement requiring the Company to provide certain registration rights to the Lender relative to the 4,500,000 shares of Common Stock issuable pursuant to the warrant.





NOTE 10. PREFERRED STOCK





At March 31, 2009, the Company had cumulative undeclared dividends relating to Series B, C and D Preferred Stock of approximately $47,000, $447,000 and $274,000 respectively.





NOTE 11. SUBSEQUENT EVENTS





On May 19, 2009, ImageWare Systems, Inc. formed a wholly owned subsidiary in Mexico in order to support the Company’s efforts to develop new business and service existing contracts to provide products and service in Mexico.  The Mexican subsidiary, ImageWare Mexico, S. DE R.L., is located in Mexico City and has one employee.





In June 2009, the Lender and the Company agreed to amend the Note (“Amendment No.1”) whereby the Company received a waiver of default and extension of certain date sensitive covenants contained in the Note.  As consideration for the waiver and extension, the Company issued to the Lender warrants to purchase 1,000,000 shares of Common Stock of the Company at an exercise price of $0.50 per share.  Such warrants may be exercised at any time from June 9, 2009 until June 9, 2014.  In conjunction with the June 2009 waiver and extension, the interest rate on the Note was changed to 9% per annum, retroactive to February 2009.





In June 2009, the Lender and the Company further amended the Note (“Amendment No.2”) whereby the Lender advanced the Company an additional $350,000 and amended certain terms of the Note.  As consideration for the additional advance, the Company issued to the Lender warrants to purchase 700,000 shares of Common Stock of the Company at an exercise price of $0.50 per share.  Such warrants may be exercised at any time from June 22, 2009 until June 22, 2014.





In July and August 2009, the Company undertook a series of warrant financings whereby the Company issued 2,401,075 warrants with an exercise price of $0.50 per share to incentivize certain warrant holders to exercise their existing warrant for cash.  Pursuant to this series of warrant financings, the Company issued an aggregate of 2,741,075 shares of common stock and raised approximately $1,371,000 in cash.





In July and August 2009, holders of existing warrants exercised 929,395 of their warrants pursuant to cashless exercise provisions and received 353,702 shares of common stock.





In October 2009, the Lender and the Company amended the Note (“Amendment No. 3”) whereby the Lender agreed to make additional advances in an aggregate amount up to One Million Dollars ($1,000,000) to only be used for the purpose of compromising certain of the Company’s outstanding vendor payables or for paying the audit of the Company’s financial statements.  The amendment calls for the Company to repay the lender in full the amount of any and all Third Amendment Advances, together with all accrued and unpaid interest thereon, on or before January 31, 2010.  On October 5, 2009, the Lender made an advance of $300,000 to the Company pursuant to these provisions.  As consideration for the additional advance, the Company issued to the Lender warrants to purchase 200,000 shares of Common Stock of the Company at an exercise price of $0.60 per share.  Such warrants may be exercised at any time from October 5, 2009 until October 5, 2014.  As additional consideration, the Company assigned certain patents related to discontinued product lines to the Lender with the condition that the Company would participate in future proceeds generated from efforts by the Lender to monetize the patents.





18


On November 4, 2009, the Lender and the Company amended the Note (“Amendment No. 4”) whereby the Lender made an additional $350,000 advance (the “Additional Advance”) under the Note.  As consideration for the Additional Advance, the Company executed an assignment of all accounts receivable (the “Assignment of Receivables”) whereby the Company assigned to the Lender all of the Company’s rights, title and interest in all accounts receivable as of the date of Amendment No. 4.  In December 2009, the Company paid back the $350,000 advance plus accrued interest.





In December 2009, the Lender advanced an additional $325,000 under Amendment No.3.





In January of 2010, holders of existing warrants exercised 13,120 of their warrants pursuant to cashless exercise provisions and received 5,665 shares of common stock.





In January of 2010, the Company issued 847,258 shares of restricted stock to members of management and the Board.  These shares will vest quarterly over a three year period.  The restricted shares were issued as compensation for the cancellation of 1,412,096 warrants held by members of management and the Board.





In February 2010, the Lender and the Company amended the Note (“Amendment No. 5”) whereby the Lender extended the due date of amounts due on January 31, 2010 to March 15, 2010.





