** **

**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington, D.C. 20549**

**FORM10-Q**
| **(Mark One)**                                              | ** ** | ** **                                                                                        |
|-------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------|
|                                                        |       |                                                                                              |
| **x**                                                       | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                        |       |                                                                                              |
| **For the  quarterly period ended September 30, 2007** |
|                                                        |       |                                                                                              |
| o                                                           |       | **TRANSITION REPORT PURSUANT TO 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 Registrant as Specified in Its Charter)

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

 

**10883Thornmint Road**

**SanDiego, CA 92127**

(Address of Principal Executive Offices)

**(858)673-8600**

(Registrant’s Telephone Number, Including Area Code)

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter 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 x  No o

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” inRule 12b-2 of the Exchange Act. (Check one):

| o Large accelerated filer |   | o Accelerated filer |   | x Non-accelerated filer |
|---------------------------|--------|---------------------|--------|-------------------------|

 

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

The number of shares ofCommon Stock, with $0.01 par value, outstanding on November 12, 2007 was16,776,785.

 

 

 

----

 

**IMAGEWARE SYSTEMS, INC. INDEX**
| PART I.    | FINANCIAL  INFORMATION |                                                                                                                                    |
|------------|------------------------|-----------------------------------------------------------------------------------------------------------------------------------------|
|       |                   |                                                                                                                                    |
|       | ITEM 1.                | FINANCIAL  STATEMENTS (UNAUDITED)                                                                                                       |   |
|       |                   |                                                                                                                                    |   |
|       |                   | Condensed  Consolidated Balance Sheets as of September 30, 2007 and December 31,  2006                                             |   |
|       |                   |                                                                                                                                    |   |
|       |                   | Condensed Consolidated  Statements of Operations for the three and nine months ended September 30,  2007 and 2006                  |   |
|       |                   |                                                                                                                                    |   |
|       |                   | Condensed Consolidated  Statements of Cash Flows for the nine months ended September 30, 2007 and  2006                            |   |
|       |                   |                                                                                                                                    |   |
|       |                   | Condensed  Consolidated Statements of Comprehensive Income (Loss) for the three and nine  months ended September 30, 2007 and 2006 |   |
|       |                   |                                                                                                                                    |   |
|       |                   | Notes to  Condensed Consolidated Financial Statements                                                                                   |   |
|       |                   |                                                                                                                                    |   |
|       | ITEM 2.                | Management’s Discussion  and Analysis of Financial Condition and Results of Operations                                             |   |
|       |                   |                                                                                                                                    |   |
|       | ITEM 3.                | Quantitative  and Qualitative Disclosures About Market Risk                                                                             |   |
|       |                   |                                                                                                                                    |   |
|       | ITEM 4.                | Controls and  Procedures                                                                                                                |   |
|       |                   |                                                                                                                                    |   |
| PART II.   | OTHER  INFORMATION     |                                                                                                                                    |
|       |                   |                                                                                                                                    |
|       | ITEM  1A.              | Risk  Factors                                                                                                                           |   |
|       |                   |                                                                                                                                    |   |
|       | ITEM  6.               | Exhibits                                                                                                                                |   |
|       |                   |                                                                                                                                    |   |   |   |
| SIGNATURES |                   |
|            |                        |                                                                                                                                         |  |  |  |  |

 

 

2

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**PART I**

**FINANCIAL INFORMATION**

**ITEM 1. Financial Statements**

**IMAGEWARE SYSTEMS, INC.**

**CONDENSED CONSOLIDATEDBALANCE SHEETS**

**(in thousands, except share data)**
| ** **                                                                                                                                                                                                                                                                                                                        | ** ** | **September 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                                                                                                                                                        | ** ** | **(Unaudited)**              | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                                                                                        | ** ** | ** **                   | ** ** | ** **                  | ** ** |
| Current Assets:                                                                                                                                                                                                                                                                                                                   |       |                         |       |                        |       |
| Cash                                                                                                                                                                                                                                                                                                                              |       | $                            | 3,438      |                        | $          | 939 |   |
| Accounts receivable, net of allowance for doubtful accounts of $498  (unaudited) and $483 at September 30, 2007 and December 31, 2006,  respectively                                                                                                                                                                    |       | 391                          |       | 1,722                       |       |
| Inventory                                                                                                                                                                                                                                                                                                                         |       | 134                          |       | 58                          |       |
| Other current assets                                                                                                                                                                                                                                                                                                              |       | 284                          |       | 138                         |       |
| Total Current Assets                                                                                                                                                                                                                                                                                                              |       | 4,247                        |       | 2,857                       |       |
|                                                                                                                                                                                                                                                                                                                              |       |                         |       |                        |       |
| Property and equipment, net                                                                                                                                                                                                                                                                                                       |       | 232                          |       | 352                         |       |
| Other assets                                                                                                                                                                                                                                                                                                                      |       | 169                          |       | 174                         |       |
| Pension assets                                                                                                                                                                                                                                                                                                                    |       | 669                          |       | 609                         |       |
| Intangible assets, net of accumulated amortization                                                                                                                                                                                                                                                                                |       | 130                          |       | 141                         |       |
| Goodwill                                                                                                                                                                                                                                                                                                                          |       | 3,416                        |       | 3,416                       |       |
| **Total Assets**                                                                                                                                                                                                                                                                                                                  | ** ** | **$**                        | **8,863**  | ** **                  | **$**      | **7,549** | ** ** |
|                                                                                                                                                                                                                                                                                                                              |       |                         |       |                        |       |
| **LIABILITIES AND SHAREHOLDERS’  EQUITY**                                                                                                                                                                                                                                                                                    | ** ** | ** **                   | ** ** | ** **                  | ** ** |
|                                                                                                                                                                                                                                                                                                                              |       |                         |       |                        |       |
| Current Liabilities:                                                                                                                                                                                                                                                                                                              |       |                         |       |                        |       |
| Accounts payable                                                                                                                                                                                                                                                                                                                  |       | $                            | 1,494      |                        | $          | 1,719 |   |
| Deferred revenue                                                                                                                                                                                                                                                                                                                  |       | 1,497                        |       | 1,258                       |       |
| Accrued expenses                                                                                                                                                                                                                                                                                                                  |       | 1,307                        |       | 1,139                       |       |
| Notes payable to third parties, net of discount                                                                                                                                                                                                                                                                                   |       | —                       |       | 1,097                       |       |
| Total Current Liabilities                                                                                                                                                                                                                                                                                                         |       | 4,298                        |       | 5,213                       |       |
|                                                                                                                                                                                                                                                                                                                              |       |                         |       |                        |       |
| Pension obligation                                                                                                                                                                                                                                                                                                                |       | 1,100                        |       | 1,016                       |       |
| Total Liabilities                                                                                                                                                                                                                                                                                                                 |       | 5,398                        |       | 6,229                       |       |
|                                                                                                                                                                                                                                                                                                                              |       |                         |       |                        |       |
| Shareholders’ equity:                                                                                                                                                                                                                                                                                                        |       |                         |       |                        |       |
| Preferred stock, authorized 4,000,000 shares:                                                                                                                                                                                                                                                                                     |       |                         |       |                        |       |
| Series B convertible redeemable preferred stock, $0.01 par value;  designated 750,000 shares, 389,400 shares issued, and 239,400 shares  outstanding at September 30, 2007 and December 31, 2006; liquidation  preference $599 at September 30, 2007 and December 31, 2006                                                   |       | 2                            |       | 2                           |       |
| Series C convertible non-redeemable preferred stock, $0.01 par value;  designated 3,500 shares, 2,500 shares issued, and 2,200 and 2,500 shares  outstanding at September 30, 2007 and December 31, 2006, respectively;  liquidation preference $2,200 and $2,500 at September 30, 2007 and December  31, 2006, respectively |       | —                       |       | —                      |       |
| Series D convertible non-redeemable preferred stock, $0.01 par value;  designated 2,000 shares, 1,500 shares issued, and 1,500 and 0 shares  outstanding at September 30, 2007 and December 31, 2006, respectively;  liquidation preference $1,500 and $0 at September 30, 2007 and December 31,  2006, respectively         |       | —                       |       | —                      |       |
| Common stock, $.01 par value, 50,000,000 shares authorized;  16,783,489 (unaudited) and 13,700,849 shares issued at September 30,  2007 and December 31, 2006, respectively, and 16,776,785 (unaudited) and  13,694,145 shares outstanding at September 30, 2007 and  December 31, 2006, respectively         |       | 167                          |       | 136                         |       |
| Additional paid in capital                                                                                                                                                                                                                                                                                                        |       | 77,902                       |       | 71,554                      |       |
| Treasury stock, at cost - 6,704 shares                                                                                                                                                                                                                                                                                            |       | (64                          | )          | (64                         | )          |
| Accumulated other comprehensive income                                                                                                                                                                                                                                                                                            |       | 31                           |       | 25                          |       |
| Accumulated deficit                                                                                                                                                                                                                                                                                                               |       | (74,573                      | )          | (70,333                     | )          |
| Total Shareholders’ equity                                                                                                                                                                                                                                                                                                   |       | 3,465                        |       | 1,320                       |       |
|                                                                                                                                                                                                                                                                                                                              |       |                         |       |                        |       |
| **Total Liabilities and Shareholders’ Equity**                                                                                                                                                                                                                                                                               | ** ** | **$**                        | **8,863**  | ** **                  | **$**      | **7,549** | ** ** |

