**U.S. SECURITIES AND EXCHANGECOMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-QSB**

 

**(Mark One)**

 

| ý                                                | ** ** | **QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
|-------------------------------------------------------|------------|---------------------------------------------------------------------------------------------|
|                                                  | ** ** | ** **                                                                                  |
| **For the quarterly period ended June 30, 2004** |
| ** **                                            | ** ** | ** **                                                                                  |
| o                                                     | ** ** | **TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE  EXCHANGE ACT**                   |

 

**For the transition periodfrom         to         **

 

**Commission file number 001-15757**

 

**IMAGEWARE SYSTEMS, INC.**

(Exact Name of Small Business Issuer as Specified in Its Charter)

 
| **California**                                                  | ** ** | **33-0224167**                    |
|-----------------------------------------------------------------|------------|-----------------------------------|
| (State or Other Jurisdiction of Incorporation or  Organization) |       | (IRS Employer Identification No.) |

 

**10883 Thornmint RoadSan Diego, CA 92127**

(Address of Principal Executive Offices)

 

**(858) 673-8600**

(Issuer’s Telephone Number, Including Area Code)

 

Checkwhether the issuer (1) filed all reports required to be filed bySection 13 or 15(d) of the Exchange Act during the past 12 months (or forsuch 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 ý  No o

 

Statethe number of shares outstanding of each of the issuer’s classes of commonequity, as of the latest practicable date: As of August 12, 2004, thenumber of outstanding shares of the Registrant’s common stock, par value $.01,was 11,942,079.

 

TransitionalSmall Business Disclosure Format (check one) Yes o  No ý

 

 

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**IMAGEWARE SYSTEMS, INC. INDEX**

 
| PART I.    | FINANCIAL INFORMATION |                                                                                                                              |
|------------|-----------------------|-----------------------------------------------------------------------------------------------------------------------------------|
|       | ITEM 1.               | FINANCIAL  STATEMENTS (UNAUDITED)                                                                                                 |   |
|       |                  | Condensed  Consolidated Balance Sheets as of June 30, 2004 and December 31,  2003                                       |   |
|       |                  | Condensed  Consolidated Statements of Operations for the three and six months ended  June 30, 2004 and 2003                  |   |
|       |                  | Condensed  Consolidated Statements of Cash Flows for the three and six months ended  June 30, 2004 and 2003                  |   |
|       |                  | Condensed  Consolidated Statements of Comprehensive Income (Loss) for the three and six  months ended June 30, 2004 and 2003 |   |
|       |                  | Notes  to Condensed Consolidated Financial Statements                                                                             |   |
|       | ITEM  2.              | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                       |   |
|       | ITEM 3.               | Controls and  Procedures                                                                                                          |   |
|       |                  |
| PART II.   | OTHER INFORMATION     |                                                                                                                              |
|       | ITEM 6.               | EXHIBITS AND  REPORTS ON FORM 8-K                                                                                                 |   |
|       |                  |
| SIGNATURES |                  |

 

2

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**PART I**

**FINANCIAL INFORMATION**

 

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

 

**IMAGEWARE SYSTEMS, INC.**

**CONDENSED CONSOLIDATEDBALANCE SHEETS**

**(IN THOUSANDS)**

 
| ** **                                                                                                                                                                                                                                                                     | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                                                                                                     | ** ** | **(Unaudited)**         | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                                     |       |                    |       |                        |       |
| Current Assets:                                                                                                                                                                                                                                                                |       |                    |       |                        |       |
| Cash                                                                                                                                                                                                                                                                           |       | $                       | 3,727      |                        | $          | 578 |   |
| Restricted cash and cash equivalents                                                                                                                                                                                                                                           |       | 107                     |       | 155                         |       |
| Accounts receivable, net                                                                                                                                                                                                                                                       |       | 1,960                   |       | 1,450                       |       |
| Inventory                                                                                                                                                                                                                                                                      |       | 727                     |       | 805                         |       |
| Other current assets                                                                                                                                                                                                                                                           |       | 388                     |       | 203                         |       |
| Total Current Assets                                                                                                                                                                                                                                                           |       | 6,909                   |       | 3,191                       |       |
|                                                                                                                                                                                                                                                                           |       |                    |       |                        |       |
| Property and equipment, net                                                                                                                                                                                                                                                    |       | 518                     |       | 635                         |       |
| Other assets                                                                                                                                                                                                                                                                   |       | 565                     |       | 570                         |       |
| Intangible assets, net of accumulated  amortization                                                                                                                                                                                                                            |       | 929                     |       | 1,121                       |       |
| Goodwill                                                                                                                                                                                                                                                                       |       | 5,298                   |       | 5,298                       |       |
| **Total Assets**                                                                                                                                                                                                                                                               |       | **$**                   | **14,219** | ** **                  | **$**      | **10,815** |   |
|                                                                                                                                                                                                                                                                           |       |                    |       |                        |       |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                                                                                                                                                                  |       |                    |       |                        |       |
|                                                                                                                                                                                                                                                                           |       |                    |       |                        |       |
| Current Liabilities:                                                                                                                                                                                                                                                           |       |                    |       |                        |       |
| Accounts payable                                                                                                                                                                                                                                                               |       | $                       | 742        |                        | $          | 1,053 |   |
| Deferred revenue                                                                                                                                                                                                                                                               |       | 853                     |       | 848                         |       |
| Accrued expenses                                                                                                                                                                                                                                                               |       | 1,562                   |       | 1,067                       |       |
| Accrued interest                                                                                                                                                                                                                                                               |       | 51                      |       | 103                         |       |
| Notes & advances payable to bank and  third parties                                                                                                                                                                                                                        |       | 151                     |       | 182                         |       |
| Notes payable to related parties                                                                                                                                                                                                                                               |       | —                  |       | 59                          |       |
| Total Current Liabilities                                                                                                                                                                                                                                                      |       | 3,359                   |       | 3,312                       |       |
|                                                                                                                                                                                                                                                                           |       |                    |       |                        |       |
| Warrant liability                                                                                                                                                                                                                                                              |       | —                  |       | 3,460                       |       |
| Pension obligation                                                                                                                                                                                                                                                             |       | 776                     |       | 732                         |       |
| Total Liabilities                                                                                                                                                                                                                                                              |       | 4,135                   |       | 7,504                       |       |
|                                                                                                                                                                                                                                                                           |       |                    |       |                        |       |
| Shareholders’ equity:                                                                                                                                                                                                                                                     |       |                    |       |                        |       |
| Preferred stock, $.01 par value, authorized  4,000,000 shares Series B convertible redeemable preferred stock, designated  750,000 shares, 389,400 shares issued, and 249,400 shares outstanding at  June 30, 2004, liquidation preference $623,500 at June 30, 2004 |       | 2                       |       | 2                           |       |
| Common stock, $.01 par value, 50,000,000  shares authorized, 11,806,552 shares issued and 11,832,668 shares outstanding  at June 30, 2004                                                                                                                                 |       | 117                     |       | 98                          |       |
| Additional paid in capital                                                                                                                                                                                                                                                     |       | 63,446                  |       | 49,222                      |       |
| Treasury stock, at cost - 6,704 shares                                                                                                                                                                                                                                         |       | (64                     | )          | (64                         | )          |
| Shareholder note receivable                                                                                                                                                                                                                                                    |       | (150                    | )          | (150                        | )          |
| Accumulated other comprehensive income                                                                                                                                                                                                                                         |       | 212                     |       | 265                         |       |
| Accumulated deficit                                                                                                                                                                                                                                                            |       | (53,479                 | )          | (46,062                     | )          |
| Total shareholders’ equity                                                                                                                                                                                                                                                |       | 10,084                  |       | 3,311                       |       |
|                                                                                                                                                                                                                                                                           |       |                    |       |                        |       |
| **Total Liabilities  and Shareholders’ Equity**                                                                                                                                                                                                                           |       | **$**                   | **14,219** | ** **                  | **$**      | **10,815** |   |

 

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

 

3

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**IMAGEWARE SYSTEMS, INC.**

**CONDENSED CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(IN THOUSANDS, EXCEPT SHAREAND PER SHARE AMOUNTS)**

**(UNAUDITED)**

 
| ** **                                            | ** ** | **THREE MONTHS ENDED  JUNE 30,** | ** ** | **SIX MONTHS ENDED  JUNE 30,** | ** ** |
|-------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                            | ** ** | **2004**                              | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                  |       |                                  |       |                                |       |   |   |   |   |
| **Revenues:**                                         |       |                                  |       |                                |       |   |   |   |   |
| Product                                               |       | $                                     | 2,199      |                                | $          | 3,835 |   | $ | 4,079 |   | $ | 6,469 |   |
| Maintenance                                           |       | 479                                   |       | 792                                 |       | 963 |   | 1,590 |   |
|                                                  |       | 2,678                                 |       | 4,627                               |       | 5,042 |   | 8,059 |   |
| **Cost of revenues:**                                 |       |                                  |       |                                |       |   |   |   |   |
| Product                                               |       | 568                                   |       | 1,840                               |       | 1,070 |   | 3,077 |   |
| Maintenance                                           |       | 222                                   |       | 314                                 |       | 470 |   | 669 |   |
| Gross profit                                          |       | 1,888                                 |       | 2,473                               |       | 3,502 |   | 4,313 |   |
|                                                  |       |                                  |       |                                |       |   |   |   |   |
| **Operating expenses:**                               |       |                                  |       |                                |       |   |   |   |   |
| General & administrative                          |       | 1,135                                 |       | 1,439                               |       | 2,277 |   | 2,881 |   |
| Sales and marketing                                   |       | 890                                   |       | 1,048                               |       | 1,572 |   | 2,137 |   |
| Research & development                            |       | 722                                   |       | 437                                 |       | 1,355 |   | 931 |   |
| Depreciation and amortization                         |       | 180                                   |       | 237                                 |       | 371 |   | 473 |   |
|                                                  |       | 2,927                                 |       | 3,161                               |       | 5,575 |   | 6,422 |   |
| Loss from operations                                  |       | (1,039                                | )          | (688                                | )          | (2,073 | ) | (2,109 | ) |
|                                                  |       |                                  |       |                                |       |   |   |   |   |
| Interest expense, net                                 |       | 3,898                                 |       | 1,893                               |       | 5,189 |   | 2,254 |   |
|                                                  |       |                                  |       |                                |       |   |   |   |   |
| Other (income) expense, net                           |       | (9                                    | )          | (92                                 | )          | (29 | ) | (173 | ) |
| Loss before income taxes                              |       | (4,928                                | )          | (2,489                              | )          | (7,233 | ) | (4,190 | ) |
|                                                  |       |                                  |       |                                |       |   |   |   |   |
| Income tax expense (benefit)                          |       | —                                |       | —                              |       | — |   | — |   |
|                                                  |       |                                  |       |                                |       |   |   |   |   |
| Net loss                                              |       | $                                     | (4,928     | )                                   | $          | (2,489 | ) | $ | (7,233 | ) | $ | (4,190 | ) |
|                                                  |       |                                  |       |                                |       |   |   |   |   |
| Basic and diluted loss per common share -  see note 2 |       | $                                     | (0.42      | )                                   | $          | (0.46 | ) | $ | (0.63 | ) | $ | (0.77 | ) |
| Weighted-average shares (basic and diluted)           |       | 11,825,414                            |       | 5,489,390                           |       | 11,517,716 |   | 5,489,390 |   |

 

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

 

4

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**IMAGEWARE SYSTEMS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASHFLOWS**

**(IN THOUSANDS)**

**(UNAUDITED)**

 
| ** **                                                                   | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                   | ** ** | **2004**                            | ** ** | **2003** | ** ** |
|                                                                         |       |                                |       |   |   |
| **Cash  flows from operating activities**                                    |       |                                |       |   |   |
| Net loss                                                                     |       | $                                   | (7,233     | ) | $ | (4,190 | ) |
| Adjustments to reconcile  net loss to net cash used by operating activities  |       |                                |       |   |   |
| Depreciation and  amortization                                               |       | 371                                 |       | 476 |   |
| Non cash interest and  amortization of debt discount and debt issuance costs |       | 4,472                               |       | 1,872 |   |
| Change in assets and  liabilities                                            |       |                                |       |   |   |
| Restricted cash and cash  equivalents                                        |       | 48                                  |       | — |   |
| Accounts receivable, net                                                     |       | (511                                | )          | 1,032 |   |
| Inventory                                                                    |       | 77                                  |       | 81 |   |
| Other current assets                                                         |       | (184                                | )          | (20 | ) |
| Intangible and other  assets                                                 |       | 6                                   |       | (54 | ) |
| Accounts payable                                                             |       | (311                                | )          | (692 | ) |
| Accrued expenses                                                             |       | 498                                 |       | 25 |   |
| Accrued interest                                                             |       | (52                                 | )          | (96 | ) |
| Deferred revenue                                                             |       | 6                                   |       | 46 |   |
| Pension obligation                                                           |       | 43                                  |       | 46 |   |
| Total adjustments                                                            |       | 4,463                               |       | 2,716 |   |
| Net cash used by  operating activities                                       |       | (2,770                              | )          | (1,474 | ) |
|                                                                         |       |                                |       |   |   |
| **Cash  flows from investing activities**                                    |       |                                |       |   |   |
| Purchase of property and  equipment                                          |       | (63                                 | )          | (134 | ) |
| Payment on advances from  related stockholders                               |       | (59                                 | )          | (128 | ) |
| Sale of property and  equipment                                              |       | —                              |       | 59 |   |
| Net cash used by  investing activities                                       |       | (122                                | )          | (203 | ) |
|                                                                         |       |                                |       |   |   |
| **Cash  flows from financing activities**                                    |       |                                |       |   |   |
| Proceeds from issuance  of notes payable with warrants                       |       | —                              |       | 4,856 |   |
| Repayment of notes  payable                                                  |       | (31                                 | )          | (2,500 | ) |
| Debt issuance costs                                                          |       | —                              |       | (554 | ) |
| Proceeds from issuance  of common stock, net of issuance costs               |       | 6,054                               |       | — |   |
| Proceeds from exercised  stock options                                       |       | 257                                 |       | — |   |
| Dividends paid                                                               |       | (185                                | )          | — |   |
| Proceeds from bank line  of credit                                           |       | —                              |       | 186 |   |
|                                                                         |       |                                |       |   |   |
| Net cash provided (used)  by financing activities                            |       | 6,095                               |       | 1,988 |   |
| Effect of exchange rate  changes on cash                                     |       | (54                                 | )          | 102 |   |
| Net increase (decrease)  in cash                                             |       | 3,149                               |       | 413 |   |
|                                                                         |       |                                |       |   |   |
| Cash at beginning of  period                                                 |       | 578                                 |       | 215 |   |
|                                                                         |       |                                |       |   |   |
| Cash at end of period                                                        |       | $                                   | 3,727      |   | $ | 628 |   |