In March 2010, the Lender and the Company amended the Note (“Amendment No.6”) whereby the Lender made an additional advance of $250,000 under the Note.  As consideration for the advance, the Company will pay the Lender additional interest on the maturity date or such earlier date as may be required under the terms of the Note in an amount equal to 200,000 multiplied by the average of the Closing prices for the Common Stock of the Company for the ten (10) trading day period immediately preceding the date of the payment of such interest payment.  As additional consideration for making the advance, the Company assigned to the Lender its rights, title and interest in and to fifty percent (50%) of certain after-cost proceeds that may be received in connection with the Borrower's prosecution of certain commercial tort claims (including, but not limited to, claims related to the infringement of Borrower's intellectual property). In conjunction with Amendment No. 6, the interest rate on the Note was changed to 10% per annum, retroactive to February 2009. Also in conjunction with Amendment No. 6, the Lender extended the due dates of amounts due on March 15, 2010 to June 30, 2010.








ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.





This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All forward-looking statements included in this report are based on information available to us as of the date hereof and we assume no obligation to update any forward-looking statements. Forward-looking statements involve known or unknown risks, uncertainties and other factors, which may cause our actual results, performance or achievements, or industry results to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Factors that could cause or contribute to such differences include but are not limited to those items discussed under “Risk Factors” beginning on page 29 and elsewhere in this Quarterly Report.





The following discussion of the financial condition and results of operations should be read in conjunction with the condensed consolidated financial statements included elsewhere within this Quarterly Report. Fluctuations in annual and quarterly results may occur as a result of factors affecting demand for our products such as the timing of new product introductions by us and by our competitors and our customers’ political and budgetary constraints. Due to such fluctuations, historical results and percentage relationships are not necessarily indicative of the operating results for any future period.





OVERVIEW





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





19


CRITICAL ACCOUNTING ESTIMATES





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





The following are our critical accounting policies because we believe they are both important to the portrayal of our financial condition and results of operations and require critical management judgments and estimates about matters that are uncertain. If actual results or events differ materially from those contemplated by us in making these estimates, our reported financial condition and results of operations for future periods could be materially affected.





Revenue Recognition





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





·
Long-term fixed-price contracts involving significant customization





·
Fixed-price contracts involving minimal customization





·
Software licensing





·
Sales of computer hardware and identification media





·
Postcontract customer support (PCS)





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





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





20





Allowance for Doubtful Accounts





Our management must make estimates of the collectability of our accounts receivable. Management specifically analyzes accounts receivable and analyzes historical bad debts, customer concentrations, customer creditworthiness, current economic trends, the age of the accounts receivable balances, and changes in our customer payment terms when evaluating the adequacy of the allowance for doubtful accounts. Our accounts receivable balance was approximately $323,000 and our allowance for doubtful accounts was approximately $28,000 as of March 31, 2009.





Income Taxes




The Company accounts for income taxes in accordance with SFAS No. 109, “Accounting for Income Taxes” and FIN No. 48, “Accounting for Uncertainty in Income Taxes”. Deferred income taxes are recognized for the tax consequences related to temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and the amounts used for tax purposes at each year-end, based on enacted tax laws and statutory tax rates applicable to the periods in which the differences are expected to affect taxable income. A valuation allowance is established when necessary based on the weight of available evidence, if it is considered more likely than not that all or some portion of the deferred tax assets will not be realized. Income tax expense is the sum of current income tax plus the change in deferred tax assets and liabilities.




FIN No. 48 requires a company to first determine whether it is more-likely-than-not (defined as a likelihood of more than fifty percent) that a tax position will be sustained based on its technical merits as of the reporting date, assuming that taxing authorities will examine the position and have full knowledge of all relevant information. A tax position that meets this more-likely-than-not threshold is then measured and recognized at the largest amount of benefit that is greater than fifty percent likely to be realized upon effective settlement with a taxing authority.





The Company incurred no income tax expenses during the three months ended March 31, 2009 and 2008, respectively.





Valuation of Goodwill and Other Intangible Assets





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





·
Significant underperformance relative to historical or expected future operating results;·
Significant changes in the manner of our use of the acquired assets or the strategy of our overall business;·
Significant negative industry or economic trends;





When we determine that the carrying value of goodwill and other intangible assets may not be recoverable based upon the existence of one or more of the above indicators of impairment, we measure any impairment based upon fair value methodologies. Goodwill and other net intangible assets amounted to approximately $3,522,000 for as of March 31, 2009. During the three months ended March 31, 2008 we amended the purchase agreement for the acquisition of substantially all the assets of Sol Logic, Inc. originally consummated December 19, 2007. As a result of this amendment, which reduced the purchase price of the Sol Logic assets, we reversed previously recorded goodwill from this acquisition of approximately $1,036,000.