 

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

 

3

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**IMAGEWARE SYSTEMS, INC.**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS****

**(inthousands, except share and per share amounts)**

**(unaudited)**
| ** **                                                                 | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                 | ** ** | **2007**                                             | ** ** | **2006**                                            | ** ** | **2007** | ** ** | **2006** | ** ** |
| **Revenues:**                                                              | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Product                                                                    |       | $                                                    | 2,832      |                                                | $          | 1,560 |   | $ | 4,698 |   | $ | 6,125 |   |
| Maintenance                                                                |       | 678                                                  |       | 617                                                 |       | 1,926 |   | 1,683 |   |
|                                                                       |       | 3,510                                                |       | 2,177                                               |       | 6,624 |   | 7,808 |   |
| **Cost of revenues:**                                                      | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Product                                                                    |       | 510                                                  |       | 498                                                 |       | 992 |   | 1,689 |   |
| Maintenance                                                                |       | 281                                                  |       | 254                                                 |       | 871 |   | 826 |   |
| Gross profit                                                               |       | 2,719                                                |       | 1,425                                               |       | 4,761 |   | 5,293 |   |
|                                                                       |       |                                                 |       |                                                |       |   |   |   |   |
| **Operating expenses:**                                                    | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| General & administrative                                               |       | 889                                                  |       | 1,053                                               |       | 2,989 |   | 3,271 |   |
| Sales and marketing                                                        |       | 607                                                  |       | 851                                                 |       | 1,974 |   | 2,742 |   |
| Research & development                                                 |       | 752                                                  |       | 962                                                 |       | 2,741 |   | 2,898 |   |
| Depreciation and amortization                                              |       | 60                                                   |       | 57                                                  |       | 199 |   | 245 |   |
|                                                                       |       | 2,308                                                |       | 2,923                                               |       | 7,903 |   | 9,156 |   |
| Income (loss) from operations                                              |       | 411                                                  |       | (1,498                                              | )          | (3,142 | ) | (3,863 | ) |
|                                                                       |       |                                                 |       |                                                |       |   |   |   |   |
| Interest expense (income), net                                             |       | (2                                                   | )          | 156                                                 |       | 236 |   | 339 |   |
|                                                                       |       |                                                 |       |                                                |       |   |   |   |   |
| Other expense (income), net                                                |       | (6                                                   | )          | (5                                                  | )          | 38 |   | (111 | ) |
| Income (loss) from continuing operations before income taxes               |       | 419                                                  |       | (1,649                                              | )          | (3,416 | ) | (4,091 | ) |
|                                                                       |       |                                                 |       |                                                |       |   |   |   |   |
| Income tax expense (benefit)                                               |       | —                                               |       | —                                              |       | — |   | — |   |
|                                                                       |       |                                                 |       |                                                |       |   |   |   |   |
| Income (loss) from continuing operations                                   |       | 419                                                  |       | (1,649                                              | )          | (3,416 | ) | (4,091 | ) |
|                                                                       |       |                                                 |       |                                                |       |   |   |   |   |
| Discontinued operations:                                                   |       |                                                 |       |                                                |       |   |   |   |   |
| Gain (loss) from operations of discontinued Digital Photography  component |       | 6                                                    |       | (114                                                | )          | 17 |   | (346 | ) |
| Income tax benefit (expense)                                               |       | —                                               |       | —                                              |       | — |   | — |   |
| Gain (loss) on discontinued operations                                     |       | 6                                                    |       | (114                                                | )          | 17 |   | (346 | ) |
|                                                                       |       |                                                 |       |                                                |       |   |   |   |   |
| Net income (loss)                                                          |       | 425                                                  |       | (1,763                                              | )          | (3,399 | ) | (4,437 | ) |
| Preferred dividends                                                        |       | (555                                                 | )          | (13                                                 | )          | (1,057 | ) | (40 | ) |
| Net loss available to common shareholders                                  |       | $                                                    | (130       | )                                                   | $          | (1,776 | ) | $ | (4,456 | ) | $ | (4,477 | ) |
|                                                                       |       |                                                 |       |                                                |       |   |   |   |   |
| Basic and diluted income (loss) per common share - note 2                  |       |                                                 |       |                                                |       |   |   |   |   |
| Continuing operations                                                      |       | $                                                    | 0.03       |                                                | $          | (0.12 | ) | $ | (0.24 | ) | $ | (0.30 | ) |
| Discontinued operations                                                    |       | —                                               |       | (0.01                                               | )          | — |   | (0.03 | ) |
| Preferred dividends                                                        |       | (0.04                                                | )          | —                                              |       | (0.08 | ) | — |   |
| Basic and diluted loss per share available to common shareholders          |       | $                                                    | (0.01      | )                                                   | $          | (0.13 | ) | $ | (0.32 | ) | $ | (0.33 | ) |
|                                                                       |       |                                                 |       |                                                |       |   |   |   |   |
| Weighted-average shares (basic and diluted)                                |       | 14,891,641                                           |       | 13,604,692                                          |       | 14,086,249 |   | 13,574,835 |   |

 

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

 

4

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**IMAGEWARE SYSTEMS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(in thousands)**

**(unaudited)**
| ** **                                                                   | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2007**                                            | ** ** | **2006** | ** ** |
| **Cash flows from operating activities**                                     |       |                                                |       |   |   |
| Net loss                                                                     |       | $                                                   | (3,399     | ) | $ | (4,437 | ) |
| Adjustments to reconcile net loss to net cash used in operating  activities  |       |                                                |       |   |   |
| Depreciation and  amortization                                               |       | 199                                                 |       | 248 |   |
| Provision for losses in investment in equity securities                      |       | 85                                                  |       | — |   |
| Non-cash interest and amortization of debt discount and debt issuance  costs |       | 229                                                 |       | 284 |   |
| Stock based compensation                                                     |       | 513                                                 |       | 912 |   |
| Provision for losses on accounts receivable                                  |       | 25                                                  |       | 14 |   |
| Reduction in inventory obsolescence reserve                                  |       | (32                                                 | )          | — |   |
| Change in assets and liabilities                                             |       |                                                |       |   |   |
| Accounts receivable, net                                                     |       | 1,306                                               |       | 359 |   |
| Costs and estimated earnings in excess of billings on uncompleted  contracts |       | —                                              |       | (322 | ) |
| Inventory                                                                    |       | (44                                                 | )          | 117 |   |
| Other current assets                                                         |       | (164                                                | )          | (35 | ) |
| Pension assets                                                               |       | (61                                                 | )          | (58 | ) |
| Other non-current assets                                                     |       | (39                                                 | )          | (10 | ) |
| Accounts payable                                                             |       | (225                                                | )          | 821 |   |
| Accrued expenses                                                             |       | 204                                                 |       | (7 | ) |
| Deferred revenue                                                             |       | 239                                                 |       | 551 |   |
| Pension obligation                                                           |       | 84                                                  |       | 69 |   |
| Total adjustments                                                            |       | 2,319                                               |       | 2,943 |   |
| Net cash used in operating activities                                        |       | (1,080                                              | )          | (1,494 | ) |
|                                                                         |       |                                                |       |   |   |
| **Cash flows from investing activities**                                     |       |                                                |       |   |   |
| Purchase of property and equipment                                           |       | (68                                                 | )          | (113 | ) |
| Net cash used in investing activities                                        |       | (68                                                 | )          | (113 | ) |
|                                                                         |       |                                                |       |   |   |
| **Cash flows from financing activities**                                     |       |                                                |       |   |   |
| Repayment of notes payable                                                   |       | (1,310                                              | )          | (215 | ) |
| Proceeds from issuance of notes payable with warrants                        |       | —                                              |       | 1,550 |   |
| Debt issuance costs                                                          |       | —                                              |       | (98 | ) |
| Proceeds from issuance of common stock, net of issuance costs                |       | 2,621                                               |       | — |   |
| Proceeds from issuance of preferred stock, net of issuance costs             |       | 1,327                                               |       | — |   |
| Other financing issuance costs                                               |       | (54                                                 | )          | — |   |
| Dividends paid                                                               |       | (25                                                 | )          | (26 | ) |
| Proceeds from exercised stock purchase warrants                              |       | 1,121                                               |       | — |   |
|                                                                         |       |                                                |       |   |   |
| Net cash provided by financing activities                                    |       | 3,680                                               |       | 1,211 |   |
| Effect of exchange rate changes on cash                                      |       | (33                                                 | )          | (69 | ) |
| Net increase (decrease) in cash                                              |       | 2,499                                               |       | (465 | ) |
|                                                                         |       |                                                |       |   |   |
| Cash at beginning of period                                                  |       | 939                                                 |       | 741 |   |
|                                                                         |       |                                                |       |   |   |
| Cash at end of period                                                        |       | $                                                   | 3,438      |   | $ | 276 |   |
|                                                                         |       |                                                |       |   |   |
| Supplemental disclosure of cash flow information:                            |       |                                                |       |   |   |
| Cash paid for interest                                                       |       | $                                                   | 46         |   | $ | 35 |   |
| Summary of non-cash investing and financing activities:                      |       |                                                |       |   |   |
| Beneficial conversion feature of series D preferred stock                    |       | $                                                   | 814        |   | $ | — |   |
| Conversion of preferred stock to common                                      |       | $                                                   | 2          |   | $ | — |   |