 

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

 

5

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**IMAGEWARE SYSTEMS, INC.**

**CONDENSED CONSOLIDATEDSTATEMENTS OF COMPREHENSIVE INCOME (LOSS)**

**(IN THOUSANDS)**

**(UNAUDITED)**

 
| ** **                              | ** ** | **THREE MONTHS ENDED  JUNE 30,** | ** ** | **SIX MONTHS ENDED  JUNE 30,** | ** ** |
|-----------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                              | ** ** | **2004**                              | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                    |       |                                  |       |                                |       |   |   |   |   |
| Net loss                                |       | $                                     | (4,928     | )                                   | $          | (2,489 | ) | $ | (7,233 | ) | $ | (4,190 | ) |
| Other comprehensive income (loss):      |       |                                  |       |                                |       |   |   |   |   |
| Foreign currency translation adjustment |       | 34                                    |       | 70                                  |       | (54 | ) | 102 |   |
| Comprehensive income (loss)             |       | $                                     | (4,894     | )                                   | $          | (2,419 | ) | $ | (7,287 | ) | $ | (4,088 | ) |

 

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

 

6

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**IMAGEWARE SYSTEMS, INC.**

 

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE 1.  DESCRIPTION OFBUSINESS AND OPERATIONS**

 

ImageWare Systems, Inc. (“we,” “our” or the “Company”), wasincorporated in the State of California on February 6, 1987. The Companyutilizes digital imaging technology to provide stand alone, networked andweb-based software solutions for secure credentials, biometrics, lawenforcement and professional photography.

 

ImageWare’s law enforcement solutions enable agencies to quicklycapture, archive, search, retrieve, and share digital photographs and criminalhistory records on a stand alone, networked, wireless or web-based platform.ImageWare develops, sells and supports a suite of modular software productsused by law enforcement and public safety agencies to create and managecriminal history records and to investigate crime. Our C.R.I.M.E.S. systemconsists of eight software modules: Crime Capture System (consisting of theCapture Module and the Retrieval Module), which provides a criminal bookingsystem and related database; Face ID, which uses biometric facial recognitionto identify suspects; Suspect ID, which facilitates the creation of full-color,photo-realistic suspect composites; Crime Lab, which allows officers to enhanceand edit digital images; and Vehicle ID, which helps officers identify motorvehicles stolen or involved in a crime. In addition, we offer Crime Web, whichprovides access to centrally stored records over the Internet in a connected orwireless fashion, Pocket CCS which enables access to centrally stored recordswhile in the field on a handheld Pocket PC compatible device, and centralrepository services which allows for inter-agency data sharing on a local,regional, and/or national level.  Werecently added a new module to CCS which incorporates fingerprint livescancapabilities into CCS for real-time capture of single to ten prints and palm tofurther improve the booking, investigative and identification procedures.

 

ImageWare’s ID solutions empower customers to create secure and smartdigital identification documents with complete ID systems. We develop, sell andsupport software and design systems which utilize digital imaging in theproduction of photo identification cards and credentials and identificationsystems. Our sales in the digital identification market were developed throughour acquisitions of ITC, Goddard and G & A (discussed below). Ourproducts in this market consist of EpiSuite, EpiWeb, EpiWeb Enterprise,EpiBuilder (SDK), Identifier for Windows, ID Card Maker, Winbadge NT and WinbadgeAviation. These products allow for the production of digital identificationcards and related databases and records and can be used by, among others,schools, airports, hospitals, corporations or governments.  We have recently added the ability to incorporatemultiple biometrics into the ID systems we offer with the addition of our newImageWare Biometric Engine to our product line.

 

ImageWare’s Digital Photography (“PDI”) product line consists of asuite of software for the professional photography market. The software allowsprofessional photographers to digitally capture images, manipulate them tocreate a custom package or layout, then store the images with an associateddatabase. They can then print the digital images themselves or send them via theInternet or CD to a professional lab for processing. Our products include PCPro, PC Event, PDI School Days+, PDI Studio, PDI Pro Lab and PDI Green Screen.Our customers use the software products in a wide variety of ways includingretail studio environments, on-location event photography and “picture day” atschools and day care centers. Our software products are sold through a dealernetwork and directly to major accounts. The PDI group also operates ane-commerce service, Picturemore.com, used by professional photographers toallow their customers to order re-prints and various service items. Our salesin the digital photography market were developed as a result of our acquisitionof Castleworks and E-Focus West in August, 2001.

 

*Liquidity and Capital Resources*

 

Asreflected in the accompanying condensed consolidated financial statements, theCompany has losses and negative cash flows from operations.  The condensed consolidated financialstatements included in this report have been prepared assuming that the Companywill continue as a going concern.

 

In view of the matters described in the preceding paragraph,recoverability of a major portion of the recorded asset amounts shown in theaccompanying condensed consolidated balance sheet is dependent upon continuedoperations of the Company, which, in turn, is dependent upon the Company’sability to continue to raise capital and generate positive cash flows fromoperations.  The condensed consolidatedfinancial statements do not include any adjustments relating to therecoverability and classification of recorded asset amounts or amounts andclassifications of liabilities that might be necessary should the Company beunable to continue its existence.

 

TheCompany operates in markets that are emerging and highly competitive. There isno assurance that the Company will operate at a profit in the future.

 

7

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*Basis of Presentation*

 

Thepreparation of financial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities, thedisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenue and expenses during thereporting period. Actual results could differ from those estimates.

 

Theaccompanying condensed consolidated unaudited financial statements ofImageWare  have been prepared pursuant tothe rules and regulations of the Securities and Exchange Commission (“SEC”)regarding interim financial reporting. Accordingly, they do not include all ofthe information and footnotes required by generally accepted accountingprinciples for annual financial statements and should be read in conjunctionwith the consolidated financial statements for the year ended December 31,2003 and notes thereto included in the Company’s Annual Report on Form 10-KSB,filed with the SEC on March 30, 2004. In the opinion of management, theaccompanying condensed consolidated financial statements contain alladjustments, consisting only of adjustments of a normal recurring nature,necessary for a fair presentation of the Company’s financial position as ofJune 30, 2004, and its results of operations for the periods presented.These condensed consolidated unaudited financial statements are not necessarilyindicative of the results to be expected for the entire year.

 

*Stock-Based Compensation*

 

Stock-based compensation to employees has been recognized as thedifference between the per share fair value of the underlying stock and thestock option exercise price at the initial grant date.  The cost of stock options granted forservices, other than those issued to employees, are recorded at the fair valueof the stock option.

 

Had compensation cost for the Company’s stock option plan beendetermined based on the fair value at the grant date for awards consistent withthe provisions of Statement of Financial Accounting Standards. (“SFAS”) No. 123,Accounting for Stock-Based Compensation, the Company’s net losses would havebeen increased to the pro forma amount indicated below for the three and sixmonths ended June 30, 2004 and 2003:

 
| ** **                                                       | ** ** | **THREE MONTHS ENDED  JUNE 30,** | ** ** | **SIX MONTHS ENDED  JUNE 30,** | ** ** |
|------------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                                       | ** ** | **2004**                              | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                             |       |                                  |       |                                |       |   |   |   |   |
| Net Loss:                                                        |       |                                  |       |                                |       |   |   |   |   |
| As reported                                                      |       | $                                     | (4,928     | )                                   | $          | (2,489 | ) | $ | (7,233 | ) | $ | (4,190 | ) |
| Current period expense calculated under APB  25                  |       | —                                |       | —                              |       | — |   | — |   |
| Stock based employee compensation under  fair value based method |       | (82                                   | )          | (152                                | )          | (164 | ) | (298 | ) |
| Pro forma net loss                                               |       | $                                     | (5,010     | )                                   | $          | (2,641 | ) | $ | (7,397 | ) | $ | (4,488 | ) |
|                                                             |       |                                  |       |                                |       |   |   |   |   |
| Basic loss per common share:                                     |       |                                  |       |                                |       |   |   |   |   |
| As reported                                                      |       | $                                     | (0.42      | )                                   | $          | (0.46 | ) | $ | (0.63 | ) | $ | (0.77 | ) |
| Pro forma                                                        |       | $                                     | (0.42      | )                                   | $          | (0.48 | ) | $ | (0.64 | ) | $ | (0.82 | ) |

 

On March 30, 2004, the Company entered into a stock exchangeagreement with certain employees whereby the employees would receive 255,792shares of restricted stock in exchange for 426,321 options previously grantedunder various stock option plans.  Underthe terms of the agreement, the employees will receive three shares ofrestricted stock for each five options exchanged.  The restricted stock will vest over threeyears on a quarterly basis and will fully vest upon either a change in control,the sale of the Company, or termination of employment unless such terminationis for cause.

 

In accordance with Financial Accounting Standards Board InterpretationNo. 44 — Accounting for Certain Transactions Involving Stock Compensation (“FIN44”), the Company will recognize stock-based compensation expense ratably overthe vesting period of the restricted stock in an amount of approximately$82,000 per quarter.  Such compensationexpense was $82,000 for the three and six months ended June 30, 2004 dueto the commencement of the vesting period on March 30, 2004.

 

The differential between the number of shares underlying the optionsexchanged of 426,321 and the number of restricted shares issued of 255,792 aresubject to variable accounting treatment under the provisions of FIN 44 shouldany option grants be awarded to the participants of this stock exchangeagreement for a six month period beginning March 30, 2004.  No options were granted to the participantsof this stock exchange agreement during the period March 30, 2004 toJune 30, 2004.

 

8

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Certainreclassifications have been made to the prior period balances in order toconform to the current period presentation.

 

**NOTE 2.  NET LOSS PERCOMMON SHARE**

 

Basic loss per common share is calculated by dividing net lossavailable to common shareholders for the period by the weighted-average number of common shares outstandingduring the period. Diluted earnings per common share is calculated by dividingnet loss available to common shareholders for the period by theweighted-average number of common shares outstanding during the period,adjusted to include, if dilutive, potential dilutive shares consisting ofconvertible preferred stock, stock options, convertible notes payable andwarrants, calculated using the treasury stock method. During the periods endedJune 30, 2004 and 2003, the Company has excluded the following securitiesfrom the calculation of diluted loss per share, as their effect would have beenantidilutive due to the Company’s net loss:

 
| **Potential  Dilutive Securities:** | ** ** | **Number of  Common Shares  Convertible into at  June 30, 2004** | ** ** | **Number of  Common Shares  Convertible into at  June 30, 2003** | ** ** |
|-------------------------------------|------------|-----------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
|                                |       |                                                                  |       |                                                                  |       |
| Convertible preferred stock         |       | 62,049                                                                |       | 62,671                                                                |       |
| Stock options                       |       | 484,197                                                               |       | 853,787                                                               |       |
| Convertible notes payable           |       | —                                                                |       | 2,332,854                                                             |       |
| Warrants                            |       | 6,305,927                                                             |       | 4,758,266                                                             |       |

 

Thefollowing table sets forth the computation of basic and diluted loss per sharefor the three and six month periods ended June 30, 2004 and 2003 (amountsin thousands except share and per share amounts):

 
| ** **                                | ** ** | **THREE MONTHS ENDED  JUNE 30,** | ** ** | **SIX MONTHS ENDED  JUNE 30,** | ** ** |
|-------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                | ** ** | **2004**                              | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| Numerator                                 |       |                                  |       |                                |       |   |   |   |   |
| Net loss                                  |       | $                                     | (4,928     | )                                   | $          | (2,489 | ) | $ | (7,233 | ) | $ | (4,190 | ) |
| Less Series B preferred dividends         |       | (13                                   | )          | (15                                 | )          | (26 | ) | (31 | ) |
| Net loss available to common shareholders |       | $                                     | (4,941     | )                                   | $          | (2,504 | ) | $ | (7,259 | ) | $ | (4,221 | ) |
|                                      |       |                                  |       |                                |       |   |   |   |   |
| Denominator                               |       |                                  |       |                                |       |   |   |   |   |
| Weighted-average shares outstanding       |       | 11,825,414                            |       | 5,489,390                           |       | 11,517,716 |   | 5,489,390 |   |
|                                      |       |                                  |       |                                |       |   |   |   |   |
| Basic and diluted loss per share          |       | $                                     | (0.42      | )                                   | $          | (0.46 | ) | $ | (0.63 | ) | $ | (0.77 | ) |

 

**NOTE 3.  SEGMENTINFORMATION**

 

The Company is comprised of three reportable segments: Law Enforcement,Identification and Digital Photography. The Law Enforcement segment develops,sells and supports a suite of modular software products and designs systemsused by law enforcement and public safety agencies to manage criminal historyrecords and investigate crime. The Identification segment develops, sells andsupports software and designs systems which utilize digital imaging in theproduction of photo identification cards, documents and identification badgingsystems. The Digital Photography segment develops digital imaging software forphotographic purposes.