In 2002, Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets” became effective, and as a result we ceased to amortize goodwill. In lieu of amortization, we performed an initial impairment review of our goodwill in June, 2002 and will perform an annual impairment review thereafter in the fourth quarter of our fiscal year.





With the sale of our Digital Photography component in 2006, we reassessed the composition of our operating segments and determined that we no longer operate in separate, distinct market segments but rather operate in one market segment, such segment being identity management. The Company’s determination was based on fundamental changes in the Company’s business structure due to the consolidation of operations, restructuring of the Company’s operations and management team, and the integration of what where previously distinct, mutually exclusive technologies. This has resulted in changes in the manner by which the Company’s chief decision maker assesses performance and makes decisions concerning resource allocation. As a result of our operation in one market segment, such segment being identity management, our 2007 and 2008 goodwill impairment review consisted of the comparison of the fair value of our identity management segment as determined by the quoted market prices of our common stock to the carrying amount of the segment. As the fair value exceeded the carrying value by a substantial margin, we determined that our goodwill was not impaired. We determined that as of March 31, 2009 there were no indicators of potential impairment.





21


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





We account for long-lived assets in accordance with the provisions of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”  This statement requires that long-lived assets and certain identifiable intangible assets be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net undiscounted cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount which the carrying amount of the assets exceeds the fair value of the assets. Fair value is determined based on discounted cash flows or appraised values, depending upon the nature of the asset. Assets to be disposed of are reported at the lower of the carrying amount of fair value less costs to sell. During the twelve months ended December 31, 2007 we completed the acquisition of substantially all the assets of Sol Logic, Inc. In March 2008, we amended the purchase price of this asset acquisition. Pursuant to this acquisition, we recorded approximately $2,311,000 in identifiable intangible assets. The assets acquired were a covenant not to compete valued at approximately $200,000, customer base valued at approximately $93,000 and developed technology valued at approximately $2,018,000. The allocation of the purchase price was based on fair value methodologies employed by an independent valuation firm.





In December 2008, we recorded an impairment charge of approximately $742,000 related to our intangible assets related to our acquisition of Sol Logic in 2007.  This loss reflects the amount by which the carrying value of this asset exceeded its estimated fair value determined by the assets’ future discounted cash flows.  We recorded no impairment losses for long-lived or intangible assets during the three months ended March 31, 2009.




Stock-Based Compensation




Upon adoption of SFAS 123R on January 1, 2006, we began estimating the value of employee stock options on the date of grant using the Black-Scholes model. Prior to the adoption of SFAS 123R, the value of each employee stock option was estimated on the date of grant using the Black-Scholes model for the purpose of the pro forma financial disclosure in accordance with SFAS 123. The determination of fair value of stock-based payment awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to the expected stock price volatility over the term of the awards and the actual and projected employee stock option exercise behaviors. The expected term of options granted is derived from historical data on employee exercises and post-vesting employment termination behavior. We calculated our expected volatility assumption required in the Black-Scholes model based on the historical volatility of our stock. In addition to the key assumptions used in the Black-Scholes model, the estimated forfeiture rate at the time of valuation is a critical assumption. The Company has estimated an annualized forfeiture rate of 10% for corporate officers, 4% for members of the Company’s Board of Directors and 24% for all other employees. The Company reviews the expected forfeiture rate annually to determine if that percent is still reasonable based on historical experience.





Fair-Value Measurements





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





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





22


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





Level 2
Level 2 applies to assets or liabilities for which there are inputs other than quoted prices included within Level 1 that are observable for the asset or liability such as quoted prices for similar assets or liabilities in active markets; quoted prices for identical assets or liabilities in markets with insufficient volume or infrequent transactions (less active markets); or model-derived valuations in which significant inputs are observable or can be derived principally from, or corroborated by, observable market data.





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





Assessing the significance of a particular input to the fair value measurement requires judgment, considering factors specific to the asset or liability.  Determining whether a fair value measurement is based on Level 1, Level 2, or Level 3 inputs is important because certain disclosures are applicable only to those fair value measurements that use Level 3 inputs.  The use of Level 3 inputs may include information derived through extrapolation or interpolation which involves management assumptions.





RESULTS OF OPERATIONS





Results as presented do not contain the results of our Digital Photography component as this component is classified as a discontinued operation due to the sale of the Digital Photography product line in November 2006.





THREE MONTHS ENDED MARCH 31, 2009 AND 2008.