 

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

 

5

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**IMAGEWARESYSTEMS, INC**

**CONDENSEDCONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)**

**(inthousands)**

**(unaudited)**
| ** **                              | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                              | ** ** | **2007**                                             | ** ** | **2006**                                            | ** ** | **2007** | ** ** | **2006** | ** ** |
| Net income (loss)                       |       | $                                                    | 425        |                                                | $          | (1,763 | ) | $ | (3,399 | ) | $ | (4,437 | ) |
| Other comprehensive income (loss):      |       |                                                 |       |                                                |       |   |   |   |   |
| Unrealized holding loss on securities   |       | —                                               |       | (28                                                 | )          | — |   | (28 | ) |
|                                    |       |                                                 |       |                                                |       |   |   |   |   |
| Foreign currency translation adjustment |       | (8                                                   | )          | (35                                                 | )          | (33 | ) | (69 | ) |
| Comprehensive income (loss)             |       | $                                                    | 417        |                                                | $          | (1,826 | ) | $ | (3,432 | ) | $ | (4,534 | ) |

 

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

 

6

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**IMAGEWARE SYSTEMS, INC.**

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**NOTE 1. DESCRIPTION OF BUSINESS AND OPERATIONS**

ImageWare Systems, Inc. (the “Company” or “ImageWare”),formerly known as ImageWare Software, Inc., utilizes identity managementtechnology to provide stand alone, networked and web-based software solutionsfor biometrics, law enforcement and secure credentials.

The Company’s “flagship” product is the IWS BiometricEngineTM.  Scalable for small citybusiness or worldwide deployment, the Company’s biometric engine is amulti-biometric platform that is hardware and algorithm independent, enablingthe enrollment and management of unlimited population sizes.  The Company’s identification products areused to manage and issue secure credentials including national IDs, passports,driver licenses, smart cards and access control credentials. The Company’s lawenforcement products provide law enforcement with integrated mug shot,fingerprint LiveScan and investigative capabilities.  The biometric technology is now an integralpart of all markets the Company addresses, and all of its products areintegrated into the Biometric Engine Platform.  Elements of the biometricengine can be used as investigative tools to law enforcement potentiallyutilizing multiple biometrics and forensic data elements, and to enhancesecurity and authenticity of public and private sector credentials.

The Company’s biometric technology is a core softwarecomponent of an organization’s security infrastructure and includes amulti-biometric identity management solution for enrolling, managing,identifying and verifying the identities of people by the physicalcharacteristics of the human body. The Company develops, sells and supportsvarious identity management capabilities within government (federal, state andlocal), law enforcement, commercial enterprises, and transportation andaviation markets for identification and verification purposes. The Company’sIWS Biometric Engine is a biometric identity management platform formulti-biometric enrollment, management and authentication, managing populationdatabases of virtually unlimited sizes. It is also offered as a SoftwareDevelopment Kit (SDK) based search engine, enabling developers and systemintegrators to implement a biometric solution or integrate biometriccapabilities into existing applications without having to derive biometricfunctionality from pre-existing applications. The IWS Biometric Engine combined with the Company’s secure credentialplatform, IWS EPI Builder, provides a comprehensive, integrated biometric andsecure credential solution that can be leveraged for high-end applications suchas passports, driver licenses, national IDs, and other secure documents. It canalso be utilized within the Company’s law enforcement systems to incorporateany number of various multiple biometrics into one system.

The Company’s law enforcement solutions enableagencies to quickly capture, archive, search, retrieve, and share digitalimages, fingerprints and criminal history records on a stand-alone, networked,wireless or Web-based platform. The Company develops, sells and supports asuite of modular software products used by law enforcement and public safetyagencies to create and manage criminal history records and to investigatecrime. The Company’s IWS Law Enforcement solution consists of seven softwaremodules: A Capture and Investigative module, which provides a criminal bookingsystem and related database; A Facial Recognition module, which uses biometricfacial recognition to identify suspects; A Suspect ID module, which facilitatesthe creation of full-color, photo-realistic suspect composites; A wirelessmodule, which provides access to centrally stored records over the Internet ina connected or wireless fashion; A PDA add-on module which enables access tocentrally stored records while in the field on a handheld Pocket PC compatibledevice combined with central repository services which allows for inter-agencydata sharing on a local, regional, and/or national level, and a LiveScan modulewhich incorporates LiveScan capabilities into IWS Law Enforcement, providingintegrated fingerprint and palm print biometric management for civil and lawenforcement use.

The Company’s Secure Credential ID solutions empowercustomers to create secure and smart digital identification documents withcomplete ID systems. The Company develops, sells and supports software anddesign systems which utilize digital imaging in the production of photoidentification cards and credentials and identification systems. The Company’sproducts in this market consist of IWS EPI Suite, IWS EPI Builder (SDK),Identifier for Windows and ID Card Maker. These products allow for the production of digital identification cardsand related databases and records and can be used by, among others, schools,airports, hospitals, corporations or governments.  The Company has recently added the ability toincorporate multiple biometrics into the ID systems it offers with the additionof the Company’s new IWS Biometric Engine to its product line.

The Company’s enterprise authentication softwareincludes the IWS Desktop Security software solution which is a comprehensiveauthentication management infrastructure specifically designed to provideenterprise networks with the most advanced authentication mechanisms includingbiometrics, RFID technology, USB flash memory modules, Trusted Platform Module(TPM), and smart cards.

 

 

7

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*Basis of Presentation*

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States of Americarequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities, the disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenue and expenses during the reporting period. Actual results could differfrom those estimates.

The accompanying condensed consolidated unauditedfinancial statements of ImageWare have been prepared pursuant to therules 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 31,2006, and notes thereto included in the Company’s Annual Report onForm 10-K, filed with the SEC on April 17, 2007, as amended on April30, 2007, May 7, 2007 and May 9, 2007. 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 ofSeptember 30, 2007, 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.

*Going Concern*

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

New financing will be required to fund working capitaland operations should the Company be unable to generate positive cash flow fromoperations in the near future. The Company is exploring the possible sale ofequity securities and/or debt financing. However, there can be no assurancethat additional financing will be available. In the event financing is notavailable in the time frame required, the Company will be forced to sellcertain of its assets or license its technologies to others. These actions,while necessary for the continuance of operations during a time of cashconstraints and a shortage of working capital, could adversely affect theCompany’s business.