 

Corporate assets are comprised primarily of cash and other assetsproviding benefits to all business segments.

 

There are no significant intersegment transactions.

 

9

----

 

The table below summarizes information about reportable segments forthe three and six months ended June 30, 2004 and 2003:

 
| ** **                   | ** ** | **THREE MONTHS ENDED  JUNE 30,** | ** ** | **SIX MONTHS ENDED  JUNE 30,** | ** ** |
|------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                   | ** ** | **2004**                              | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                   | ** ** | **(in thousands)  (unaudited)**       | ** ** | **(in thousands)  (unuadited)**     | ** ** |
| Net Revenue:                 | * *   | * *                              | * *   | * *                            | * *   | * * | * * | * * | * * |
| Law Enforcement              |       | $                                     | 1,364      |                                | $          | 1,149 |   | $ | 2,578 |   | $ | 1,941 |   |
| Identification               |       | 1,168                                 |       | 3,266                               |       | 2,164 |   | 5,644 |   |
| Digital Photography          |       | 146                                   |       | 212                                 |       | 300 |   | 474 |   |
| Total consolidated net sales |       | $                                     | 2,678      |                                | $          | 4,627 |   | $ | 5,042 |   | $ | 8,059 |   |
|                         |       |                                  |       |                                |       |   |   |   |   |
| Operating income (loss):     |       |                                  |       |                                |       |   |   |   |   |
| Law Enforcement              |       | $                                     | 247        |                                | $          | 104 |   | $ | 409 |   | $ | (76 | ) |
| Identification               |       | (1,023                                | )          | (646                                | )          | (1,992 | ) | (1,745 | ) |
| Digital Photography          |       | (263                                  | )          | (146                                | )          | (490 | ) | (288 | ) |
|                         |       |                                  |       |                                |       |   |   |   |   |
| Other unallocated amounts:   |       |                                  |       |                                |       |   |   |   |   |
| Interest expense (income)    |       | 3,898                                 |       | 1,893                               |       | 5,189 |   | 2,254 |   |
| Other expense (income)       |       | (9                                    | )          | (92                                 | )          | (29 | ) | (173 | ) |
|                         |       |                                  |       |                                |       |   |   |   |   |
| Income (loss) before taxes   |       | $                                     | (4,928     | )                                   | $          | (2,489 | ) | $ | (7,233 | ) | $ | (4,190 | ) |

 
| ** **                           | ** ** | **June 30,  2004** | ** ** |
|--------------------------------------|------------|-------------------------|------------|
| ** **                           | ** ** | **(in thousands)**      | ** ** |
| Total Assets by Segment:             |       |                    |       |
|                                 |       |                    |       |
| Law Enforcement                      |       | $                       | 1,442      |   |
| Identification                       |       | 7,685                   |       |
| Digital Photography                  |       | 1,421                   |       |
| Total assets for reportable segments |       | 10,548                  |       |
| Corporate                            |       | 3,671                   |       |
| Total consolidated assets            |       | $                       | 14,219     |   |

 

10

----

 

**NOTE 4. WARRANT LIABILITY**

 

In conjunction with the Company’s issuance of secured convertiblepromissory notes in June 2003 (the “Notes”), the Company agreed toregister with the Securities and Exchange Commission the shares of common stockunderlying the warrants issued in connection with the Notes.  In conjunction with the Company’s issuance ofcommon stock in separate private placement transactions in November 2003and January 2004, the Company agreed to register with the Securities andExchange Commission the shares of common stock underlying the warrants issuedas part of the private placement transactions. In accordance with the Financial Accounting Standards Board EmergingIssue Task Force 00-19 (“EITF 00-19”), the Company has recorded a long-termliability for the allocated value of the warrants.  Accordingly, the Company is accounting forthe liability under fair value accounting. During the three months ended June 30, 2004, the Company registeredwith the Securities and Exchange Commission the shares of common stockunderlying the warrants issued in connection with both the notes and privateplacement transactions.  In accordancewith EITF 00-19, the Company has reclassified the fair value of the warrantliability as determined on effective date of the registration statements toadditional paid in capital.  Thefollowing table sets forth the changes in fair value, resulting interest incomeor expense of this liability as determined under fair value accounting andamount reclassified to additional paid in capital:

 
| **(IN THOUSANDS)**                                                                                                                                                                                                   | ** ** | **Warrant  Liability  in Conjunction  with warrants  issued with  New Notes** | ** ** | **Interest  Expense  (Income)  from warrant  revaluation  of New Notes  Warrants** | ** ** | **Warrant  Liability  in Conjunction  with warrants  issued with  November 2003  Private  Placement** | ** ** | **Interest  Expense  (Income)  from warrant  revaluation of  November 2003  Private  Placement  Warrants** | ** ** | **Warrant  Liability  in Conjunction  with warrants  issued with  January 2004  Private  Placement** | ** ** | **Interest  Expense  (Income)  from warrant  revaluation of  January 2004  Private  Placement  Warrants** | ** ** | **Total** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------|------------|-----------|------------|
|                                                                                                                                                                                                                 |       |                                                                          |       |                                                                               |       |                                                                                                       |       |                                                                                                            |       |                                                                                                      |       |                                                                                                           |       |      |       |
| Warrant liability at December 31, 2003                                                                                                                                                                          |       | $                                                                             | 2,046      |                                                                               |       |                                                                                                       | $          | 1,414                                                                                                           |       |                                                                                                      |       | $                                                                                                              | —     |      |       |   | $ | 3,460 |   |
|                                                                                                                                                                                                                 |       |                                                                          |       |                                                                               |       |                                                                                                       |       |                                                                                                            |       |                                                                                                      |       |                                                                                                           |       |      |       |
| Warrant liability at date of inception of warrants  issued in January 2004 private placement of securities                                                                                                      |       |                                                                          |       |                                                                               |       |                                                                                                       |       |                                                                                                            |       | $                                                                                                         | 1,080      |                                                                                                           |       |      | $          | 1,080 |   |
|                                                                                                                                                                                                                 |       |                                                                          |       |                                                                               |       |                                                                                                       |       |                                                                                                            |       |                                                                                                      |       |                                                                                                           |       |      |       |
| Change in fair value of warrant liability                                                                                                                                                                            |       | $                                                                             | 669        |                                                                               | $          | 669                                                                                                        |       | $                                                                                                               | 309        |                                                                                                      | $          | 309                                                                                                            |       | $         | (113       | ) | $ | (113 | ) | $ | 865 |   |
|                                                                                                                                                                                                                 |       |                                                                          |       |                                                                               |       |                                                                                                       |       |                                                                                                            |       |                                                                                                      |       |                                                                                                           |       |      |       |
| Warrant liability at March 31, 2004                                                                                                                                                                             |       | $                                                                             | 2,715      |                                                                               |       |                                                                                                       | $          | 1,723                                                                                                           |       |                                                                                                      |       | $                                                                                                              | 967        |      |       |   | $ | 5,405 |   |
|                                                                                                                                                                                                                 |       |                                                                          |       |                                                                               |       |                                                                                                       |       |                                                                                                            |       |                                                                                                      |       |                                                                                                           |       |      |       |
| Change in fair value of warrant liability due to  final valuation of warrant liability upon registration of underlying shares  with Securities and Exchange Commission during three months ended  June 30, 2004 |       | $                                                                             | 2,516      |                                                                               | $          | 2,516                                                                                                      |       | $                                                                                                               | 1,248      |                                                                                                      | $          | 1,248                                                                                                          |       | $         | (157       | ) | $ | (157 | ) | $ | 3,607 |   |
|                                                                                                                                                                                                                 |       |                                                                          |       |                                                                               |       |                                                                                                       |       |                                                                                                            |       |                                                                                                      |       |                                                                                                           |       |      |       |
| Warrant liability at date of final valuation                                                                                                                                                                         |       | $                                                                             | 5,231      |                                                                               |       |                                                                                                       | $          | 2,971                                                                                                           |       |                                                                                                      |       | $                                                                                                              | 810        |      |       |   | $ | 9,012 |   |
|                                                                                                                                                                                                                 |       |                                                                          |       |                                                                               |       |                                                                                                       |       |                                                                                                            |       |                                                                                                      |       |                                                                                                           |       |      |       |
| Reclassification of warrant liability to  additional paid-in-capital                                                                                                                                                 |       | $                                                                             | (5,231     | )                                                                                  |       |                                                                                                       | $          | (2,971                                                                                                          | )          |                                                                                                      |       | $                                                                                                              | (810       | )         |       |   | $ | (9,012 | ) |
|                                                                                                                                                                                                                 |       |                                                                          |       |                                                                               |       |                                                                                                       |       |                                                                                                            |       |                                                                                                      |       |                                                                                                           |       |      |       |
| Warrant liability at June 30, 2004                                                                                                                                                                              |       | $                                                                             | (0         | )                                                                                  |       |                                                                                                       | $          | 0                                                                                                               |       |                                                                                                      |       | $                                                                                                              | 0          |      |       |   | $ | 0 |   |
|                                                                                                                                                                                                                 |       |                                                                          |       |                                                                               |       |                                                                                                       |       |                                                                                                            |       |                                                                                                      |       |                                                                                                           |       |      |       |
| Interest Expense (Income) from revaluation of  warrant liability for six months ended June 30, 2004                                                                                                             |       |                                                                          |       | $                                                                                  | 3,185      |                                                                                                       |       |                                                                                                            | $          | 1,557                                                                                                     |       |                                                                                                           |       | $         | (270       | ) | $ | 4,472 |   |

 

# **NOTE 5. COMMON STOCK**

# ** **

On January 29, 2004, the Company completed a private placement,which involved the sale of units consisting of one share of common stock and awarrant to purchase 0.20 shares of common stock.  Each unit was priced at $3.65.  The warrants, which are first exercisablesix-months after the closing date, have a five-year term and an exercise priceof $5.48 per share.  As a result of thistransaction, the Company issued an aggregate of 1,818,332 new shares of commonstock and warrants to purchase up to approximately 364,000 shares of commonstock.  In connection with thistransaction, the Company also issued to certain placement agents warrants topurchase an additional 199,000 shares of common stock.  The Company raised approximately $6.6 millionfrom the 

 

11

----

 

private placement.  During thesix months ended June 30, 2004, the Company issued 61,933 shares of commonstock pursuant to stock option exercises and issued 29,070 shares of commonstock pursuant to warrant exercises.

 

# **NOTE 6. ACCRUED LIABILITIES**

# ** **

At June 30, 2004, the Company has recorded an accrued liability ofapproximately $613,000 for liquidated damages. The liquidated damages were incurred as the Company did not meet certaintime requirements for the registration of shares of the Company’s common stockunder the registration rights agreements for the November 2003 andJanuary 2004 private placements.

The Company has offered the participants in the private placements theoption of either receiving any amounts due in a cash payment or accepting areduction to the exercise price of the warrants issued to the participantsranging from 15% to 17%.  For thoseparticipants that have elected the warrant exercise price reduction, theCompany has recorded the value of the warrant strike price reduction using theBlack-Sholes option pricing model.

 

# **NOTE 7. SUBSEQUENT EVENTS**

# ** **

During July 2004, the Company issued 46,664 shares of common stockpursuant to stock option exercises and 62,747 shares pursuant to warrantexercises.

 

12

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**ITEM2.  MANAGEMENT’S DISCUSSION AND ANALYSISOR PLAN OF OPERATION.**

 

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

 

Thefollowing discussion of the financial condition and results of operationsshould be read in conjunction with the condensed consolidated financialstatements included elsewhere within this quarterly report. Fluctuations inannual and quarterly results may occur as a result of factors affecting demandfor the our products such as the timing of new product introductions by us andby our competitors and our customers’ political and budgetary constraints. Dueto such fluctuations, historical results and percentage relationships are notnecessarily indicative of the operating results for any future period.

 

**OVERVIEW**

 

ImageWareSystems, Inc. utilizes its imaging technology to develop software used tocreate booking and investigative software, smart and secure identificationsystems and documents, and software for professional photographers. Oursoftware systems and associated hardware enable our customers to quicklycapture, archive, search, retrieve and share digital photographs and associatedtext records.