THREE MONTHS

ENDED

MARCH 31,Net Product Revenues

2009


2008


$ Change


% Change(dollars in thousands)Software and royalties

$
390


$
659


$
(269
)


(41
)%Percentage of total net product revenue


58
%


85
%Hardware and consumables

$
60


$
21


$
39



186
%Percentage of total net product revenue


9
%


3
%Services

$
225


$
97


$
128



132
%Percentage of total net product revenue


33
%


12
%Total net product revenues

$
675


$
777


$
(102
)


(13
)%





Software and royalty revenues decreased 41% or $269,000 during the three months ended March 31, 2009 as compared to the corresponding period in 2008. The decrease is due to lower sales of our biometric engine of approximately $222,000 sold into project-oriented solutions, lower sales of approximately $10,000 of boxed identity management software sold through our distribution channel, lower royalties and license revenues of approximately $54,000 offset by higher project-oriented revenues of our Law Enforcement software solutions of approximately $17,000.




Revenues from the sale of hardware and consumables increased 186% or approximately $39,000 during the three months ended March 31, 2009 as compared to the corresponding period in 2008. The increase reflects higher revenues from project solutions containing hardware and consumable components.





23


Services revenues are comprised primarily of software integration services, system installation services and customer training. Such revenues increased approximately $128,000 during the three months ended March 31, 2009 as compared to the corresponding period in 2008 due primarily to a higher percentage of overall revenues being generated from project work and a decrease in our sales of boxed products, which do not typically require integration or installation services.





We expect service revenues to continue to be a significant component of our revenues through our implementation of large-scale high-end installations.





We believe that the period-to-period fluctuations of identity management software revenue in project-oriented solutions are largely due to the timing of government procurement with respect to the various programs we are pursuing.  Based on management’s current visibility into the timing of potential government procurements, we believe that we will see a significant increase in government procurement and implementations with respect to identity management initiatives; however we cannot predict the timing of such initiatives.





Our backlog of product orders as of March 31, 2009, was approximately $1,687,000.  At March 31, 2009, we also had maintenance and support backlog of approximately $901,000 under existing maintenance agreements.  Product revenue is typically recognized within a three to six month period for projects not requiring significant customization. Projects that require significant customization can range from six months to two years depending upon the required degree of customization and customer implementation schedules. Historically, we have experienced a very minimal risk of order cancellation and do not anticipate order cancellations in excess of 5%.  Our revenue from maintenance agreements is generally recognized ratably over the respective maintenance periods provided no significant obligations remain and collectability of the related receivable is probable.





THREE MONTHS

ENDED

MARCH 31,Maintenance Revenues

2009


2008


$ Change


% Change(dollars in thousands)Maintenance revenues

$
638


$
606


$
32



5
%





The increase in maintenance revenues reflects higher maintenance revenues generated from our Law Enforcement Products due to our expanding installed base of this product suite.





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





THREE MONTHS

ENDED

MARCH 31,Cost of Product Revenues:

2009


2008


$ Change


% Change(dollars in thousands)Software and royalties

$
45


$
106


$
(61
)


(58
)%Percentage of software and royalty product revenue


12
%


16
%Hardware and consumables

$
40


$
25


$
15



60
%Percentage of hardware and consumables product revenue


67
%


119
%Services

$
199


$
8


$
191



2388
%Percentage of services product revenue


88
%


8
%Total product cost of revenues

$
284


$
139


$
145



104
%Percentage of total product revenues


42
%


18
%





The cost of software and royalty product revenue decreased 58% or $61,000 during the three months ended March 31, 2009 as compared to the corresponding period in 2008 due to lower third-party software content in solutions provided during the three months ended March 31, 2009 as compared to the corresponding period in 2008. Costs of products can vary as a percentage of product revenue from period to period depending upon the level of software customization and third party software license content included in product sales during a given period.





24


The increase in the cost of product revenues for our hardware and consumable sales of $15,000 for the three months ended March 31, 2009 as compared to the corresponding period in 2008 reflects the increase in hardware and consumable revenues of approximately $39,000 for the three months ended March 31, 2009 as compared to the comparable period in 2008.





Costs of service revenues increased $191,000 for the three month period ending March 31, 2009 as compared to the corresponding period in 2008.  This increase is due primarily to an increase of 132% or $128,000 in service revenues generated during the three month period ending March 31, 2009 as compared to the 2008 period.  This increase is due to integration and installation services of our Biometric Engine and PIV solutions into project-oriented solutions.