As a result of theCompany’s continuing losses and negative cash flows from operations, theCompany currently does not meet certain listing standards of the American StockExchange (“AMEX”) Company Guide.  As aresult, the Company may be considered for suspension or delisting fromAMEX.  During May 2006, the Companyreceived notification from AMEX that it was not in compliance with certainsections of the AMEX Company Guide.  Tomaintain an AMEX listing, the Company was required to submit a plan to AMEXwhich demonstrates the Company’s ability to regain compliance with thecontinued listing standards within a maximum of 18 months.  The Company submitted its plan to AMEX duringJune 2006.  The Listing QualificationsDepartment of AMEX evaluated the Company’s plan and in September 2006 notifiedthe Company that it had made a reasonable demonstration in the plan of anability to regain compliance with the continued listing standards by the end ofthe plan periods which AMEX determined to be November 15, 2006 for Section1003(a)(iv) of the AMEX Company Guide and November 30, 2007 for Sections1003(a)(i), 10033(a)(ii) and 1003(a)(iii) of the AMEX Company Guide.   Accordingly, in September 2006, AMEXnotified the Company that they would continue its listing subject to theCompany making a public announcement disclosing the fact that the Company isnot in compliance with the continued listing standards of the AMEX and that theCompany’s listing is being continued pursuant to an extension and the Company’sproviding certain supporting documentation of key elements of the Company’splan.  The Company made the requiredpublic announcement and provided the requested information.  The Company is subject to periodic review todetermine if it is making progress consistent with the plan.  Failure to make progress consistent with theplan or regain compliance with the continued listing standards by the end ofthe applicable extension periods could result in AMEX initiating delistingproceedings pursuant to Section 1009 of the AMEX Company Guide.  The Company’s ability to raise additionalcapital may be dependent upon the Company’s common stock continuing to bequoted on the AMEX. There can be no assurance that the Company will makeprogress consistent with the Company’s plan or that the Company will be able tosatisfy the criteria for continued listing on the AMEX. Insufficient funds willrequire the Company to sell certain of the Company’s assets or license theCompany’s technologies to others and if the Company is unable to obtainadditional funding there is substantial doubt about the Company’s ability tocontinue as a going concern.

In view of thematters described in the preceding paragraphs, recoverability of a majorportion of the recorded asset amounts shown in the accompanying condensedconsolidated balance sheets is dependent upon continued operations of the 

 

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Company, which, in turn,is dependent upon the Company’s ability to continue to raise capital andgenerate positive cash flows from operations. 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.

The Company operates in markets that are emerging andhighly competitive. There is no assurance that the Company will be able toachieve profitability.

*Recently Issued Accounting Standards*

In September 2006, the Financial Accounting StandardsBoard (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No.157, “Fair Value Measurements” (“SFAS No. 157”), to increase consistency andcomparability in fair value measurements and to expand their disclosures. Thenew standard includes a definition of fair value as well as a framework formeasuring fair value. The standard is effective for fiscal periods beginningafter November 15, 2007 and should be applied prospectively, except for certainfinancial instruments where it must be applied retrospectively as acumulative-effect adjustment to the balance of opening retained earnings in theyear of adoption. The Company is currently evaluating the impact of SFAS No.157 on its consolidated financial statements.

In February 2007, the FASB issued SFAS No. 159, “TheFair Value Option for Financial Assets and Financial Liabilities, including anamendment of FASB Statement No. 115” (“SFAS No. 159”). This statement permitsentities to choose to measure many financial instruments and certain otheritems at fair value that are not currently required to be measured at fairvalue and establishes presentation and disclosure requirements designed tofacilitate comparisons between entities that choose different measurementattributes for similar types of assets and liabilities. SFAS No. 159 iseffective on January 1, 2008. The Company is currently evaluating the impact ofSFAS No. 159 on its consolidated financial statements.

                In June 2007,the FASB ratified the consensus reached by the Emerging Issues Task Force (“EITF”)on Issue No. 07-3, “Accountingfor Advance Payments for Goods or Services Received for Use in Future Researchand Development Activities”**(“Issue07-3”), which is effective January 1, 2008 and is applied prospectivelyfor new contracts entered into on or after the effective date. Issue 07-3addresses nonrefundable advance payments for goods or services that will beused or rendered for future research and development activities. Issue 07-3will require these payments be deferred and capitalized and recognized as anexpense as the related goods are delivered or the related services areperformed. The Company is assessing the effects of adoption of Issue 07-3 onits financial position and results of operations.

 

In June 2006, the FASB issued Interpretation No. 48, “Accountingfor Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN48”), which clarifies the accounting for uncertainty in income taxes recognizedin a company’s financial statements. The interpretation prescribes arecognition threshold and measurement attribute criteria for the financialstatement recognition and measurement of an uncertain tax position taken orexpected to be taken in a tax return. The interpretation also provides guidanceon derecognition, classification, interest and penalties, accounting in interimperiods, disclosure and transition.

The Company adopted the provisions of FIN 48 onJanuary 1, 2007. The implementation of FIN 48 did not have a material impact onthe Company’s financial statements. At the adoption date on January 1, 2007,and as of September 30, 2007, the Company recorded no cumulative effectadjustments related to the adoption of FIN 48.

Upon adoption of FIN 48 on January 1, 2007, and as ofSeptember 30, 2007, the Company had no unrecognized tax benefits or accrualsfor the potential payment or interest and penalties. For the nine months endedSeptember 30, 2007, no interest or penalties were recorded.

The Company files tax returns in the U.S. federaljurisdiction, and in various states and foreign jurisdictions. The Company isnot aware of any jurisdictions currently under examination by tax authorities.

 

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            *Reclassifications*

* *

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

**NOTE 2.  NETINCOME (LOSS) PER COMMON SHARE**

Basic earnings (loss) per common share is calculatedby dividing net income (loss) available to common shareholders for the periodby the weighted-average number of common shares outstanding during the period.Diluted earnings per common share is calculated by dividing net income (loss)available to common shareholders for the period by the weighted-average numberof common shares outstanding during the period, adjusted to include, ifdilutive, potential dilutive shares consisting of convertible preferred stock,stock options and warrants, calculated using the treasury stock method andif-converted method. During the periods ended September 30, 2007 and 2006, theCompany has excluded the following securities from the calculation of dilutedloss per share, as their effect would have been antidilutive:
| **Potential dilutive securities excluded from diluted  earnings (loss) per share computation:** | ** ** | **Number of  Common Shares  Convertible into at  September 30, 2007** | ** ** | **Number of  Common Shares  Convertible into at  September 30, 2006** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|
| Convertible preferred stock                                                                               |       | 2,512,052                                                                                      |       | 45,384                                                                                              |       |
| Stock options                                                                                             |       | 1,671,839                                                                                      |       | 1,632,304                                                                                           |       |
| Warrants                                                                                                  |       | 6,020,778                                                                                      |       | 4,680,805                                                                                           |       |

 

The table below presents the computation of basic anddiluted earnings (loss) per share:
| ** **                                                                                       | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                       | ** ** | **2007**                                             | ** ** | **2006**                                            | ** ** | **2007** | ** ** | **2006** | ** ** |
| Numerator for basic and diluted earnings per share:                                              |       |                                                 |       |                                                |       |   |   |   |   |
| Net income (loss) from continuing operations                                                     |       | $                                                    | 419        |                                                | $          | (1,649 | ) | $ | (3,416 | ) | $ | (4,091 | ) |
| Preferred dividends                                                                              |       | (555                                                 | )          | (13                                                 | )          | (1,057 | ) | (40 | ) |
| Net loss from continuing operations available to common shareholders                             |       | $                                                    | (136       | )                                                   | $          | (1,662 | ) | $ | (4,473 | ) | $ | (4,131 | ) |
|                                                                                             |       |                                                 |       |                                                |       |   |   |   |   |
| Net income (loss) from discontinued operations                                                   |       | 6                                                    |       | (114                                                | )          | 17 |   | (346 | ) |
| Net loss available to common shareholders                                                        |       | (130                                                 | )          | (1,776                                              | )          | (4,456 | ) | (4,477 | ) |
|                                                                                             |       |                                                 |       |                                                |       |   |   |   |   |
| Denominator for basic and diluted earnings per share —  weighted-average shares outstanding |       | 14,891,641                                           |       | 13,604,692                                          |       | 14,086,249 |   | 13,574,835 |   |
|                                                                                             |       |                                                 |       |                                                |       |   |   |   |   |
| Basic and diluted income (loss) per share:                                                       |       |                                                 |       |                                                |       |   |   |   |   |
| Continuing operations                                                                            |       | $                                                    | 0.03       |                                                | $          | (0.12 | ) | $ | (0.24 | ) | $ | (0.30 | ) |
| Discontinued operations                                                                          |       | —                                               |       | (0.01                                               | )          | — |   | (0.03 | ) |
| Preferred dividends                                                                              |       | (0.04                                                | )          | —                                              |       | (0.08 | ) | — |   |
| Net loss available to common shareholders                                                        |       | $                                                    | (0.01      | )                                                   | $          | (0.13 | ) | $ | (0.32 | ) | $ | (0.33 | ) |
|                                                                                             |       |                                                 |       |                                                |       |   |   |   |   |

 

Preferred dividends for the three and nine monthsended September 30, 2007 contains approximately $470,000 and $814,000,respectively, in preferred stock dividends attributable to an embeddedbeneficial conversion feature recognized in conjunction with the Company’sSeries D Preferred Stock as more fully explained in Note 6.