 

**RESULTS OF OPERATIONS**

 

***THREE MONTHS ENDED JUNE 30, 2004 AND2003.***

 
| ** **                              | ** ** | **THREE MONTHS  ENDED  JUNE 30,** | ** ** | ** ** | ** ** | ** **      | ** ** |
|-----------------------------------------|------------|----------------------------------------|------------|------------|------------|-----------------|------------|
| **Net  Product Revenues**               | ** ** | **2004**                               | ** ** | **2003**   | ** ** | **$****Change** | ** ** | **%****Change** | ** ** |
| **(dollars  in thousands)**             | ** ** | ** **                             | ** ** | ** ** | ** ** | ** **      | ** ** | ** ** | ** ** | ** ** |
|                                    |       |                                   |       |       |       |            |       |   |   |
| **Product  revenues:**                  |       |                                   |       |       |       |            |       |   |   |
| Law Enforcement                         |       | $                                      | 913        |       | $          | 556             |       | $ | 357 |   | 64 | % |
| Percentage of total net product revenue |       | 42                                     | %          | 14         | %          |            |       |   |   |
| Identification                          |       | $                                      | 1,141      |       | $          | 3,067           |       | $ | (1,926 | ) | -63 | % |
| Percentage of total net product revenue |       | 52                                     | %          | 80         | %          |            |       |   |   |
| Digital Photography                     |       | $                                      | 145        |       | $          | 212             |       | $ | (67 | ) | -31 | % |
| Percentage of total net product revenue |       | 7                                      | %          | 6          | %          |            |       |   |   |
| Total net product revenues              |       | $                                      | 2,199      |       | $          | 3,835           |       | $ | (1,636 | ) | -43 | % |

 

Overallproduct revenues decreased 43% from $3,835,000 for the three months endedJune 30, 2003 to $2,199,000 for the corresponding period in 2004.  Revenues related to law enforcement productsincreased $357,000 for the three months ended June 30, 2004 as compared tothe corresponding period in 2003.  Thisincrease is due primarily to increased revenues from implementations of ourCrime Capture System (CCS) and Face ID products.  We believe that the increase in terrorism hascreated heightened interest in the ability of law enforcement and othergovernment agencies to be able to efficiently retrieve analyze and shareinformation from their respective criminal databases.  We anticipate that these factors willcontinue to increase the overall demand for the Company’s law enforcementproducts and software; however, we cannot predict the timing of the shift indemand.

 

Identification product revenues decreased 63% from $3,067,000 for thethree months ended June 30, 2003 to $1,141,000 for the correspondingperiod in 2004.  Domestically,Identification revenues decreased approximately $623,000 or 46% for the threemonths ended June 30, 2004 as compared to the corresponding period in2003.  This decrease in domestic revenueis reflective of a decrease in project-oriented work and a decrease in boxedsoftware sold through distribution channels. In mid 2003, we established a master distributor to handle our domesticsales of our EPI line of boxed software. The master distributor model has not produced the results weanticipated, and we have terminated that arrangement effective June ofthis year and have re-established direct sales to our distributionchannel.  Internationally, ourIdentification revenues decreased approximately $1,303,000.  This decrease is a result of actions taken inthe fourth quarter of 2003 to reposition our foreign sales offices in Germanyand Singapore to lower fixed costs and pursue significant Identificationprojects utilizing the Company’s software technologies as our primarydifferentiator.  These offices hadhistorically emphasized the resale of third party merchandise (hardware andconsumables) which generated lower gross margins than software (as a percentageof revenue) and required significant fixed costs for sales, service andsupport.  Revenues from these two officeswere $1.3 million below their levels in the same quarter of 2003, however,fixed costs during the quarter were approximately $400,000 lower than theprevious year.  The Company feels thatforeign markets served by these offices will embrace 

 

13

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the Company’s identification and biometricsolutions for large-scale high-end installations.  We continue to be of the opinion thatgovernment agencies and private entities will react to heightened securityconcerns resulting from acts of terrorism by re-evaluating and upgrading theirability to positively identify and track their citizens, employees, consultants and visitors. Weanticipate that these factors will increase overall demand for ouridentification products; however, we cannot predict the timing of the shift indemand.

 

Wefeel that we are well positioned for participation in one or more large-scaledomestic or international projects which will enable the Company to achievesignificant product revenue growth in our identification segment.  In the past twelve months we have retooledour identification products to enable customization for large projectapplications, added the biometric engine for incorporation into large scalebiometric installations and reoriented our organization to direct our resourcesand capabilities toward establishing a foothold in the market for large-scalesecure identification solutions.

 

DigitalPhotography product revenues decreased 31% from $212,000 for the three monthsended June 30, 2003 to $145,000 for the corresponding period in 2004.  This decrease is due to a reduction in customcontract programming during the three months ended June 30, 2004.

 

Ourbacklog of product orders as of June 30, 2004 was approximately$663,000.  At June 30, 2004, we alsohad maintenance and support backlog of approximately $806,000 under existingmaintenance agreements.  Product revenueis typically recognized within a three to six month time period depending uponthe required degree of customization, if any. Historically, we have experienced a very minimal risk of ordercancellation.  Our revenue frommaintenance agreements is generally recognized ratably over the respectivemaintenance periods provided no significant obligations remain andcollectibility of the related receivable is probable.

 
| ** **                                  | ** ** | **THREE MONTHS  ENDED  JUNE 30,** | ** ** | ** ** | ** ** | ** **      | ** ** |
|---------------------------------------------|------------|----------------------------------------|------------|------------|------------|-----------------|------------|
| **Maintenance  Revenues**                   | ** ** | **2004**                               | ** ** | **2003**   | ** ** | **$****Change** | ** ** | **%****Change** | ** ** |
| **(dollars  in thousands)**                 | ** ** | ** **                             | ** ** | ** ** | ** ** | ** **      | ** ** | ** ** | ** ** |
|                                        |       |                                   |       |       |       |            |       |   |   |
| **Maintenance  revenues:**                  |       |                                   |       |       |       |            |       |   |   |
| Law Enforcement                             |       | $                                      | 451        |       | $          | 593             |       | $ | (142 | ) | -24 | % |
| Percentage of total net maintenance revenue |       | 94                                     | %          | 75         | %          |            |       |   |   |
| Identification                              |       | $                                      | 28         |       | $          | 198             |       | $ | (170 | ) | -86 | % |
| Percentage of total net maintenance revenue |       | 6                                      | %          | 25         | %          |            |       |   |   |
| Digital Photography                         |       | $                                      | —     |       | $          | 1               |       | $ | (1 | ) | -100 | % |
| Percentage of total net maintenance revenue |       | 0                                      | %          | 0          | %          |            |       |   |   |
| Total net maintenance revenues              |       | $                                      | 479        |       | $          | 792             |       | $ | (313 | ) | -40 | % |

 

Maintenancerevenues decreased 40% from $792,000 for the three months ended June 30,2003 to $479,000 for the corresponding period in 2004. Law enforcementmaintenance revenues decreased 24% or $142,000 for the three months endedJune 30, 2004 from $593,000 for the three months ended June 30, 2003to $451,000 for the corresponding period in 2004. This decrease is dueprimarily to the expiration of the New York City Police Department service andmaintenance contract during the third quarter of 2003.

 

Identificationmaintenance revenues decreased 86% or $170,000 for the three months endedJune 30, 2004 from $198,000 for the three months ended June 30, 2003to $28,000 for the corresponding period in 2004. This decrease is due primarilyto the shift in our strategy in late 2003 to outsource international serviceand maintenance for hardware.  This shifthas enabled us to reduce costs and focus our resources on expanding our internationalsales effort of Digital Identification, Biometric, Law Enforcement and DigitalPhotography solutions.

 

14

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| ** **                                         | ** ** | **THREE MONTHS  ENDED  JUNE 30,** | ** ** | ** ** | ** ** | ** **      | ** ** |
|----------------------------------------------------|------------|----------------------------------------|------------|------------|------------|-----------------|------------|
| **Cost  of Product Revenues:**                     | ** ** | **2004**                               | ** ** | **2003**   | ** ** | **$****Change** | ** ** | **%****Change** | ** ** |
| **(dollars  in thousands)**                        | ** ** | ** **                             | ** ** | ** ** | ** ** | ** **      | ** ** | ** ** | ** ** |
|                                               |       |                                   |       |       |       |            |       |   |   |
| **Cost of  Product Revenues:**                     |       |                                   |       |       |       |            |       |   |   |
| Law Enforcement                                    |       | $                                      | 157        |       | $          | 252             |       | $ | (95 | ) | -38 | % |
| Percentage of Law Enforcement product  revenue     |       | 17                                     | %          | 45         | %          |            |       |   |   |
| Identification                                     |       | $                                      | 394        |       | $          | 1,579           |       | $ | (1,185 | ) | -75 | % |
| Percentage of Identification product revenue       |       | 35                                     | %          | 51         | %          |            |       |   |   |
| Digital Photography                                |       | $                                      | 17         |       | $          | 9               |       | $ | 8 |   | 89 | % |
| Percentage of Digital Photography product  revenue |       | 12                                     | %          | 4          | %          |            |       |   |   |
| Total net product revenues                         |       | $                                      | 568        |       | $          | 1,840           |       | $ | (1,272 | ) | -69 | % |
| Percentage of total product revenues               |       | 26                                     | %          | 48         | %          |            |       |   |   |

 

Overallcost of product revenues as a percentage of product revenues decreased from 48%for the three month period ended June 30, 2003 to 26% of product revenuesfor the corresponding period in 2004. This decrease is due primarily to productmix with a greater percentage of product revenues being from software.

 

Costof product revenues for our Law Enforcement segment decreased 38%, or $95,000from $252,000 or 45% of Law Enforcement product revenues for the three monthsended June 30, 2003 to $157,000, or 17% of product revenues for thecorresponding period in 2004.  Thisdecrease, as a percentage of product revenues is due primarily to the largerrevenue base to absorb fixed product costs and product mix with an uncharacteristicallyhigh percentage of software sales.  Costsof products also can vary as a percentage of product revenue from period toperiod depending upon product mix and the hardware content, print mediaconsumable content and software content included in systems installed during agiven period.

 

Costof product revenues related to our Identification segment decreased 75% or$1,185,000 from $1,579,000 or 51% of Identification product revenues for thethree months ended June 30, 2003 to $394,000 or 35% of Identificationproduct revenues for the corresponding period in 2004.  The dollar decrease is reflective of lowerIdentification revenues both domestically and internationally.  The percentage decrease in Identificationcost of revenues as a percentage of Identification revenues from 51% for thethree months ended June 30, 2003 to 35% for the corresponding period in2004 is reflective higher sales of software only solutions during the threemonths ended June 30, 2004.

 

Costof product revenues related to our Digital Photography segment increased $8,000for the three months ended June 30, 2004 as compared to the correspondingperiod in 2003 due to the sale of certain hardware components in the 2004period as compared to software only sales during the comparable period in 2003

 

 
| ** **                                              | ** ** | **THREE MONTHS  ENDED  JUNE 30,** | ** ** | ** ** | ** ** | ** **      | ** ** |
|---------------------------------------------------------|------------|----------------------------------------|------------|------------|------------|-----------------|------------|
| **Maintenance  cost of revenues**                       | ** ** | **2004**                               | ** ** | **2003**   | ** ** | **$****Change** | ** ** | **%****Change** | ** ** |
|                                                    |       |                                   |       |       |       |            |       |   |   |
| **Maintenance  cost of revenues:**                      |       |                                   |       |       |       |            |       |   |   |
| Law Enforcement                                         |       | $                                      | 190        |       | $          | 215             |       | $ | (25 | ) | -12 | % |
| Percentage of Law Enforcement  maintenance revenue |       | 42                                     | %          | 36         | %          |            |       |   |   |
| Identification                                          |       | $                                      | 32         |       | $          | 99              |       | $ | (67 | ) | -69 | % |
| Percentage of Identification maintenance  revenue       |       | 116                                    | %          | 50         | %          |            |       |   |   |
| Digital Photography                                     |       | $                                      | —     |       | $          | —          |       | $ | — |   | N/A |   |
| Percentage of Digital Photography  maintenance revenue  |       | —                                 | %          | —     | %          | —          |       | N/A |   |
| Total net maintenance revenues                          |       | $                                      | 222        |       | $          | 314             |       | $ | (92 | ) | -29 | % |
| Percentage of total maintenance revenues                |       | 46                                     | %          | 40         | %          |            |       |   |   |

 

Costsof maintenance revenues decreased 29% from $314,000, or 40% of maintenancerevenues, for the three months ended June 30, 2003 to $222,000, or 46% ofmaintenance revenues, for the corresponding period in 2004. Cost of maintenancerevenues in Law Enforcement decreased 12%, from $215,000 or 36% of maintenancerevenues for the three months ended June 30, 2003 to $190,000 or 42% ofmaintenance revenues for the corresponding period in 2003. This dollar decreasein costs of maintenance revenues is reflective of reduced costs due to theexpiration of the New York City Police Department service and maintenancecontract in the third quarter of 2003 offset by costs necessary to service ourexpanding installed base. Identification maintenance cost of revenues decreased$67,000 largely due to the shift in strategy to outsource hardware service andmaintenance in late 2003.