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





THREE MONTHS

ENDED

MARCH 31,Maintenance cost of revenues

2009


2008


$ Change


% Change(dollars in thousands)Total maintenance cost of revenues

$
209


$
315


$
(106
)


(34
)%Percentage of total maintenance revenues


33
%


52
%





Cost of maintenance revenues as a percentage of maintenance revenues decreased to 33% during the three months ended March 31, 2009 from 52% for the corresponding period in 2008 due to slightly higher maintenance revenues to absorb fixed maintenance costs combined with head count reductions in our technical support staffing levels. The dollar decrease of $106,000 or 34% during the three months ended March 31, 2009 as compared to the corresponding period in 2008 reflects lower costs from these reductions.





THREE MONTHS

ENDED

MARCH 31,Product gross profit

2009


2008


$ Change


% Change(dollars in thousands)Software and royalties

$
345


$
553


$
(208
)


(38
)%Percentage of software and royalty product revenue


88
%


84
%Hardware and consumables

$
20


$
(4
)

$
24



(600
)%Percentage of hardware and consumables product

revenue


33
%


(19
)%Services

$
27


$
89


$
(62
)


(70
)%Percentage of services product revenue


12
%


92
%Total product gross profit

$
391


$
638


$
(246
)


(39
)%Percentage of total product revenues


58
%


82
%





Total product gross profit decreased due to lower product revenues during the three months ended March 31, 2009 as compared to the corresponding period in 2008.





Software and royalty gross profit decreased by 38% or approximately $208,000 for the three months ended March 31, 2009 from the corresponding period in 2008 as the 2008 period contained a higher composition of  software and royalty revenues, which typically carry a lower cost of sales than solutions containing higher percentages of third-party software. Costs of software products can vary as a percentage of product revenue from quarter to quarter depending upon product mix and third party software licenses included in software solutions.





Services gross profit decreased approximately $62,000 due to higher cost of services revenues generated through project sales for the three month period ending March 31, 2009 as compared to the corresponding period in 2008 primarily attributed to increased integration services requiring a higher mix of more senior and costly engineering resources.





25


THREE MONTHS

ENDED

MARCH 31,Maintenance gross profit

2009


2008


$ Change


% Change(dollars in thousands)Total maintenance gross profit

$
429


$
291


$
138



47
%Percentage of total maintenance revenues


67
%


48
%





Gross margins related to maintenance revenues increased due primarily to higher maintenance revenues to absorb fixed maintenance costs combined with lower costs incurred as a result of head count reductions in our technical support staffing levels.





THREE MONTHS ENDED

MARCH 31,Operating expenses

2009


2008


$ Change


% Change(dollars in thousands)General & administrative

$
609


$
1,101


$
(492
)


(45
)%Percentage of total net revenue


46
%


80
%Sales and marketing

$
429


$
667


$
(238
)


(36
)%Percentage of total net revenue


33
%


48
%Research & development

$
587


$
897


$
(310
)


(35
)%Percentage of total net revenue


45
%


65
%Depreciation and amortization

$
33


$
201


$
(168
)


(84
)%Percentage of total net revenue


3
%


15
%





GENERAL AND ADMINISTRATIVE EXPENSES.General and administrative expenses are comprised primarily of salaries and other employee-related costs for executive, financial, and other infrastructure personnel. General legal, accounting and consulting services, insurance, occupancy and communication costs are also included with general and administrative expenses. The dollar decrease of $492,000 is primarily comprised of the following major components:





·
Decrease in stock-based compensation expense of approximately $49,000 due to the expiration of certain restricted stock grants combined with lower expenses recorded pursuant to SFAS 123(R) due to the expiration of vesting periods for certain prior year share-based payment issuances.·
Decrease in contract services expense of $25,000·
Decrease in insurance and occupancy costs of approximately $39,000·
Decrease in professional services of approximately $313,000·
Decrease in travel related expenses of approximately $14,000·
Decrease in personnel related expenses of approximately $52,000





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





SALES AND MARKETING.Sales and marketing expenses consist primarily of the salaries, commissions, other incentive compensation, employee benefits and travel expenses of our sales, marketing, business development and product management functions. The dollar decrease of $238,000 during the three months ended March 31, 2009 as compared to the corresponding period in 2008 is primarily comprised of the following major components:





·
Decrease in personnel related expenses of approximately $116,000 due to reductions in headcount and the consolidation of various positions.


·
Decrease in sales related travel and trade shows of approximately $77,000.


·
Decrease in stock-based compensation expense of approximately $14,000 due to the expiration of certain restricted stock grants combined with lower expenses recorded pursuant to SFAS 123(R) due to the expiration of vesting periods for certain prior year share-based payment issuances.