**NOTE 3. SALE OF BUSINESS AND DISCONTINUED OPERATIONS**

On November 30, 2006, the Company completed the saleof its entire Digital Photography (“PDI”) product line and inventory (the “PDIProducts”) to an unaffiliated third party for a total of $400,000, including aninitial cash payment of $25,000.  Thepurchaser is required to pay up to the full remaining amount of $375,000 in aseries of quarterly installments equal to 12.5% of all newly acquired sales andlicense revenues relating to the PDI product line (the “Percentage Payments”).  Until such time when the Company has receivedthe full purchase price of $400,000, during any 12-month period during 

 

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which the aggregatePercentage Payments to the Company are less than $50,000, the purchaser willpay the Company the difference between the Percentage Payments and$50,000.  As of September 30, 2007, thepurchaser had paid the Company approximately $17,000 in PercentagePayments.  This component of the Company’sbusiness was previously classified as the Company’s Digital Photographysegment.

The Company decided to sell this component because ithas incurred significant operating losses in each of the last five years andhas lost significant market share in the last three years.  The assets sold consisted primarily of asuite of software and related inventory including source, copyrights,trademarks, documentation and client base.

At September 30, 2007 and December 31, 2006, theCompany has recorded the fair value of the remaining amount due of $358,000 and$375,000, respectively, offset by a full valuation allowance due to theuncertainty of the ultimate collectibility of such amounts. This determinationwas based upon the maximum repayment period of 7 years of amounts owing theCompany at the transaction date combined with the purchaser operating in ahighly competitive business environment evidenced by rapid technologicalchange.  Accordingly, the Company hasdeferred any remaining gain from the disposal of this component until such timeas the Company determines that the realization of the remaining amounts owed isreasonably assured.

Digital Photography sales, reported in discontinuedoperations, for the nine months ended September 30, 2007 and 2006 were $0 and$151,000, respectively.  DigitalPhotography sales, reported in discontinued operations, for the three monthsended September 30, 2007 and 2006 were $0 and $75,000, respectively.  Digital Photography’s pretax income (loss),reported in discontinued operations for the nine months ended September 30,2007 and 2006 were $17,000 and ($346,000), respectively.  Digital Photography’s pretax income (loss),reported in discontinued operations for the three months ended September 30,2007 and 2006 were $6,000 and ($114,000), respectively.

Prior period financial statements for the three andnine months ended September 30, 2006 have been restated to present theoperations of Digital Photography as discontinued operations.

**NOTE 4. INVENTORIES**

At September 30, 2007 the Company had work in processinventories of $98,000 representing direct labor costs on in-process projectsand finished goods inventories of $56,000 net of reserves for obsolete andslow-moving items of $20,000. Inventories at December 31, 2006 consisted of finished goods of $58,000net of reserves of $52,000.

**NOTE 5. COMMON STOCK AND WARRANTS**

**               **OnSeptember 25, 2007, the Company sold to certain accredited investors a total of2,016,666 shares of the Company’s common stock, par value $0.01 per share, at apurchase price of $1.50 per share for aggregate gross proceeds of $3,025,003(the “Common Stock Financing”).

                Inconjunction with the issuance of the common stock, the Company issued to theinvestors warrants (the “Investor Warrants”) to purchase up to an aggregate of1,008,333 shares of Common Stock with an exercise price of $1.67 per share. TheInvestor Warrants have been classified as equity instruments on the balancesheet in accordance with the provisions of Emerging Issues Task Force (“EITF”)Issue 00-19, “Accounting for Derivative Financial Instruments Indexed to, andPotentially Settled in, a Company’s Own Stock”.

                Theissuance of common stock and warrants pursuant to the Common Stock Financingtriggered certain antidilution and exercise price reduction clauses in existingwarrant agreements. As a result of these modifications, the Company was required to issue an additional113,834 warrants and reduce the exercise price of certain previouslyissued warrants. As these warrants were classified as permanent equity, and theadjustment was related to antidilution features within these financialinstruments, this increase in warrants and reduction of exercise price resultedin no adjustment to the financial statements.

                Ascompensation to the placement agent for the Common Stock Financing, the Companypaid approximately $212,000 inplacement agent fees and agreed to reimburse up to $25,000 of placement agentlegal expense incurred in connection with this financing.  In addition, the Company issued the placementagent for the financing, and certain of its affiliates, a 5.5 year warrant (the“Placement Agent Warrants”) to purchase up to an aggregate of 151,249 shares ofCommon Stock on the same terms and conditions included in the InvestorWarrants. The cash payment has been recorded as adjustment to additional paidin capital as a reduction of net proceeds. The Placement Agent Warrants have been classified as equity instrumentson the balance sheet.

 

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**NOTE 6. PREFERRED STOCK**

In March 2007, the Company’sArticles of Incorporation were amended to authorize 2,000 shares ofSeries D 8% Convertible Preferred Stock (“Series D Preferred Stock”). Eachshare of Series D Preferred Stock has a parvalue of $0.01, a statedvalue of $1,000 and is convertible into the Company’s common stockat an initial conversion price of $1.90 per share. The Series D Preferred Stockdoes not have voting rights.

At March 31, 2007, the Company had issued a total of1,500 shares of Series D Preferred Stock and generated gross proceeds of $1.5million from the sale of such shares. In conjunction with the issuance of theSeries D Preferred Stock, the Company issued warrants to the holders of theSeries D Preferred Stock to purchase 59,207 shares of the Company’s commonstock at $2.33 per share. These warrants have been classified as equityinstruments on the balance sheet.  Theproceeds from the Series D Preferred Stock financing were allocated to thewarrants and the Series D Preferred Stock based on the relative fair value ofeach on the date of issuance.  Thisallocation process resulted in the initial recognition of a discountattributable to an embedded beneficial conversion feature of approximately$344,000.  The discount was amortizedover the minimum period from the date of issuance to the date at which thepreferred shareholders are permitted to convert as a dividend to the Series DPreferred Stock shareholders.

The issuance of common stock and warrants pursuant tothe Common Stock Financing triggered certain antidilution clauses in theCompany’s Series D Preferred Stock agreement. As a result of these antidilutionclauses, the Company was required to adjustthe conversion price of the Series D Preferred Stock from $1.90 per share to$1.50 per share.  This antidilutionfeature will cause an additional 210,528 common shares to be issued uponconversion of the Series D Preferred Stock into common stock. Inaccordance with EITF Issue 00-27, “Application of Issue No. 98-5 to CertainConvertible Instruments”, this antidilution feature resulted in the additionalrecognition of a discount attributable to an embedded beneficial conversionfeature of approximately $470,000.  Thisdiscount was amortized over the minimum period from the date of the conversionprice adjustment to the date at which the preferred shareholders are permittedto convert as a dividend to the Series D Preferred Stock shareholders.

At September 30, 2007, the Company had cumulativeundeclared dividends relating to Series B, C and D Preferred Stock ofapproximately $21,000, $162,000 and $68,000 respectively.

**NOTE 7. REGISTRATION PAYMENT ARRANGEMENTS**

As part of the Common Stock Financing, the Companyentered into a Registration Payment Arrangement as defined by FASB StaffPosition No. EITF 00-19-2, “Accounting for Registration Payment Arrangements” (“EITF00-19-2”).  EITF 00-19-2 specifies thatthe contingent obligation to make future paymentsor otherwise transfer consideration under a registration payment arrangementshould be separately recognized and measured in accordance with SFAS No.5 “Accounting for Contingencies” (“SFAS No. 5”). EITF 00-19-2 is effective forregistration payment arrangements entered into after December 21, 2006 or forthe fiscal year beginning after December 15, 2006.  The Company early adopted the provisions ofEITF 00-19-2 in December 2006. The Company determined that no loss contingencyrelated to the Common Stock Financing registration payment arrangement wasrequired to be recorded as of September 30, 2007.