 

15

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| ** **                                         | ** ** | **THREE MONTHS  ENDED  JUNE 30,** | ** ** | ** ** | ** ** | ** **            | ** ** |
|----------------------------------------------------|------------|----------------------------------------|------------|------------|------------|-----------------------|------------|
| **Product  gross profit (dollars in thousands)**   | ** ** | **2004**                               | ** ** | **2003**   | ** ** | **$ ****Change** | ** ** | **%****Change** | ** ** |
|                                               |       |                                   |       |       |       |                  |       |   |   |
| **Product  gross profit**                          |       |                                   |       |       |       |                  |       |   |   |
| Law Enforcement                                    |       | $                                      | 756        |       | $          | 304                   |       | $ | 452 |   | 149 | % |
| Percentage of Law Enforcement product  revenue     |       | 83                                     | %          | 55         | %          |                  |       |   |   |
| Identification                                     |       | $                                      | 747        |       | $          | 1,488                 |       | $ | (741 | ) | -50 | % |
| Percentage of Identification product  revenue      |       | 65                                     | %          | 49         | %          |                  |       |   |   |
| Digital Photography                                |       | $                                      | 128        |       | $          | 203                   |       | $ | (75 | ) | -37 | % |
| Percentage of Digital Photography product  revenue |       | 88                                     | %          | 96         | %          |                  |       |   |   |
| Total net product revenues                         |       | $                                      | 1,631      |       | $          | 1,995                 |       | $ | (364 | ) | -18 | % |
| Percentage of total product revenues               |       | 74                                     | %          | 52         | %          |                  |       |   |   |

 

Totalproduct gross margin as a percentage of product revenues increased from 52% forthe three month period ended June 30, 2003 to 74% of product revenues forthe corresponding period in 2004. The overall increase is primarily due to ahigher percentage of total revenues coming from the sales of software.

 

LawEnforcement gross profit as a percentage of Law Enforcement product revenueincreased from 55% for the three months ended June 30, 2003 to 83% for thecorresponding period of 2004. This increase is due primarily to our product mixcontaining an uncharacteristically  highpercentage of software than the comparable period in 2003, as well as a higherrevenue base to absorb fixed product costs. Costs of products can vary as a percentage of product revenue fromquarter to quarter depending upon product mix and hardware content and printmedia consumable content included in systems installed during a given period.

 

Identification gross profit as a percentage of Identification productrevenue increased from 49% for the three months ended June 30, 2003 to 65%of Identification product revenues for the corresponding period in 2004.  This increase is due primarily to our productmix containing higher percentages of software than the comparable period in2003.  The shift in product mix is aresult of lower sales in the period of hardware and consumables due toprocurement problems experienced during the second quarter of 2004.

 

Grossmargins for the Digital Photography product segment decreased 37% or $75,000,from $203,000 or 96% of Digital Photography product revenues for the threemonths ended June 30, 2003 to $128,000, or 88% of Digital Photographyrevenues for the corresponding period in 2004. The dollar decrease of $75,000is reflective of our lower custom contract programming in the three monthsended June 30, 2004 as compared to the corresponding period in 2003.  The decrease in Digital Photography grossprofit as a percentage of Digital Photography product revenues from 96% for thethree months ended June 30, 2003 to 88% for the corresponding period in2004 is reflective of the sale of certain hardware components during the 2004period.

 
| ** **                                             | ** ** | **THREE MONTHS  ENDED  JUNE 30,** | ** ** | ** ** | ** ** | ** **            | ** ** |
|--------------------------------------------------------|------------|----------------------------------------|------------|------------|------------|-----------------------|------------|
| **Maintenance  gross profit**                          | ** ** | **2004**                               | ** ** | **2003**   | ** ** | **$ ****Change** | ** ** | **%****Change** | ** ** |
| **(dollars  in thousands)**                            | ** ** | ** **                             | ** ** | ** ** | ** ** | ** **            | ** ** | ** ** | ** ** |
|                                                   |       |                                   |       |       |       |                  |       |   |   |
| **Maintenance  gross profit**                          |       |                                   |       |       |       |                  |       |   |   |
| Law Enforcement                                        |       | $                                      | 261        |       | $          | 379                   |       | $ | (118 | ) | -31 | % |
| Percentage of Law Enforcement maintenance  revenue     |       | 58                                     | %          | 64         | %          |                  |       |   |   |
| Identification                                         |       | $                                      | (4         | )          | $          | 99                    |       | $ | (103 | ) | -104 | % |
| Percentage of Identification maintenance  revenue      |       | -14                                    | %          | 50         | %          |                  |       |   |   |
| Digital Photography                                    |       | $                                      | —     |       | $          | 1                     |       | $ | (1 | ) | -100 | % |
| Percentage of Digital Photography  maintenance revenue |       | N/A                                    |       | N/A        |       |                  |       |   |   |
| Total net maintenance revenues                         |       | $                                      | 257        |       | $          | 479                   |       | $ | (222 | ) | -46 | % |
| Percentage of total maintenance revenues               |       | 54                                     | %          | 60         | %          |                  |       |   |   |

 

Grossmargins related to maintenance revenues decreased $222,000 from $479,000, or60% of maintenance revenues for the three months ended June 30, 2003 to$257,000, or 54% of maintenance revenues for the corresponding period in 2004.This percentage decrease is due primarily to lower maintenance revenues toabsorb fixed maintenance costs.

 

16

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| ** **                      | ** ** | **THREE MONTHS ENDED  JUNE 30,** | ** ** | ** ** | ** ** | ** **            | ** ** |
|---------------------------------|------------|---------------------------------------|------------|------------|------------|-----------------------|------------|
| **Operating  expenses**         | ** ** | **2004**                              | ** ** | **2003**   | ** ** | **$ ****Change** | ** ** | **%****Change** | ** ** |
| **(dollars  in thousands)**     | ** ** | ** **                            | ** ** | ** ** | ** ** | ** **            | ** ** | ** ** | ** ** |
|                            |       |                                  |       |       |       |                  |       |   |   |
| General & administrative    |       | $                                     | 1,135      |       | $          | 1,439                 |       | $ | (304 | ) | -21 | % |
| Percentage of total net revenue |       | 42                                    | %          | 31         | %          |                  |       |   |   |
| Sales and marketing             |       | $                                     | 890        |       | $          | 1,048                 |       | $ | (158 | ) | -15 | % |
| Percentage of total net revenue |       | 33                                    | %          | 23         | %          |                  |       |   |   |
| Research & development      |       | $                                     | 722        |       | $          | 437                   |       | $ | 285 |   | 65 | % |
| Percentage of total net revenue |       | 27                                    | %          | 9          | %          |                  |       |   |   |
| Depreciation and amortization   |       | $                                     | 180        |       | $          | 237                   |       | $ | (57 | ) | -24 | % |
| Percentage of total net revenue |       | 7                                     | %          | 5          | %          |                  |       |   |   |

 

*GENERAL AND ADMINISTRATIVE EXPENSES.* General and administrative expenses are comprised primarily of salariesand other employee-related costs for executive, financial, and otherinfrastructure personnel. General legal, accounting and consulting services,insurance, occupancy and communication costs are also included with general andadministrative expenses. Such expenses decreased 21%, or $304,000 from$1,439,000 for the three months ended June 30, 2003 to $1,135,000 for thecorresponding period in 2004.  Suchexpenses, as a percentage of total net revenues, increased from 31% for thethree months ended June 30, 2003 to 42% for the corresponding period in2004.  This percentage increase isreflective of lower total net revenues during the three months endedJune 30, 2004 as compared to the corresponding period in 2003.  We are continuing to focus our efforts onachieving additional future operating efficiencies by reviewing and improvingupon existing business processes and evaluating our cost structure. We believethese efforts will allow us to gradually decrease our level of general andadministrative expenses expressed as a percentage of total revenues.

 

*SALES AND MARKETING.*  Salesand marketing expenses consist primarily of the salaries, commissions, otherincentive compensation, employee benefits and travel expenses of our salesforce. Such expenses decreased 15%, or $158,000 from $1,048,000 for the threemonths ended June 30, 2003 to $890,000 for the corresponding period in2004.  Such expenses, as a percentage oftotal net revenues, increased from 23% for the three months ended June 30,2003 to 33% for the corresponding period in 2004. This percentage increase is reflectiveof lower total net revenues during the three months ended June 30, 2004 ascompared to the corresponding period in 2003. The dollar decrease of $158,000 is due primarily to reduced headcountand lower sales commissions.  Theheadcount reduction reflects the consolidation in 2003 of our product lines andsales force under the direction of our San Diego office.  We anticipate that expenses for sales andmarketing will increase through 2004 as we add personnel and resources forlarge project solution sales.

 

*RESEARCH AND DEVELOPMENT.* Research and development costs consist primarily of salaries, employeebenefits and outside contractors for new product development, productenhancements and custom integration work. Such expenses increased 65% or $285,000from $437,000 for the three months ended June 30, 2003 to $722,000 for thecorresponding period in 2004 due primarily to the accelerateddevelopment of our new ImageWare Biometric Engine and the web enablement of ourCCS product line utilizing contract programming services in conjunction withinternal research and development resources.   Our level of expenditures inresearch and development reflects our belief that to maintain our competitiveposition in markets characterized by rapid rates of technological advancement,we must continue to invest significant resources in new systems and software aswell as continue to enhance existing products.

 

*DEPRECIATION AND AMORTIZATION.* Depreciation and amortization decreased $57,000 from $237,000 for thethree months ended June 30, 2003 to $180,000 for the corresponding periodin 2004. This decrease is due primarily to lower amortization of intangibleassets due to such assets being fully amortized and lower depreciation expenserelated to fixed assets previously utilized in our South Carolina office, whichwas closed in June 2003.

 

*INTEREST (INCOME) EXPENSE, NET.*  Forthe three months ended June 30, 2004, we recognized interest income of$3,000 and interest expense of $3,901,000. For the three months endedJune 30, 2003, we recognized interest income of $1,000 and interestexpense of $1,894,000.  Interest expensefor the three months ended June 30, 2004 contains approximately $3,607,000of interest expense related to fair value accounting for our warrant liabilitydue to the registration rights agreement associated with the underlying sharesof the Company’s common stock to be issued upon conversion of thewarrants.  During the three months endedJune 30, 2004, the Company registered the underlying shares of commonstock with the Securities and Exchange Commission.  In accordance with EITF 00-19, there will beno further interest expense or income incurred in conjunction with thesewarrants.  Interest expense for the threemonths ended June 30, 2004 also contains $290,000 in liquidated damages,which were classified as interest expense. The liquidated damages were incurred as the Company did not meet certaintime requirements for the registration of shares of the Company’s common stockunder the registration rights agreements for the November 2003 andJanuary 2004 private placements. Interest expense for the three months ended June 30, 2003 includesapproximately of $1,410,000 of debt discount and deferred financing feeamortization classified as interest expense and $321,000 related to fair valueaccounting for our warrant liability. The following table sets forth the major components of net interestexpense for the three months ended June 30, 2004 and 2003:

 

17

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| ** **                                                                                                                                                           | ** ** | **THREE MONTHS ENDED  JUNE 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| **Components  of net interest expense (income):**                                                                                                                    | ** ** | **2004**                              | ** ** | **2003** | ** ** |
| **(dollars  in thousands)**                                                                                                                                          | ** ** | ** **                            | ** ** | ** ** | ** ** |
|                                                                                                                                                                 |       |                                  |       |   |   |
| Senior secured convertible promissory note  issued May 22, 2002, interest rate 12.5% due May 22, 2004; Principal amount  $2,000,000                                  |       |                                  |       |   |   |
| Coupon interest rate expense                                                                                                                                         |       | $                                     | —     |   | $ | 102 |   |
| Amortization to interest expense of note  discount related to fair value of warrants                                                                                 |       |                                  |       | 67 |   |
| Amortization to interest expense of note  discount related to beneficial conversion feature                                                                          |       |                                  |       | 1,001 |   |
| Interest expense from amortization of  deferred financing fees                                                                                                       |       |                                  |       | 219 |   |
|                                                                                                                                                                 |       |                                  |       |   |   |
| Secured demand promissory note issued  September, 2002, interest rate 12.5%, due upon demand                                                                         |       | —                                |       | 11 |   |
|                                                                                                                                                                 |       |                                  |       |   |   |
| Subordinated convertible promissory notes  issued                                                                                                                    |       |                                  |       |   |   |
| March 2003, interest rate 8.5%, due  April 15, 2005; principal amount $600,000                                                                             |       |                                  |       |   |   |
| Coupon interest rate expense                                                                                                                                         |       |                                  |       | 13 |   |
| Amortization to interest expense of note  discount related to beneficial conversion feature                                                                          |       |                                  |       | 13 |   |
| Interest expense from amortization of deferred  financing fees                                                                                                       |       |                                  |       | 7 |   |
|                                                                                                                                                                 |       |                                  |       |   |   |
| Senior secured convertible promissory notes  issued June 2003, interest rate 12.5% due May 22, 2005, principal amount  $4,256,000; (“the New Notes”): |       |                                  |       |   |   |
| Coupon interest rate expense                                                                                                                                         |       |                                  |       | 22 |   |
| Amortization to interest expense of note  discount related to fair value of warrants                                                                                 |       |                                  |       | 44 |   |
| Amortization to interest expense of note  discount relating to beneficial conversion feature                                                                         |       |                                  |       | 44 |   |
| Interest expense from amortization of  deferred financing fees                                                                                                       |       |                                  |       | 15 |   |
| Other note payable interest expense                                                                                                                                  |       | 4                                     |       | 14 |   |
|                                                                                                                                                                 |       |                                  |       |   |   |
| Change in warrant liability classified as  interest (income) or expense                                                                                              |       | 3,607                                 |       | 321 |   |
|                                                                                                                                                                 |       |                                  |       |   |   |
| Interest expense from incurrence of  liquidated damages related to non-timely registration of common stock                                                           |       | 290                                   |       | — |   |
|                                                                                                                                                                 |       |                                  |       |   |   |
| Interest income                                                                                                                                                      |       | (3                                    | )          | — |   |
|                                                                                                                                                                 |       |                                  |       |   |   |
| Net interest (income) expense                                                                                                                                        |       | $                                     | 3,898      |   | $ | 1,893 |   |