·
Decrease in contract services of approximately $16,000 and decrease in expenses paid to sales consultants of approximately $15,000.





26


RESEARCH AND DEVELOPMENT.Research and development expenses consist primarily of salaries, employee benefits and outside contractors for new product development, product enhancements and custom integration work. Such expenses decreased 35% or approximately $310,000 for the three months ended March 31, 2009 as compared to the corresponding period in 2008. The dollar decrease of $310,000 during the three months ended March 31, 2009 as compared to the corresponding period in 2008 is primarily comprised of the following major components:





·
Decrease in personnel expenditures of approximately $183,000 combined with decreases in contractor and contract services of $106,000


·
Decreases in equipment and engineering supplies and other expenditures of approximately $42,000


·
Increases in occupancy costs of approximately $21,000.





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





DEPRECIATION AND AMORTIZATION.During the three months ended March, 31, 2009, depreciation and amortization expense decreased 84% or $168,000 as compared to the corresponding period in 2008. The decrease in depreciation and amortization expense reflects lower amortization of approximately $143,000 for certain definite long-lived intangible assets acquired in the Company’s December 2007 purchase of certain assets of Sol Logic, Inc. due to impairment charges being recorded against these assets in December 2008. For the three months ended March 31, 2009, the Company’s amortization expense of $3,000 consisted solely of amortization expense incurred on the Company’s EPI trademark and trade name intangible asset.




INTEREST EXPENSE (INCOME), NET.For the three months ended March 31, 2009, we recognized interest income of $0 and interest expense of $131,000. For the three months ended March 31, 2008, we recognized interest income of $5,000 and interest expense of $0. Interest expense for the three months ended March 31, 2009 contains three components approximating a total of $98,000 related to our secured notes payable issued in February 2009: $6,000 in coupon interest, $76,000 in note discount amortization and additional financing obligation amortization and $16,000 in deferred financing fee amortization classified as interest expense.





LIQUIDITY AND CAPITAL RESOURCES





As of March 31, 2009, we had total current assets of $904,000 and total current liabilities of $5,111,000, or negative working capital of $4,207,000. At March 31, 2009, we had available cash of $376,000.  Subsequent to March 31, 2009, we borrowed an aggregate amount of approximately $1,325,000 and subsequently repaid $350,000 in conjunction with a line of credit arrangement secured through the issuance of a secured promissory note. In July and August 2009, we also undertook a series of warrant financings whereby we raised approximately $1,371,000 in cash.  Despite securing these financing arrangements, we still have negative working capital and will need to secure additional new financing to fund working capital and operations should we be unable to generate positive cash flow from operations in the near future.




Net cash used in operating activities was $636,000 for the three month period ended March 31, 2009 as compared to $1,061,000 for the corresponding period in 2008. We used cash to fund net losses of $751,000, excluding non-cash expenses (depreciation, amortization, stock-based compensation, change in fair value of additional financing obligation and amortization of debt discount and debt issuance costs) of $297,000 for the three months ended March 31, 2009. We used cash to fund net losses of $1,611,000, excluding non-cash expenses (depreciation, amortization, and stock-based compensation) of $293,000 for the three months ended March 31, 2008. For the three months ended March 31, 2009, we generated cash of $213,000 through reductions in current assets and used cash of $98,000 through reduction in current liabilities and deferred revenues, excluding debt. For the three months ended March 31, 2008, we used cash of $419,000 to fund increases in current assets and generated cash of $969,000 through increases in current liabilities and deferred revenues, excluding debt.





Net cash used in investing activities was $5,000 for the three months ended March 31, 2009. Net cash used in investing activities was $185,000 for the three months ended March 31, 2008. For the three months ended March 31, 2009, we used cash to fund capital expenditures of computer equipment, software and furniture and fixtures of approximately $5,000. This level of equipment purchases resulted primarily from the replacement of older equipment. For the three months ended March 31, 2008, we used cash to fund capital expenditures of computer equipment and software, furniture and fixtures and leasehold improvements of approximately $26,000. We also used cash of approximately $159,000 for our acquisition of Sol Logic, Inc.





27


Net cash provided by financing activities was $845,000 for the three month period ended March 31, 2009 as compared to $542,000 for the corresponding period in 2008. For the three months ended March 31, 2009, we generated cash of $1,000,000 through our issuance of a secured note payable offset by financing transaction costs of $155,000. For the three months ended March 31, 2008, we generated cash of $542,000 from our issuance of common stock pursuant to warrant exercises.