As part of the September 25, 2007 Common Stockregistration payment arrangement, the Company agreed to register the shares ofcommon stock issued in the financing and the shares of common stock underlyingthe warrants issued to the investors in the Common Stock Financing with the SECwithin certain contractually specified time periods.  The Company also agreed to use its bestefforts to keep the registration statement continuously effective until theearlier of either the second year after the date the registration statement isdeclared effective by the SEC or the date when all the common stock, includingthe common stock underlying the warrants have been sold or may be sold withoutvolume limitations.  If the Company isunable to register the shares of common stock with the SEC or keep theregistration statement continuously effective in accordance with the SecuritiesPurchase Agreement dated September 25, 2007, between the Company and certain accreditedinvestors, the Company is subject to a liquidated damages penalty equal to 1%of the aggregate purchase price paid for each month the registration statementis not effective, provided that such liquidated damages shall not exceed 12% ofthe aggregate purchase price.  Themaximum exposure at September 30, 2007 is approximately $363,000. The Companyis working to meet the requirements of the September 25, 2007 Common Stockregistration payment arrangement by filing the required registration statementwith the SEC within the time frame specified by the agreement.  Company management believes that it will beable to achieve and maintain current filing status with the SEC over theprescribed period.

As part of the Series D Preferred Stock financing, theCompany entered into a Registration Payment Arrangement as defined by FSP No.EITF 00-19-2.  EITF 00-19-2 specifiesthat the contingent obligation to make future paymentsor otherwise transfer consideration under a registration payment arrangementshould be separately recognized and measured in 

 

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accordance with SFAS No.5. EITF 00-19-2 is effective for registration payment arrangements entered intoafter December 21, 2006 or for the fiscal year beginning after December 15,2006.  The Company early adopted theprovisions of EITF 00-19-2 in December 2006. The Company determined that noloss contingency related to the Series D Preferred Stock registration paymentarrangement was required to be recorded as of September 30, 2007.

As part of the Series D Preferred Stock registrationpayment arrangement, the Company agreed to register the shares of common stockthe Series D Preferred Stock is convertible into and the shares of common stockunderlying the warrants issued to the investors in the Series D Preferred Stockfinancing with the SEC within certain contractually specified timeperiods.  The Company also agreed to useits best efforts to keep the registration statement continuously effectiveuntil the earlier of either the fifth year after the date the registrationstatement is declared effective by the SEC or the date when all the commonstock, including the common stock underlying the warrants have been sold.  If the Company is unable to register theshares of common stock with the SEC or keep the registration statementcontinuously effective in accordance with the Securities Purchase Agreementdated March 9, 2007, between the Company and certain accredited investors, theCompany is subject to a liquidated damages penalty equal to 1% of the aggregatepurchase price paid for each month the registration statement is not effective,provided that such liquidated damages shall not exceed 12% of the aggregatepurchase price.  The maximum exposure atSeptember 30, 2007 is approximately $180,000. The Company has met therequirements of the Series D Preferred Stock registration payment arrangementby filing the required registration statement with the SEC within the timeframe specified by the agreement. Company management believes that it will be able to achieve and maintaincurrent filing status with the SEC over the prescribed period.

As part of the Series C Preferred Stock financingconsummated in November and December of 2006, the Company entered into aRegistration Payment Arrangement as defined by EITF 00-19-2.  EITF 00-19-2 specifies that the contingentobligation to make future payments or otherwise transfer consideration under aregistration payment arrangement should be separately recognized and measuredin accordance with SFAS No. 5, “Accounting for Contingencies”.   EITF 00-19-2 is effective for registrationpayment arrangements entered into after December 21, 2006 or for the fiscalyear beginning after December 15, 2006, however early adoption is permitted forinterim or annual periods for which financial statements have not beenissued.  The Company adopted theprovisions of FSP EITF 00-19-2 for the annual period ending December 31, 2006.  The Company determined that no losscontingency related to the Series C Preferred Stock registration paymentarrangement was required to be recorded as of September 30, 2007.

As part of the Series C Preferred Stock registrationpayment arrangement, the Company agreed to register the shares of common stockthe Series C Preferred Stock is convertible into and the shares of common stockunderlying the warrants issued to the Series C investors with the SEC withincertain contractually specified time periods. The Company also agreed to use its best efforts to keep the registrationstatement continuously effective until the earlier of either the fifth yearafter the date the registration statement is declared effective by the SEC orthe date when all the common stock, including the common stock underlying thewarrants have been sold.  If the Companyis unable to register the shares of common stock with the SEC or keep theregistration statement continuously effective in accordance with the SecuritiesPurchase Agreement dated November 14, 2006, between the Company and certainaccredited investors,  the Company issubject to a liquidated damages penalty equal to 1% of the aggregate purchaseprice paid for each month the registration statement is not effective, providedthat such liquidated damages shall not exceed 12% of the aggregate purchaseprice.  The maximum exposure at September30, 2007 is approximately $300,000. The Company has met the requirements of theSeries C Preferred Stock registration payment arrangement by registering theshares of common stock with the SEC within the time frame specified by theagreement and has kept the registration continuously effective thereafter.  Company management believes that it will beable to maintain current filing status with the sec over the prescribed period.

As part of a private placement in July 2005 (the “July2005 private placement”), the Company entered into a registration paymentarrangement, whereby the Company agreed to register the shares of common stockissued in the July 2005 private placement with the SEC within certain contractuallyspecified time periods.  The Company alsoagreed to use its best efforts to keep the registration statement continuouslyeffective until the earlier of either the fifth year after the date theregistration statement is declared effective by the SEC or the date when allthe common stock, including the common stock underlying the warrants have beensold.  If the Company is unable toregister the shares of common stock with the SEC or keep the registration statementcontinuously effective in accordance with the Securities Purchase Agreementdated July 22, 2005, between the Company and certain accredited investors, theCompany is subject to a liquidated damages penalty equal to 1% of the aggregatepurchase price paid for each month the registration statement is not effective.The maximum exposure at September 30, 2007 is approximately $54,000. TheCompany determined that no loss contingency related to the July 2005 privateplacement registration payment arrangement was required to be recorded as of September30, 2007. The Company has met the requirements of the July 2005 privateplacement registration payment arrangement by registering the shares of commonstock with the SEC within the time frame specified by the agreement and haskept the registration continuously effective thereafter.  Company management believes that it will beable to maintain current filing status with the SEC over the prescribed period.

 

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**ITEM2.  Management’s Discussion and Analysis of FinancialCondition and Results of Operations**

This Quarterly Report on Form 10-Q containsforward-looking statements within the meaning of Section 27A of theSecurities Act of 1933, as amended, and Section 21E of the SecuritiesExchange Act of 1934, as amended. All forward-looking statements included inthis report are based on information available to us as of the date hereof andwe assume no obligation to update any forward-looking statements.Forward-looking statements involve known or unknown risks, uncertainties andother factors, which may cause our actual results, performance or achievements,or industry results to be materially different from any future results,performance or achievements expressed or implied by such forward-lookingstatements. Factors that could cause or contribute to such differences includebut are not limited to those items discussed under “Risk Factors” beginning onpage 23 and elsewhere in this Quarterly Report.

The following discussion of the financial conditionand results of operations should be read in conjunction with the condensedconsolidated financial statements included elsewhere within this QuarterlyReport. Fluctuations in annual and quarterly results may occur as a result offactors affecting demand for our products such as the timing of new productintroductions by us and by our competitors and our customers’ political andbudgetary constraints. Due to such fluctuations, historical results andpercentage relationships are not necessarily indicative of the operatingresults for any future period.

**OVERVIEW**

ImageWare Systems, Inc. is a leader in theemerging market for software-based identity management solutions, providingbiometric, secure credential and law enforcement technologies.  Our “flagship” product is the IWS BiometricEngineTM.  Scalable for small citybusiness or worldwide deployment, our biometric engine is a multi-biometricplatform that is hardware and algorithm independent, enabling the enrollmentand management of unlimited population sizes. Our identification products are used to manage and issue securecredentials including national IDs, passports, driver licenses, smart cards andaccess control credentials. Our law enforcement products provide lawenforcement with integrated mug shot, fingerprint LiveScan and investigativecapabilities.  The biometric technologyis now an integral part of all markets we address, and all of our products areintegrated into the Biometric Engine Platform.  Elements of the biometricengine can be used as investigative tools to law enforcement potentiallyutilizing multiple biometrics and forensic data elements, and to enhancesecurity and authenticity of public and private sector credentials.