 

***SIX MONTHS ENDED JUNE 30, 2004 AND2003.***

 
| ** **                              | ** ** | **SIX MONTHS  ENDED  JUNE 30,** | ** ** | ** ** | ** ** | ** **      | ** ** |
|-----------------------------------------|------------|--------------------------------------|------------|------------|------------|-----------------|------------|
| **Net  Product Revenues**               | ** ** | **2004**                             | ** ** | **2003**   | ** ** | **$****Change** | ** ** | **% Change** | ** ** |
| **(dollars  in thousands)**             | ** ** | ** **                           | ** ** | ** ** | ** ** | ** **      | ** ** | ** ** | ** ** |
|                                    |       |                                 |       |       |       |            |       |   |   |
| **Product  revenues:**                  |       |                                 |       |       |       |            |       |   |   |
| Law Enforcement                         |       | $                                    | 1,694      |       | $          | 760             |       | $ | 934 |   | 123 | % |
| Percentage of total net product revenue |       | 42                                   | %          | 11         | %          |            |       |   |   |
| Identification                          |       | $                                    | 2,085      |       | $          | 5,236           |       | $ | (3,151 | ) | -60 | % |
| Percentage of total net product revenue |       | 51                                   | %          | 82         | %          |            |       |   |   |
| Digital Photography                     |       | $                                    | 300        |       | $          | 473             |       | $ | (173 | ) | -37 | % |
| Percentage of total net product revenue |       | 7                                    | %          | 7          | %          |            |       |   |   |
| Total net product revenues              |       | $                                    | 4,079      |       | $          | 6,469           |       | $ | (2,390 | ) | -37 | % |

 

Totalproduct revenues decreased 37% from $6,469,000 for the six months endedJune 30, 2003 to $4,079,000 for the corresponding period in 2004. Revenuesrelated to law enforcement products increased $934,000 for the six months endedJune 30, 2004 as compared to the corresponding period in 2003.  This increase is due primarily to revenuesfrom our implementation of a browser-based, investigative law enforcementsystem for the New South Wales Police Department and increased sales of our CCSand Face ID products.  We believe thatthe increase in terrorism has created heightened interest in the ability of lawenforcement and other

 

18

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governmentagencies to be able to efficiently retrieve, analyze and share information fromtheir respective criminal databases.  Weanticipate that these factors will continue to increase the overall demand forthe Company’s law enforcement products, however, we cannot predict the timingof the shift in demand.

 

Identificationproduct revenues decreased 60% from $5,236,000 for the six months endedJune 30, 2003 to $2,085,000 for the corresponding period in 2004.  Domestically, Identification revenuesdecreased approximately $1,142,000, or 45%. This decrease in domestic revenue is reflective of a decrease inproject-oriented work and a decrease in boxed software sold throughdistribution channels.  In mid 2003, weestablished a master distributor to handle our domestic sales of our EPI lineof boxed software.  The masterdistributor model has not produced the results we anticipated and we haveterminated that arrangement effective June of this year and havere-established direct sales to our distribution channel.  Internationally, our Identification revenuesdecreased approximately $2,009,000.  This decrease is a result of actions taken in the fourth quarter of 2003to reposition our foreign sales offices in Germany and Singapore tolower fixed costs and pursue significant Identification projects utilizing theCompany’s software technologies as our primary differentiator.  These offices had historically emphasized theresale of third party merchandise (hardware and consumables) which generatedlower gross margins than software (as a percentage of revenue) and requiredsignificant fixed costs for sales, service and support.  Revenues from these two offices were $2.0million below their levels in the first six months of 2003, however, fixedcosts during the quarter were approximately $840,000 lower than the previousyear.  The Company feels that foreign marketsserved by these offices will embrace the Company’s identification and biometricsolutions for large-scale high-end installations.  We continue to be of the opinion thatgovernment agencies and private entities will react to heightened securityconcerns resulting from acts of terrorism by re-evaluating and upgrading theirability to positively identify and track their citizens, employees, consultants and visitors. Weanticipate that these factors will increase overall demand for the Company’sidentification products; however, we cannot predict the timing of the shift indemand.

 

Wefeel that we are well positioned for participation in one or more large-scaledomestic or international projects which will enable the Company to achievesignificant product revenue growth in our identification segment.  In the past twelve months we have retooledour identification products to enable customization for large projectapplications, added the biometric engine for incorporation into large scalebiometric installations and reoriented our organization to direct our resourcesand capabilities toward establishing a foothold in the market for large-scalesecure identification solutions.

 

DigitalPhotography product revenues decreased 37% from $473,000 for the six monthsended June 30, 2003 to $300,000 for the corresponding period in 2004.  This decrease is due to a decrease in customcontract programming during the first six months of  2004.

 
| ** **                                  | ** ** | **SIX MONTHS  ENDED  JUNE 30,** | ** ** | ** ** | ** ** | ** **            | ** ** |
|---------------------------------------------|------------|--------------------------------------|------------|------------|------------|-----------------------|------------|
| **Maintenance  Revenues**                   | ** ** | **2004**                             | ** ** | **2003**   | ** ** | **$ ****Change** | ** ** | **%****Change** | ** ** |
| **(dollars  in thousands)**                 | ** ** | ** **                           | ** ** | ** ** | ** ** | ** **            | ** ** | ** ** | ** ** |
|                                        |       |                                 |       |       |       |                  |       |   |   |
| **Maintenance  revenues:**                  |       |                                 |       |       |       |                  |       |   |   |
| Law Enforcement                             |       | $                                    | 883        |       | $          | 1,181                 |       | $ | (298 | ) | -25 | % |
| Percentage of total net maintenance revenue |       | 92                                   | %          | 74         | %          |                  |       |   |   |
| Identification                              |       | $                                    | 79         |       | $          | 408                   |       | $ | (329 | ) | -81 | % |
| Percentage of total net maintenance revenue |       | 8                                    | %          | 26         | %          |                  |       |   |   |
| Digital Photography                         |       | $                                    | 1          |       | $          | 1                     |       | $ | — |   | 0 |   |
| Percentage of total net maintenance revenue |       | 0                                    | %          | 0          | %          |                  |       |   |   |
| Total net maintenance revenues              |       | $                                    | 963        |       | $          | 1,590                 |       | $ | (627 | ) | -39 | % |

 

Maintenancerevenues decreased 39% from $1,590,000 for the six months ended June 30,2003 to $963,000 for the corresponding period in 2004.  Law enforcement maintenance revenuesdecreased 25% or $298,000 for the six months ended June 30, 2004 from$1,181,000 for the six months ended June 30, 2003 to $883,000 for thecorresponding period in 2004. This decrease is due primarily to the expirationof the New York City Police Department service and maintenance contract duringthe third quarter of 2003.

 

Identificationmaintenance revenues decreased 81% or $329,000 for the six months endedJune 30, 2004 from $408,000 for the six months ended June 30, 2004 to$79,000 for the corresponding period in 2003. This decrease is due primarily tothe shift in our strategy in late 2003 to outsource international service andmaintenance for hardware.  This shift hasenabled the Company to reduce costs and focus its resources on expanding ourinternational sales effort of Digital Identification, Biometric, LawEnforcement and Digital Photography solutions.

 

19

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| ** **                                         | ** ** | **SIX MONTHS  ENDED  JUNE 30,** | ** ** | ** ** | ** ** | ** **            | ** ** |
|----------------------------------------------------|------------|--------------------------------------|------------|------------|------------|-----------------------|------------|
| **Cost  of Product Revenues:**                     | ** ** | **2004**                             | ** ** | **2003**   | ** ** | **$ ****Change** | ** ** | **%****Change** | ** ** |
| **(dollars  in thousands)**                        | ** ** | ** **                           | ** ** | ** ** | ** ** | ** **            | ** ** | ** ** | ** ** |
|                                               |       |                                 |       |       |       |                  |       |   |   |
| **Cost of  Product Revenues:**                     |       |                                 |       |       |       |                  |       |   |   |
| Law Enforcement                                    |       | $                                    | 341        |       | $          | 416                   |       | $ | (75 | ) | -18 | % |
| Percentage of Law Enforcement product  revenue     |       | 20                                   | %          | 55         | %          |                  |       |   |   |
| Identification                                     |       | $                                    | 696        |       | $          | 2,632                 |       | $ | (1,936 | ) | -74 | % |
| Percentage of Identification product  revenue      |       | 33                                   | %          | 50         | %          |                  |       |   |   |
| Digital Photography                                |       | $                                    | 33         |       | $          | 29                    |       | $ | 4 |   | 14 | % |
| Percentage of Digital Photography product  revenue |       | 11                                   | %          | 6          | %          |                  |       |   |   |
| Total net product revenues                         |       | $                                    | 1,070      |       | $          | 3,077                 |       | $ | (2,007 | ) | -65 | % |
| Percentage of total product revenues               |       | 26                                   | %          | 48         | %          |                  |       |   |   |

 

Totalcost of product revenues as a percentage of product revenues decreased from 48%for the six month period ended June 30, 2003 to 26% of product revenuesfor the corresponding period in 2004. This decrease is due primarily to productmix with a greater percentage of product revenues being from software.

 

Costof product revenues for our Law Enforcement segment decreased 18%, or $75,000from $416,000 or 55% of Law Enforcement product revenues for the six monthsended June 30, 2003 to $341,000, or 20% of product revenues for thecorresponding period in 2004.  This decrease,as a percentage of product revenues is due primarily to the larger revenue baseto absorb fixed product costs and product mix with a higher percentage ofsoftware sales.  The dollar decrease of$75,000 for the six month period ended June 30, 2004 as compared with thecorresponding period of 2003 despite higher law enforcement revenues isreflective of an uncharacteristically high percentage of software onlysolutions.   Costs of products also canvary as a percentage of product revenue from period to period depending uponproduct mix and the hardware content, print media consumable content andsoftware content included in systems installed during a given period.

 

Costof product revenues related to our Identification segment decreased 74% or$1,936,000 from $2,632,000 or 50% of Identification product revenues for thesix months ended June 30, 2003 to $696,000 or 33% of Identificationproduct revenues for the corresponding period in 2004.  The dollar decrease of $1,936,000 isreflective of lower identification revenues both domestically and internationallyin the six month period ended June 30, 2004 as compared to thecorresponding period in 2003.  Thedecrease in Identification cost of product revenues as a percentage ofIdentification revenues from 50% for the six month period ended June 30,2003 to 33% for the corresponding period in 2004 is reflective of higher salesof software only solutions and procurement problems relating to our primaryidentification card printer and related print media consumables, which causedsignificant delays in our ability to ship identification printers and relatedmedia.  Costs of products also can varyas a percentage of product revenue from period to period depending upon productmix and the hardware content, print media consumable content and softwarecontent included in systems installed during a given period.

 
| ** **                                              | ** ** | **SIX MONTHS  ENDED  JUNE 30,** | ** ** | ** ** | ** ** | ** **            | ** ** |
|---------------------------------------------------------|------------|--------------------------------------|------------|------------|------------|-----------------------|------------|
| **Maintenance  cost of revenues**                       | ** ** | **2004**                             | ** ** | **2003**   | ** ** | **$ ****Change** | ** ** | **%****Change** | ** ** |
|                                                    |       |                                 |       |       |       |                  |       |   |   |
| **Maintenance  cost of revenues:**                      |       |                                 |       |       |       |                  |       |   |   |
| Law Enforcement                                         |       | $                                    | 385        |       | $          | 438                   |       | $ | (53 | ) | -12 | % |
| Percentage of Law Enforcement  maintenance revenue |       | 44                                   | %          | 37         | %          |                  |       |   |   |
| Identification                                          |       | $                                    | 85         |       | $          | 231                   |       | $ | (146 | ) | -63 | % |
| Percentage of Identification maintenance  revenue       |       | 107                                  | %          | 57         | %          |                  |       |   |   |
| Digital Photography                                     |       | $                                    | —     |       | $          | —                |       | $ | — |   | N/A |   |
| Percentage of Digital Photography  maintenance revenue  |       |                                 | %          |       | %          |                  |       |   |   |
| Total net maintenance revenues                          |       | $                                    | 470        |       | $          | 669                   |       | $ | (199 | ) | -30 | % |
| Percentage of total maintenance revenues                |       | 49                                   | %          | 42         | %          |                  |       |   |   |

 

Costsof maintenance revenues decreased 30% from $669,000, or 42% of maintenancerevenues, for the six months ended June 30, 2003 to $470,000, or 49% ofmaintenance revenues, for the corresponding period in 2004. Cost of maintenancerevenues in Law Enforcement decreased 12%, from $438,000 or 37% of maintenancerevenues for the six months ended June 30, 2003 to $385,000 or 44% ofmaintenance revenues for the corresponding period in 2003. This dollar decreasein costs of maintenance revenues is reflective of reduced costs due to theexpiration of the New York City Police Department service and maintenancecontract in the third quarter of 2003 offset by costs necessary to service ourexpanding installed base. Identification maintenance cost of revenues decreased$146,000 largely due to the shift in strategy to outsource internationalhardware service and maintenance in late 2003.