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





The report of our independent accountants included with our Annual Report on Form 10-K as filed with the Commission on February 24, 2010, contained an explanatory paragraph regarding our ability to continue as a going concern.  We are seeking additional financing that we believe is necessary to fund our working capital requirements for at least the next twelve months in conjunction with the successful implementation of our business plan. Our business plan includes, among other things, the monitoring and controlling of operating expenses, collection of significant trade and other accounts receivables, and controlling of capital expenditures.  If we are unable to secure additional financing or successfully implement our business plan, we will be required to seek funding from alternate sources and/or institute cost reduction measures.  We may seek to sell equity or debt securities, secure a bank line of credit, or consider strategic alliances.  The sale of equity or equity-related securities could result in additional dilution to our shareholders.  There can be no assurance that additional financing, in any form, will be available at all or, if available, will be on terms acceptable to us.  In addition, our ability to raise additional capital may be impacted by the markets on which our common stock is quoted and our ability to maintain compliance with SEC filing requirements.  In May of 2008 the AMEX removed ImageWare’s common stock from being listed on their exchange as we failed to comply with AMEX’s continued listing standards.  In December of 2008 our common stock was removed from being quoted on the Over-the-Counter Bulletin Board as we failed to make the required filings with the SEC in the required timeframe.  As of the end of the third quarter of 2008 we were faced with limited funds for operations and were compelled to suspend SEC filings and the associated costs until such time as we had sufficient resources to cover ongoing operations and the expenses of maintaining compliance with SEC filing requirements.   There is no assurance that we will be able to attain compliance with SEC filing requirements in the future, and if we are able to attain compliance, there is no assurance we will be able to maintain compliance.  If we are not able to attain and maintain compliance for minimum required periods, we will not be eligible for re-listing on the Over-the-Counter Bulletin board or other exchanges.





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





ITEM 4T. CONTROLS AND PROCEDURES





Conclusions Regarding the Effectiveness of Disclosure Controls and Procedures.Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we conducted an evaluation of our disclosure controls and procedures as such term is defined under Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended. Based on this evaluation, our principal executive officer and principal financial officer have concluded, based upon their evaluation as of the end of the period covered by this report, that our disclosure controls and procedures were effective as of March 31, 2009. There has been no change in our internal control over financial reporting that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting during the three months ended March 31, 2009. As of the end of the third quarter of 2008, we were faced with limited funds for operations and were compelled to suspend SEC filings. Management has determined that this late filing situation was due to shortages in capital resources and is not related to internal controls over financial reporting.





Changes in Internal Control over Financial Reporting.There has been no change in our internal control over financial reporting during the fiscal quarter ended March 31, 2009, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.





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PART II





ITEM 1A. RISK FACTORS





Our results of operations and financial condition are subject to numerous risks and uncertainties described in our Annual Report on Form 10-K for our fiscal year ended December 31, 2008, filed on February 24, 2010 and incorporated herein by reference. You should carefully consider these risk factors in conjunction with the other information contained in this report. Should any of these risks materialize, our business, financial condition and future prospects could be negatively impacted. As of March 31, 2009, there have been no material changes to the disclosures made on the above-referenced Form 10-K, as amended, except as follows:





We have a history of significant recurring losses totaling approximately $88.3million, and these losses may continue in the future.





As of March 31, 2009, we had an accumulated deficit of $88.3 million, and these losses may continue in the future. We will need to raise capital to fund our continuing operations, and financing may not be available to us on favorable terms or at all. In the event financing is not available in the time frame required, we will be forced to sell certain of our assets or license our technologies to others. We expect to continue to incur significant sales and marketing, research and development, and general and administrative expenses. As a result, we will need to generate significant revenues to achieve profitability and we may never achieve profitability.





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





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





·
changes in our product or customer mix;





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





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





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





·
competitive pressures on selling prices;





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





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





·
our accounting and legal expenses; and





·
general economic conditions.





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





The holders of our preferred stock have certain rights and privileges that are senior to our common stock, and we may issue additional shares of preferred stock without stockholder approval that could have a material adverse effect on the market value of the common stock.