CRITICAL ACCOUNTING ESTIMATES

The discussion and analysis of our financial conditionand results of operations are based on our consolidated financial statements,which have been prepared in accordance with accounting principals generallyaccepted in the United States of America, or U.S. GAAP. The preparation ofthese financial statements in accordance with U.S. GAAP requires us to utilizeaccounting policies and make certain estimates and assumptions that affect thereported amounts of assets and liabilities, the disclosure of contingencies asof the date of the financial statements and the reported amounts of revenue andexpenses during a fiscal period. The SEC considers an accounting policy to becritical if it is important to a company’s financial condition and results ofoperations, and if it requires significant judgment and estimates on thepart of management in its application. Although we believe that ourjudgments and estimates are appropriate and correct, actual resultsmay differ from those estimates.

The following are our critical accounting policiesbecause we believe they are both important to the portrayal of our financialcondition and results of operations and require critical management judgmentsand estimates about matters that are uncertain. If actual results or eventsdiffer materially from those contemplated by us in making these estimates, ourreported financial condition and results of operations for future periods couldbe materially affected.

***Revenue Recognition***

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

•                  Long-term fixed-price contractsinvolving significant customization

•                  Fixed-price contracts involvingminimal customization

 

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•                  Software licensing

•                  Sales of computer hardware andidentification media

•                  Postcontract customer support (PCS)

The Company’s revenue recognition policies areconsistent with U. S. GAAP including Statements of Position 97-2 “SoftwareRevenue Recognition” and 98-9 “Modification of SOP 97-2, Software RevenueRecognition With Respect to Certain Transactions”, SEC Staff AccountingBulletin 104, Emerging Issues Task Force (“EITF”) Issue 00-21 “RevenueArrangements with Multiple Deliverables”, and EITF Issue 03-05 “Applicabilityof AICPA Statement of Position 97-2 to Non-Software Deliverables in anArrangement Containing More-Than-Incidental Software”. Accordingly, the Companyrecognizes revenue when all of the following criteria are met: persuasiveevidence of an arrangement exists, delivery has occurred or services have beenrendered, the fee is fixed or determinable, and collectibility is reasonableassured.

We recognize revenue and profit as work progresses onlong-term, fixed-price contracts involving significant amounts of hardware andsoftware customization using the percentage of completion method based on costsincurred to date compared to total estimated costs at completion. Revenue fromcontracts for which we cannot reliably estimate total costs or which do notinvolve significant amounts of customization are recognized upon completion.Determining when a contract should be accounted for using the percentage ofcompletion method involves judgment. Critical items that are considered in thisprocess are the degree of customization and related labor hours necessary tocomplete the required work as well as ongoing estimates of the future laborhours needed to complete the contract. We also generate non-recurring revenuefrom the licensing of our software. Software license revenue is recognized uponthe execution of a license agreement, upon deliverance, fees are fixed anddeterminable, collectibility is probable and when all other significantobligations have been fulfilled. We also generate revenue from the sale ofcomputer hardware and identification media. Revenue for these items isrecognized upon delivery of these products to the customer. Our revenue fromperiodic maintenance agreements is generally recognized ratably over therespective maintenance periods provided no significant obligations remain andcollectibility of the related receivable is probable.

***Allowance for Doubtful Accounts***

Our management must make estimates of theuncollectibility of our accounts receivable. Management specifically analyzes accountsreceivable and analyzes historical bad debts, customer concentrations, customercreditworthiness, current economic trends, the age of the accounts receivablebalances, and changes in our customer payment terms when evaluating theadequacy of the allowance for doubtful accounts. Our accounts receivablebalance was approximately $889,000 and our allowance for doubtful accounts wasapproximately $498,000 as of September 30, 2007.

***Valuation Of Goodwill And OtherIntangible Assets***

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

•              Significantunderperformance relative to historical or expected future operating results;

•                                          Significant changes in the manner of ouruse of the acquired assets or the strategy of our overall business; and

•              Significantnegative industry or economic trends.

When we determine that the carrying value of goodwilland other intangible assets may not be recoverable based upon theexistence of one or more of the above indicators of impairment, we measure anyimpairment based upon fair value methodologies. Goodwill and other netintangible assets amounted to approximately $3,546,000 as of September 30,2007.

In 2002, SFAS No. 142, “Goodwill and OtherIntangible Assets” became effective, and as a result we ceased to amortizegoodwill. In lieu of amortization, we performed an initial impairment review ofour goodwill in June, 2002 and will perform an annual impairment reviewthereafter in the fourth quarter of our fiscal year.

 

15

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With the sale of our Digital Photography component in2006, we reassessed the composition of our operating segments and determinedthat we no longer operate in separate, distinct market segments but ratheroperate in one market segment, such segment being identity management.  The Company’s determination was based onfundamental changes in the Company’s business structure due to theconsolidation of operations, restructuring of the Company’s operations andmanagement team, and the integration of what were previously distinct, mutuallyexclusive technologies.  This hasresulted in changes in the manner by which the Company’s chief decision makerassesses performance and makes decisions concerning resource allocation.  As a result of our operation in one marketsegment, such segment being identity management, our 2006 goodwill impairmentreview consisted of the comparison of the fair value of our identity managementsegment as determined by the quoted market prices of our common stock to thecarrying amount of the segment. As the fair value exceeded the carrying valueby a substantial margin, we determined that our goodwill was not impaired.  Using the same methodologies, we determinedthat as of September 30, 2007 there were no indicators of potential impairment.

There are many management assumptions and estimatesunderlying the determination of an impairment loss, and estimates usingdifferent, but reasonable, assumptions could produce significantly differentresults. Significant assumptions include estimates of future levels of revenuesand operating expenses. Therefore, the timing and recognition of impairmentlosses by us in the future, if any, may be highly dependent upon our estimatesand assumptions.  There can be noassurance that goodwill impairment will not occur in the future.

We account for long-lived assets in accordance withthe provisions of SFAS No. 144, “Accounting for the Impairment or Disposalof Long-Lived Assets.”  This statementrequires that long-lived assets and certain identifiable intangible assets bereviewed for impairment whenever events or changes in circumstances indicatethat the carrying amount of an asset may not be recoverable.Recoverability of assets to be held and used is measured by a comparison of thecarrying amount of an asset to future net undiscounted cash flows expected tobe generated by the asset. If such assets are considered to be impaired, theimpairment to be recognized is measured by the amount which the carrying amountof the assets exceeds the fair value of the assets. Fair value is determinedbased on discounted cash flows or appraised values, depending upon the natureof the asset. Assets to be disposed of are reported at the lower of thecarrying amount of fair value less costs to sell. We determined that as ofSeptember 30, 2007 there were no indicators of potential impairment. Thereare many management assumptions and estimates underlying the determination ofan impairment loss, and estimates using different, but reasonable, assumptionscould produce significantly different results. Significant assumptions includeestimates of future levels of revenues and operating expenses. Therefore, thetiming and recognition of impairment losses by us in the future, if any,may be highly dependent upon our estimates and assumptions. There can beno assurance that intangible asset impairment will not occur in the future.

***Stock-Based Compensation***

Upon adoption of SFAS 123(R), Share-Based Payment, orSFAS 123(R) on January 1, 2006, we began estimating the value of employeestock options on the date of grant using the Black-Scholes model. Prior to theadoption of SFAS 123R, the value of each employee stock option was estimated onthe date of grant using the Black-Scholes model for the purpose of the proforma financial disclosure in accordance with SFAS 123(R). The determination offair value of stock-based payment awards on the date of grant using anoption-pricing model is affected by our stock price as well as assumptionsregarding a number of highly complex and subjective variables. These variablesinclude, but are not limited to the expected stock price volatility over theterm of the awards and the actual and projected employee stock option exercisebehaviors. The expected term of options granted is derived from historical dataon employee exercises and post-vesting employment termination behavior. Wecalculated our expected volatility assumption required in the Black-Scholesmodel based on the historical volatility of our stock. In addition to the keyassumptions used in the Black-Scholes model, the estimated forfeiture rate atthe time of valuation is a critical assumption. The Company has estimated an annualized forfeiture rate of 5.7% forcorporate officers, 2.4% for members of the Company’s Board of Directors and25% for all other employees.  The Companyreviews the expected forfeiture rate annually to determine if that percent isstill reasonable based on historical experience.

As of January 1, 2006 we have adopted themodified prospective transition method and its effect is included in ourCondensed Consolidated Statements of Operations for all periods presented.

**RESULTS OF OPERATIONS**

Results as presented do not contain the results of ourDigital Photography component due to this component being classified asdiscontinued operations as a result of its sale in November 2006.