 

20

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| **Product gross profit (dollars  in thousands)**   | ** ** | **SIX MONTHS  ENDED  JUNE 30,** | ** ** | ** ** | ** **            | ** ** | ** **      |
|----------------------------------------------------|------------|--------------------------------------|------------|------------|-----------------------|------------|-----------------|
| ** **                                         | **2004**   | ** **                           | **2003**   | ** ** | **$ ****Change** | ** ** | **%****Change** | ** ** |
|                                               |       |                                 |       |       |                  |       |            |   |   |
| **Product  gross profit**                          |       |                                 |       |       |                  |       |            |   |   |
| Law Enforcement                                    |       | $                                    | 1,354      |       | $                     | 344        |            | $ | 1,010 |   | 294 | % |
| Percentage of Law Enforcement product  revenue     |       | 80                                   | %          | 45         | %                     |       |            |   |   |
| Identification                                     |       | $                                    | 1,388      |       | $                     | 2,604      |            | $ | (1,216 | ) | -47 | % |
| Percentage of Identification product  revenue      |       | 67                                   | %          | 50         | %                     |       |            |   |   |
| Digital Photography                                |       | $                                    | 267        |       | $                     | 445        |            | $ | (178 | ) | -40 | % |
| Percentage of Digital Photography product  revenue |       | 89                                   | %          | 94         | %                     |       |            |   |   |
| Total net product revenues                         |       | $                                    | 3,009      |       | $                     | 3,393      |            | $ | (384 | ) | -11 | % |
| Percentage of total product revenues               |       | 74                                   | %          | 52         | %                     |       |            |   |   |

 

Totalproduct gross margin as a percentage of product revenues increased from 52% forthe six month period ended June 30, 2003 to 74% of product revenues forthe corresponding period in 2004. The overall increase is primarily due to ahigher percentage of total revenues coming from the sales of software.

 

LawEnforcement gross profit as a percentage of Law Enforcement product revenueincreased from 45% for the six months ended June 30, 2003 to 80% for thecorresponding period of 2004. This increase is due primarily to our product mixcontaining uncharacteristically high percentages of software than thecomparable period in 2003, as well as a higher revenue base to absorb fixedproduct costs.  Costs of products canvary as a percentage of product revenue from quarter to quarter depending uponproduct mix and hardware content and print media consumable content included insystems installed during a given period.

 

Identification gross profit as a percentage of Identification productrevenue increased from 50% for the six months ended June 30, 2003 to 67%of Identification product revenues for the corresponding period in 2004.  This increase is due primarily to our productmix containing higher percentages of software than the comparable period in2003.  The shift in product mix is aresult of lower sales in the period of hardware and consumables due toprocurement problems experienced during the first and second quarter of 2004.

 

Grossmargins for the Digital Photography product segment decreased 40% or $178,000,from $445,000 or 94% of Digital Photography product revenues for the six monthsended June 30, 2003 to $267,000, or 89% of Digital Photography revenuesfor the corresponding period in 2004. This decrease of $178,000 resultsprimarily from lower custom contract programming in the six months endedJune 30, 2004 as compared to the corresponding period in 2003.

 
| **Maintenance  gross profit**                          | ** ** | **SIX MONTHS  ENDED  JUNE 30,** | ** ** | ** ** | ** **      | ** ** | ** **      |
|--------------------------------------------------------|------------|--------------------------------------|------------|------------|-----------------|------------|-----------------|
| ** **                                             | **2004**   | ** **                           | **2003**   | ** ** | **$****Change** | ** ** | **%****Change** | ** ** |
| **(dollars in thousands)**                             |       |                                 |       |       |            |       |            |   |   |
|                                                   |       |                                 |       |       |            |       |            |   |   |
| **Maintenance  gross profit**                          |       |                                 |       |       |            |       |            |   |   |
| Law Enforcement                                        |       | $                                    | 498        |       | $               | 743        |            | $ | (245 | ) | -33 | % |
| Percentage of Law Enforcement maintenance  revenue     |       | 56                                   | %          | 63         | %               |       |            |   |   |
| Identification                                         |       | $                                    | (6         | )          | $               | 177        |            | $ | (183 | ) | -103 | % |
| Percentage of Identification maintenance  revenue      |       | -8                                   | %          | 43         | %               |       |            |   |   |
| Digital Photography                                    |       | $                                    | 1          |       | $               | 1          |            | $ | — |   | 0 | % |
| Percentage of Digital Photography  maintenance revenue |       | 100                                  | %          | 100        | %               |       |            |   |   |
| Total net maintenance revenues                         |       | $                                    | 493        |       | $               | 921        |            | $ | (428 | ) | -46 | % |
| Percentage of total maintenance revenues               |       | 51                                   | %          | 58         | %               |       |            |   |   |

 

Grossmargins related to maintenance revenues decreased $428,000 from $921,000, or58% of maintenance revenues for the six months ended June 30, 2003 to$493,000, or 51% of maintenance revenues for the corresponding period in 2004.This percentage decrease is due primarily to lower maintenance revenues to absorbfixed maintenance costs.

 

21

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| **Operating  expenses**         | ** ** | **SIX MONTHS ENDED  JUNE 30,** | ** ** | ** ** | ** **      | ** ** | ** **      |
|---------------------------------|------------|-------------------------------------|------------|------------|-----------------|------------|-----------------|
| ** **                      | **2004**   | ** **                          | **2003**   | ** ** | **$****Change** | ** ** | **%****Change** | ** ** |
| **(dollars in thousands)**      | ** ** | ** **                          | ** ** | ** ** | ** **      | ** ** | ** **      | ** ** | ** ** |
|                            |       |                                |       |       |            |       |            |   |   |
| General & administrative    |       | $                                   | 2,277      |       | $               | 2,881      |            | $ | (604 | ) | -21 | % |
| Percentage of total net revenue |       | 45                                  | %          | 36         | %               |       |            |   |   |
| Sales and marketing             |       | $                                   | 1,572      |       | $               | 2,137      |            | $ | (565 | ) | -26 | % |
| Percentage of total net revenue |       | 31                                  | %          | 27         | %               |       |            |   |   |
| Research & development      |       | $                                   | 1,355      |       | $               | 931        |            | $ | 424 |   | 46 | % |
| Percentage of total net revenue |       | 27                                  | %          | 12         | %               |       |            |   |   |
| Depreciation and amortization   |       | $                                   | 371        |       | $               | 473        |            | $ | (102 | ) | -22 | % |
| Percentage of total net revenue |       | 7                                   | %          | 6          | %               |       |            |   |   |

 

*GENERAL AND ADMINISTRATIVE EXPENSES.*  General and administrative expenses arecomprised primarily of salaries and other employee-related costs for executive,financial, and other infrastructure personnel. General legal, accounting andconsulting services, insurance, occupancy and communication costs are alsoincluded with general and administrative expenses. Such expenses decreased 21%,or $604,000 from $2,881,000 for the six months ended June 30, 2003 to$2,277,000 for the corresponding period in 2004.  Such expenses, as a percentage of total netrevenues, increased from 36% for the six months ended June 30, 2003 to 45%for the corresponding period in 2004. This percentage increase is reflective of lower total net revenuesduring the six months ended June 30, 2004 as compared to the correspondingperiod in 2003.  We are continuing tofocus our efforts on achieving additional future operating efficiencies byreviewing and improving upon existing business processes and evaluating ourcost structure. We believe these efforts will allow us to gradually decreaseour level of general and administrative expenses expressed as a percentage oftotal revenues.

 

*SALES AND MARKETING.*  Salesand marketing expenses consist primarily of the salaries, commissions, otherincentive compensation, employee benefits and travel expenses of our salesforce. Such expenses decreased 26%, or $565,000 from $2,137,000 for the sixmonths ended June 30, 2003 to $1,572,000 for the corresponding period in2004.  Such expenses, as a percentage oftotal net revenues, increased from 27% for the six months ended June 30,2003 to 31% for the corresponding period in 2004.  The dollar decrease of $565,000 is dueprimarily to reduced headcount and lower sales commissions.  The headcount reduction reflects theconsolidation in 2003 of our product lines and sales force under the directionof our San Diego office.  We anticipatethat expenses for sales and marketing will increase through 2004 as we addpersonnel and resources for large project solution sales.

 

*RESEARCH AND DEVELOPMENT.* Research and development costs consist primarily of salaries, employeebenefits and outside contractors for new product development, productenhancements and custom integration work. Such expenses increased 46% or$424,000 from $931,000 for the six months ended June 30, 2003 to$1,355,000 for the corresponding period in 2004 due primarily to theaccelerated development of our new ImageWare Biometric Engine and the webenablement of our CCS product line utilizing contract programming services inconjunction with internal research and development resources.   Ourlevel of expenditures in research and development reflects our belief that tomaintain our competitive position in markets characterized by rapid rates oftechnological advancement, we must continue to invest significant resources innew systems and software as well as continue to enhance existing products.

 

*DEPRECIATION AND AMORTIZATION.* Depreciation and amortization decreased $102,000 from $473,000 for thesix months ended June 30, 2003 to $371,000 for the corresponding period in2004. This decrease is due primarily to lower amortization of intangible assetsdue to such assets being fully amortized and lower depreciation expense relatedto fixed assets previously utilized in our South Carolina office, which wasclosed in June 2003.

 

*INTEREST (INCOME) EXPENSE, NET.*  Forthe six months ended June 30, 2004, we recognized interest income of$3,000 and interest expense of $5,192,000. For the six months endedJune 30, 2003, we recognized interest income of $2,000 and interestexpense of $2,256,000.  Interest expensefor the six months ended June 31, 2004 contains approximately $4,472,000of interest expense related to fair value accounting for our warrant liabilitydue to the registration rights agreement associated with the underlying sharesof the Company’s common stock to be issued upon conversion of thewarrants.  During the three months endedJune 30, 2004, the Company registered the underlying shares of commonstock with the Securities and Exchange Commission.  In accordance with EITF 00-19, there will beno further interest expense or income incurred in conjunction with thesewarrants.  Interest expense for the sixmonths ended June 30, 2004 also contains $713,000 in liquidated damages,which were classified as interest expense. The liquidated damages were incurred as the Company did not meet certaintime requirements for the registration of shares of the Company’s common stockunder the registration rights agreements for the November 2003 andJanuary 2004 private placements.  Interestexpense for the six months ended June 30, 2003 includes approximately of$1,645,000 of debt discount and deferred financing fee amortization classifiedas interest expense and $321,000 related to fair value accounting for ourwarrant liability.  The following tablesets forth the major components of net interest expense for the six monthsended June 30, 2004 and 2003:

 

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| **Components of net interest  expense (income):**                                                                                                                    | ** ** | **SIX MONTHS ENDED  JUNE 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                                                                           | **2004**   | ** **                          | **2003**   | ** ** |
| **(dollars in thousands)**                                                                                                                                           | ** ** | ** **                          | ** ** | ** ** | ** ** |
|                                                                                                                                                                 |       |                                |       |   |   |
| Senior secured convertible promissory note  issued May 22, 2002, interest rate 12.5% due May 22, 2004; Principal amount  $2,000,000                                  |       |                                |       |   |   |
| Coupon interest rate expense                                                                                                                                         |       | $                                   | —     |   | $ | 199 |   |
| Amortization to interest expense of note  discount related to fair value of warrants                                                                                 |       |                                |       | 134 |   |
| Amortization to interest expense of note  discount related to beneficial conversion feature                                                                          |       |                                |       | 1,118 |   |
| Interest expense from amortization of  deferred financing fees                                                                                                       |       |                                |       | 267 |   |
|                                                                                                                                                                 |       |                                |       |   |   |
| Secured demand promissory note issued  September, 2002, interest rate 12.5%, due upon demand                                                                         |       | —                              |       | 27 |   |
|                                                                                                                                                                 |       |                                |       |   |   |
| Subordinated convertible promissory notes  issued March 2003, interest rate 8.5%, due April 15, 2005;  principal amount $600,000                           |       |                                |       |   |   |
| Coupon interest rate expense                                                                                                                                         |       |                                |       | 14 |   |
| Amortization to interest expense of note  discount related to beneficial conversion feature                                                                          |       |                                |       | 15 |   |
| Interest expense from amortization of  deferred financing fees                                                                                                       |       |                                |       | 8 |   |
|                                                                                                                                                                 |       |                                |       |   |   |
| Senior secured convertible promissory notes  issued June 2003, interest rate 12.5% due May 22, 2005, principal amount  $4,256,000; (“the New Notes”): |       |                                |       |   |   |
| Coupon interest rate expense                                                                                                                                         |       |                                |       | 22 |   |
| Amortization to interest expense of note  discount related to fair value of warrants                                                                                 |       |                                |       | 44 |   |
| Amortization to interest expense of note  discount relating to beneficial conversion feature                                                                         |       |                                |       | 44 |   |
| Interest expense from amortization of  deferred financing fees                                                                                                       |       |                                |       | 15 |   |
|                                                                                                                                                                 |       |                                |       |   |   |
| Other note payable interest expense                                                                                                                                  |       | 7                                   |       | 28 |   |
|                                                                                                                                                                 |       |                                |       |   |   |
| Change in warrant liability classified as  interest (income) or expense                                                                                              |       | 4,472                               |       | 321 |   |
|                                                                                                                                                                 |       |                                |       |   |   |
| Interest expense from incurrence of  liquidated damages related to non-timely registration of common stock                                                           |       | 713                                 |       | — |   |
|                                                                                                                                                                 |       |                                |       |   |   |
| Interest income                                                                                                                                                      |       | (3                                  | )          | (2 | ) |
|                                                                                                                                                                 |       |                                |       |   |   |
| Net interest (income) expense                                                                                                                                        |       | $                                   | 5,189      |   | $ | 2,254 |   |

 

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*LIQUIDITY AND CAPITAL RESOURCES*

 

Asof June 30, 2004, we had total current assets of $6,909,000 and totalcurrent liabilities of $3,359,000, or working capital of $3,550,000. AtJune 30, 2004, we had available cash of $3,727,000 and $107,000 inrestricted cash securing our performance on certain software implementationcontracts.