Our Board of Directors (“Board”) has the authority to issue a total of up to 4,000,000 shares of preferred stock and to fix the rights, preferences, privileges, and restrictions, including voting rights, of the preferred stock, which typically are senior to the rights of the common stockholders, without any further vote or action by the common stockholders. The rights of our common stockholders will be subject to, and may be adversely affected by, the rights of the holders of the preferred stock that have been issued, or might be issued in the future. Preferred stock also could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. This could delay, defer, or prevent a change in control. Furthermore, holders of preferred stock may have other rights, including economic rights, senior to the common stock. As a result, their existence and issuance could have a material adverse effect on the market value of the common stock. We have in the past issued and may from time to time in the future issue, preferred stock for financing or other purposes with rights, preferences, or privileges senior to the common stock. As of March 31, 2009, we had three series of preferred stock outstanding, Series B preferred stock, Series C 8% convertible preferred stock and Series D 8% convertible preferred stock.





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The provisions of our Series B Preferred Stock prohibit the payment of dividends on the common stock unless the dividends on those preferred shares are first paid. In addition, upon a liquidation, dissolution or sale of our business, the holders of the Series B Preferred Stock will be entitled to receive, in preference to any distribution to the holders of common stock, initial distributions of $2.50 per share, plus all accrued but unpaid dividends.  Pursuant to the terms of our Series B Preferred Stock we are obligated to pay cumulative cash dividends on shares of Series B Preferred Stock from legally available funds at the annual rate of $0.2125 per share, payable in two semi-annual installments of $0.10625 each, which cumulative dividends must be paid prior to payment of any dividend on our common stock. As of March 31, 2009, we had cumulative undeclared dividends on the Series B Preferred Stock of approximately $47,000.





The Series C Preferred Stock has a liquidation preference equal to its stated value, plus any accrued and unpaid dividends thereon and any other fees or liquidated damages owing thereon. The Series C Preferred Stock accrues cumulative dividends at the rate of 8.0% of the stated value per share per annum.  At the option of the Company, the dividend payment may be made in the form of cash, after the payment of cash dividends to the holders of Series B Preferred Stock, or common stock issuable upon conversion of the Series C Preferred Stock.  Each share of Series C Preferred Stock is convertible at any time at the option of the holder into a number of shares of common stock equal to the stated value (initially $1,000 per share, subject to adjustment), plus any accrued and unpaid dividends, divided by the conversion price (initially $1.50 per share, subsequently adjusted to $0.50 per share and subject to further adjustment). Subject to certain limitations, the conversion price per share shall be adjusted in the event of certain subsequent stock dividends, splits, reclassifications, dilutive issuances, rights offerings, and reclassifications.  Certain activities may not be undertaken by the Company without the affirmative vote of a majority of the holders of the outstanding shares of Series C Preferred Stock. As of March 31, 2009, we had cumulative undeclared dividends on the Series C Preferred Stock of approximately $447,000.





The Series D Preferred Stock has a liquidation preference equal to its stated value, plus any accrued and unpaid dividends thereon and any other fees or liquidated damages owing thereon. The Series D Preferred Stock accrues cumulative dividends at the rate of 8.0% of the stated value per share per annum.  At the option of the Company, the dividend payment may be made in the form of cash, after the payment of cash dividends to the holders of Series B and Series C Preferred Stock, or common stock issuable upon conversion of the Series D Preferred Stock.  Each share of Series D Preferred Stock is convertible at any time at the option of the holder into a number of shares of common stock equal to the stated value (initially $1,000 per share, subject to adjustment), plus any accrued and unpaid dividends, divided by the conversion price (initially $1.90 per share, subsequently adjusted to 0.50 per share and subject to further adjustment). Subject to certain limitations, the conversion price per share shall be adjusted in the event of certain subsequent stock dividends, splits, reclassifications, dilutive issuances, rights offerings, and reclassifications.  Certain activities may not be undertaken by the Company without the affirmative vote of a majority of the holders of the outstanding shares of Series D Preferred Stock. As of March 31, 2009, we had cumulative undeclared dividends on the Series D Preferred Stock of approximately $274,000.








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ITEM 6. EXHIBITS





(a)

EXHIBITS31.1

Certification of the Principal Executive Officer pursuant to Rule 13a-14(a) and 15d-14(a)31.2

Certification of the Principal Financial and Accounting Officer pursuant to Rule 13a-14(a) and 15d-14(a)32.1

Certification by the Principal Executive Officer and Principal Financial and Accounting Officer pursuant to 18 U.S.C. 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002





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SIGNATURES





Pursuant to the requirements of the Securities Exchange Act, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.





IMAGEWARE SYSTEMS, INC.Date:
April 29, 2010

By:

/s/ Wayne WetherellWayne Wetherell, Chief FinancialOfficer(on behalf of the Registrant and as Registrant’s Principal Financial and Accounting Officer)







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