 

Netcash used in operating activities was $2,770,000 for the six month period endedJune 30, 2004 as compared to $1,474,000 for the corresponding period in2003. We used cash to fund net losses of $2,390,000, excluding non-cashexpenses (depreciation, amortization and change in warrant liability) of$4,843,000 for the six months ended June 30, 2004.  We used cash to fund net losses of$1,842,000, excluding non-cash expenses (depreciation, amortization and changein warrant liability) of $2,348,000 for the corresponding period in 2003. Forthe six months ended June 30, 2004, we used cash of $563,000 to fundincreases in current assets and generated cash of $183,000 through increases incurrent liabilities and deferred revenues, excluding debt. In the first sixmonths of 2003, we generated cash of $1,039,000 from reductions to currentassets and used cash of $671,000 from reductions in current liabilities anddeferred revenues, excluding debt.

 

Netcash used by investing activities was $122,000 for the six months endedJune 30, 2004 as compared to $203,000 for the corresponding period in2003. For the six months ended June 30, 2004, we used cash to fund capitalexpenditures of computer equipment and software, furniture and fixtures andleasehold improvements of approximately $63,000. The level of equipmentpurchases resulted primarily from continued growth of the business andreplacement of older equipment. For the six months ended June 30, 2004, weused cash of approximately $59,000 to repay advances from related stockholders.For the six months ended June 30, 2003, we used cash of $134,000 to fundcapital expenditures of computer equipment, software, furniture and fixtures.We used cash of $128,000 to repay advances from related stockholders andgenerated cash of $59,000 from the sale of equipment.

 

Netcash provided by financing activities was $6,095,000 for the six month periodended June 30, 2004 as compared to $1,988,000 for the corresponding period in 2003.  For the six months ended June 30, 2004,we generated cash of $6,054,000 from  ourissuance of common stock in a private placement.  We also generated cash of $257,000 from theexercise of stock options.   For the sixmonth period ended June 30, 2004, we used cash of $185,000 for the paymentof dividends on our Series B Preferred Stock and used cash of $31,000 for therepayment of notes payable.  For the sixmonths ended June 30, 2003, we generated cash of $4,856,000 from ourissuance of subordinated convertible promissory notes payable offset by$554,000 in debt issuance costs and $2,500,000 for the repayment of notespayable.  We also generated cash of$186,000 from short-term borrowings under bank line of credit agreements.

 

We conduct operations in leased facilities under operating leasesexpiring at various dates through 2006. In conjunction with our performance onvarious software installation and implementation contracts, we are contingentlyliable under an irrevocable letter of credit in the amount of $106,000. Theletter of credit expires on December 26, 2008.  We also have various short-term notes payabledue at various times during the next twelve months.

 

Webelieve that our current cash balances will satisfy our projected workingcapital and capital expenditure requirements for at least the next12 months. Thereafter, we anticipate continuing to use cash, cashequivalents, and short-term investment balances to satisfy our projected workingcapital and capital expenditure requirements. However, because of our concernthat currently weak economic conditions may continue through 2004, if not longer, we havetaken and continue to take steps to limit our expenses and align our coststructure to our revenues. These steps include, among other things, consideringand/or taking steps, as needed, to restructure our business, consolidating ouroperations, negotiating volume pricing with vendors, centralizing certainservices, and standardizing products. We recognize that our operating expenselevels, including research, development, engineering, selling, marketing,general and administrative expenses, depend on anticipated business activitylevels. While research, development, engineering and marketing expenses arebased on anticipated investment levels in technology development, productdevelopment and market development activities, the appropriate expense levelsin selling, general and administrative expenses are dependant on the level ofinfrastructure required to support our anticipated business volume. We reviewour business plans periodically to determine the appropriate level of suchexpenses based on various business factors. In the past we have takenappropriate measures to control our expenses based on business circumstances.In the future we will continue to review our business plans from time to timeand make appropriate changes to our expense levels, as we have in the past, toreduce operating expenses where it is advantageous to do so to improveoperational efficiencies.

 

In order to takeadvantage of opportunities, we may find it necessary to obtain additionalequity financing, debt financing, or credit facilities although we do notbelieve at this time that our long-term working capital and capitalexpenditures will be of such a nature that we would be required to take stepspresently to obtain such financings. If it were necessary to obtain additionalfinancings or credit facilities, we may not be able to do so, or if these fundsare available, they may not be available on satisfactory terms.

 

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**RISK FACTORS**

 

**WE HAVE A HISTORY OF SIGNIFICANT RECURRINGLOSSES TOTALLING APPROXIMATELY $53.5 MILLION, AND THESE LOSSES MAY CONTINUE INTHE FUTURE.**

 

As of June 30, 2004, we had an accumulated deficit of $53.5million, and these losses may continue in the future. We may need to raisecapital to cover these losses, and financing may not be available to us onfavorable terms. We expect to continue to incur significant sales andmarketing, research and development, and general and administrative expenses.As a result, we will need to generate significant revenues to achieveprofitability and may never achieve profitability.

 

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

 

Our Board of Directors has the authority to issue a total of up to4,000,000 shares of preferred stock and to fix the rights, preferences,privileges, and restrictions, including voting rights, of the preferred stock,which typically are senior to the rights of the common shareholders, withoutany further vote or action by you and the other common shareholders. Yourrights will be subject to, and may be adversely affected by, the rights of theholders of the preferred stock that have been issued, or might be issued in thefuture. Preferred stock could also have the effect of making it more difficultfor a third party to acquire a majority of the outstanding voting stock ofImageWare. This could delay, defer, or prevent a change in control.Furthermore, holders of preferred stock may have other rights, includingeconomic rights, senior to the common stock. As a result, their existence andissuance could have a material adverse effect on the market value of the commonstock. We have in the past issued, and, may from time to time in the futureissue, preferred stock for financing or other purposes with rights,preferences, or privileges senior to the common stock.

 

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

 

Pursuant to the terms of our Series B Preferred Stock we are obligatedto pay cumulative cash dividends on shares of Series B Preferred Stock fromlegally available funds at the annual rate of $0.2125 per share, payable in twosemi-annual installments of $0.10625 each, which cumulative dividends must bepaid prior to payment of any dividend on our Common Stock.  As of June 30, 2004, the Company hadcumulative undeclared dividends of approximately $4,000.

 

**WE DEPEND UPON A SMALL NUMBER OF LARGE SYSTEMSALES RANGING FROM $300,000 TO IN EXCESS OF $1,000,000, AND WE MAY FAIL TOACHIEVE ONE OR MORE LARGE SYSTEM SALES IN THE FUTURE.**

 

In the past three years we have derived a substantial portion of ourrevenues from a small number of sales of large, relatively expensive systems,typically ranging in price from $300,000 to in excess of  $1,000,000. As a result, if we fail to receiveorders for these large systems in a given sales cycle on a consistent basis,our business could be significantly harmed. Further, our quarterly results aredifficult to predict because we cannot predict in which quarter, if any, largesystem sales will occur in a given year. As a result, we believe thatquarter-to-quarter comparisons of our results of operations are not a goodindication of our future performance. In some future quarters our operatingresults may be below the expectations of securities analysts and investors, inwhich case the market price of our common stock may decrease significantly.

 

**OUR RELIANCE ON SINGLE SOURCE SUPPLIERS COULDDELAY PRODUCT SHIPMENTS.**

 

We purchase printers, cameras and custom consumable products (printerribbons and card materials) which we resell to our customers.  There are a number of suppliers that sellthese items; however, in some cases these are purchased from a single supplierdue to price, quality, technology or customer requirements.  If we are unable to purchase sufficientquantities of these products on acceptable terms or experience significantdelays or quality issues in the delivery of these products and must find a newsupplier of equivalent products, our new and existing product shipments couldbe delayed or reduced, adversely affecting our business and operating results.

 

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

 

When considering the purchase of a large computerized booking oridentification system, a government agency may take as long as a year toevaluate different systems and obtain approval for the purchase. If we fail tocomplete a sale, we will have expended significant resources and received norevenue in return. Generally, agencies consider a wide range of issues beforecommitting to

 

25

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purchase our products, including product benefits, ability to operatewith their current systems, product reliability and their own budgetaryconstraints. While potential customers are evaluating our products and beforethey place an order with us, we may incur substantial selling costs and expendsignificant management effort to accomplish a sale.

 

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

 

A significant number of our customers are government agencies. Theseagencies often do not set their own budgets and therefore have little controlover the amount of money they can spend. In addition, these agencies experiencepolitical pressure that may dictate the manner in which they spend money. Due topolitical and budgetary processes and other scheduling delays that mayfrequently occur relating to the contract or bidding process, some governmentagency orders may be canceled or substantially delayed, and the receipt ofrevenues or payments may be substantially delayed. In addition, future sales togovernment agencies will depend on our ability to meet government contractingrequirements, certain of which may be onerous or impossible to meet, resultingin our inability to obtain a particular contract. Common requirements ingovernment contracts include bonding requirements, provisions permitting thepurchasing agency to modify or terminate at will the contract without penalty,and provisions permitting the agency to perform investigations or audits of ourbusiness practices.

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

**WE MAY CONTINUE TO GROW THROUGH ACQUISITIONSTHAT GIVE RISE TO RISKS THAT COULD ADVERSELY AFFECT OUR FUTURE OPERATINGRESULTS.**

 

 Our strategy includes buildingour business through acquisitions and we will likely pursue futureacquisitions. Integrating acquired businesses is a complex, time consuming andexpensive process. To integrate acquired businesses, we must implement ourtechnology systems in the acquired operations and assimilate and manage thepersonnel of the acquired operations. Our success in completing the integrationof acquired businesses may impact the market acceptance of such acquisitions,and our willingness to acquire additional businesses in the future. Further,the difficulties of integrating acquired businesses could disrupt our ongoingbusiness, distract our

 

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management focus from other opportunities and challenges, and increaseour expenses and working capital requirements. Future acquisitions may cause usto recognize substantial amounts of goodwill and other intangible assets thatwill be subject to impairment testing and amortization, and we may assumeliabilities. In addition, acquisitions may result in substantial restructuringand other related expenses and write-offs of acquired in-process research anddevelopment costs. Further, we may need to issue equity or incur additionaldebt to finance future acquisitions, which could be dilutive to our existingstockholders or could increase our leverage. Any of these and other factorscould harm our ability to achieve anticipated levels of profitability fromacquired operations or to realize other anticipated benefits of an acquisition.Mergers and acquisitions of high technology companies are inherently risky, andno assurance can be given that our previous or future acquisitions will besuccessful and will not materially adversely affect our business, operatingresults or financial condition.

 

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

 

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

 

**ITEM3.  CONTROLS AND PROCEDURES**

 

*Evaluation of disclosure controls andprocedures. *ImageWare’schief executive officer and its chief financial officer, after evaluating theeffectiveness of ImageWare’s disclosure controls and procedures (as defined inExchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of the period coveredby this report, have concluded that as of such date, ImageWare’s disclosurecontrols and procedures were adequate and sufficient to ensure that informationrequired to be disclosed by ImageWare in the reports that it files under theSecurities Exchange Act of 1934, as amended, is recorded, processed, summarizedand reported within the time period specified in the Securities and ExchangeCommission’s rules and forms.

 

*Changes in internal controls. *There has been nochange in our internal control over financial reporting during the fiscalquarter ended June 30, 2004 that has materially affected, or is reasonablylikely to materially affect, our internal control over financial reporting.

 

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**PART II**

 

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

 
| **(a)**    | ** ** | **EXHIBITS**                                                                                                                 |
|------------|------------|------------------------------------------------------------------------------------------------------------------------------|
|       |       |                                                                                                                         |
| 10.1       |       | Offer  of Restricted Stock in Exchange for Certain Stock Options Previously Granted  - Offer Made to James Miller            |
| 10.2       |       | Offer  of Restricted Stock in Exchange for Certain Stock Options Previously Granted  - Offer Made to Paul Devermann          |
| 10.3       |       | Offer  of Restricted Stock in Exchange for Certain Stock Options Previously Granted  - Offer Made to Wayne Wetherell         |
| 31.1       |       | Certification  of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley  Act                            |
| 31.2       |       | Certification of Chief Financial Officer pursuant to Section 302  of the Sarbanes-Oxley Act                             |
| 32.1       |       | Certification by Chief Executive Officer and Chief Financial Officer  pursuant to Section 906 of the Sarbanes-Oxley Act |
|       |       |                                                                                                                         |
| ** ** | **(b)**    |                                                                                                                         | **Reports on Form 8-K** |
|       |       |                                                                                                                         |
|       |       |                                                                                                                         | None. |

 

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**SIGNATURES**

 

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

 

 
|                        | IMAGEWARE  SYSTEMS, INC. |                                                                                                                                           |
|-----------------------------|--------------------------|------------------------------------------------------------------------------------------------------------------------------------------------|
|                        |                     |                                                                                                                                           |   |
|                        |                     |                                                                                                                                           |   |
| Date:  August 16, 2004 | By:                      | /s/  Wayne Wetherell                                                                                                                           |   |
|                        |                     | Wayne Wetherell, Chief Financial Officer  (on behalf of the Registrant and  as Registrant’s Principal Financial and   Accounting Officer) |   |

 

29

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