16

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**Three Months Ended September 30, 2007 Compared tothe Three Months Ended September 30, 2006**

** **

***Product Revenues***
| ** **                              | ** ** | **Three Months  Ended  September 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|-----------------------------------------|------------|--------------------------------------------------|------------|------------|------------|-------------------|------------|
| **Net Product Revenues**      | ** ** | **2007**                                         | ** ** | **2006**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**    |       |                                             |       |       |       |              |       |   |   |
| Software and royalties                  |       | $                                                | 2,768      |       | $          | 1,300             |       | $ | 1,468 |   | 113 | % |
| Percentage of total net product revenue |       | 98                                               | %          | 83         | %          |              |       |   |   |
| Hardware and consumables                |       | $                                                | 37         |       | $          | 236               |       | $ | (199 | ) | (84 | )% |
| Percentage of total net product revenue |       | 1                                                | %          | 15         | %          |              |       |   |   |
| Services                                |       | $                                                | 27         |       | $          | 24                |       | $ | 3 |   | 13 | % |
| Percentage of total net product revenue |       | 1                                                | %          | 2          | %          |              |       |   |   |
| Total net product revenues              |       | $                                                | 2,832      |       | $          | 1,560             |       | $ | 1,272 |   | 82 | % |

 

Software and royalty revenues increased 113% or$1,468,000 during the three months ended September 30, 2007 as compared to thecorresponding period in 2006.  Theincrease is due primarily to higher project-oriented revenues of our PersonalIdentity Verification (“PIV”) and Biometric Engine solution of approximately$1,627,000 offset by lower royalties and license revenues of approximately$28,000, lower sales of our boxed identification management software throughour distribution channel of $120,000 and lower law enforcement related softwareof $11,000.

Revenues from the sale of hardware and consumablesdecreased 84% or $199,000 during the three months ended September 30, 2007 ascompared to the corresponding period in 2006. The decrease reflects lower revenues from project work containing hardwareand consumable components.

Services revenues are comprised primarily of softwareintegration services, system installation services and customer training.  Such revenues increased approximately $3,000during the three months ended September 30, 2007 as compared to thecorresponding period in 2006 due primarily to higher revenues being generatedfrom software integration project work of our Biometric Engine offset by adecrease in our installation of hardware products.  We expect service revenues to increase in theremainder of 2007 through increased implementations of large-scale high-endsolutions.

We believe that the period-to-period fluctuations of identitymanagement software revenue in project-oriented solutions is largely due to thetiming of government procurement with respect to the various programs we arepursuing.  Based on management’s currentvisibility into the timing of potential government procurements, we believethat we will see a significant increase in government procurement andimplementations with respect to identity management initiatives during theremainder of 2007 and continuing into 2008 and 2009.

We feel that we are well positioned for participationin one or more large-scale domestic or international projects which will enableour company to achieve significant product revenue growth.  In the past eighteen months we havecontinuously retooled our identity management suite of products to meetchanging government specifications and to enable customization for largeproject applications.  Additionally, wereoriented our sales organization to direct our resources and efforts towardestablishing partnerships with large systems integrators as we believe theseintegrators will be the ultimate choice for awards of large-scale secureidentification solutions.

Our backlog of product orders as of September 30,2007 was approximately $1,757,000.  AtSeptember 30, 2007, we also had maintenance and support backlog ofapproximately $1,472,000 under existing maintenance agreements.  Product revenue is typically recognizedwithin a three to six month time period depending upon the required degree ofcustomization, if any and customer implementation schedules.  Historically, we have experienced a veryminimal risk of order cancellation.  Ourrevenue from maintenance agreements is generally recognized ratably over therespective maintenance periods provided no significant obligations remain andcollectibility of the related receivable is probable.

 

17

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**                *Maintenance Revenues***

** **
| ** **                           | ** ** | **Three Months  Ended  September 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|--------------------------------------|------------|--------------------------------------------------|------------|------------|------------|-------------------|------------|
| **Maintenance Revenues**        | ** ** | **2007**                                         | ** ** | **2006**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)** | ** ** | ** **                                       | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| Maintenance revenues                 |       | $                                                | 678        |       | $          | 617               |       | $ | 61 |   | 10 | % |
|                                      |            |                                                  |            |            |            |                   |            |  |  |  |  |  |

 

The increase in maintenance revenues reflects theexpansion of our installed base resulting from the completion of  project-oriented work during the year endedDecember 31, 2006 and the first nine months of 2007.

We anticipate continued growth of our maintenancerevenues through the retention of existing customers combined with theexpansion of installed base resulting from the completion of project-orientedwork, however, we cannot predict the timing of this anticipated growth.

***Cost of Product Revenues***
| ** **                                             | ** ** | **Three Months  Ended  September 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|--------------------------------------------------------|------------|--------------------------------------------------|------------|------------|------------|-------------------|------------|
| **Cost of Product Revenues:**           | ** ** | **2007**                                         | ** ** | **2006**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**                   |       |                                             |       |       |       |              |       |   |   |
| Software and royalties                                 |       | $                                                | 472        |       | $          | 278               |       | $ | 194 |   | 70 | % |
| Percentage of software and royalty product revenue     |       | 17                                               | %          | 21         | %          |              |       |   |   |
| Hardware and consumables                               |       | $                                                | 33         |       | $          | 218               |       | $ | (185 | ) | (85 | )% |
| Percentage of hardware and consumables product revenue |       | 89                                               | %          | 92         | %          |              |       |   |   |
| Services                                               |       | $                                                | 5          |       | $          | 2                 |       | $ | 3 |   | 150 | % |
| Percentage of services product revenue                 |       | 19                                               | %          | 8          | %          |              |       |   |   |
| Total cost of product revenues                         |       | $                                                | 510        |       | $          | 498               |       | $ | 12 |   | 2 | % |
| Percentage of total product revenues                   |       | 18                                               | %          | 32         | %          |              |       |   |   |

 

The cost of software and royalty product revenueincreased 70%, or approximately $194,000, during the three months endedSeptember 30, 2007 as compared to the corresponding period in 2006 dueprimarily to the 2007 period containing higher revenues of $1,468,000.  However, as a percentage of software androyalty product revenue, such costs decreased to 17% from 21% for the threemonths ended September 30, 2007 as compared to the corresponding period in2006. Cost of software and royalty product revenues for the three months endedSeptember 30, 2007 contain third-party software license costs of approximately$163,000. Such costs were lower for the three months ended September 30, 2006due to lower project sales of software solutions requiring such licenses.  Costs of products can vary as a percentage ofproduct revenue from period to period depending upon level of softwarecustomization and third party software license content included in productsales during a given period.

The cost of product revenues for our hardware andconsumable sales decreased 85%, or approximately $185,000 for the three monthsended September 30, 2007 as compared to the corresponding period in 2006. Thisdecrease was due primarily to the decrease in hardware and consumable revenuesof $199,000 for the three months ended September 30, 2007 as compared to thecomparable period in 2006, resulting from an increase in software content inproject solutions for the same periods.

Cost of service revenue increased $3,000 during thethree months ended September 30, 2007 as compared to the corresponding periodin 2006 due to higher software integration revenues of our Biometric Engineinto project solutions.

18

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***Costof Maintenance Revenues***
| ** **                               | ** ** | **Three Months  Ended  September 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|------------------------------------------|------------|--------------------------------------------------|------------|------------|------------|-------------------|------------|
| **Cost of maintenance revenues**    | ** ** | **2007**                                         | ** ** | **2006**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**     |       |                                             |       |       |       |              |       |   |   |
| Total cost of maintenance revenues       |       | $                                                | 281        |       | $          | 254               |       | $ | 27 |   | 11 | % |
| Percentage of total maintenance revenues |       | 41                                               | %          | 41         | %          |              |       |   |   |
|                                          |            |                                                  |            |            |            |                   |            |  |  |  |  |  |

 

Cost of maintenance revenues increased of $27,000 or11% during the three months ended September 30, 2007 as compared to thecorresponding period in 2006 due to higher costs of servicing our expandinginstalled base.

***Product Gross Profit***
| ** **                                             | ** ** | **Three Months  Ended  September 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|--------------------------------------------------------|------------|--------------------------------------------------|------------|------------|------------|-------------------|------------|
| **Product gross profit**                     | ** ** | **2007**                                         | ** ** | **2006**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**                   |       |                                             |       |       |       |              |       |   |   |
| Software and royalties                                 |       | $                                                | 2,296      |       | $          | 1,022             |       | $ | 1,274 |   | 125 | % |
| Percentage of software and royalty product revenue     |       | 83                                               | %          | 79         | %          |              |       |   |   |
| Hardware and consumables                               |       | $                                                | 4          |       | $          | 18                |       | $ | (14 | ) | (78 | )% |
| Percentage of hardware and consumables product revenue |       | 11                                               | %          | 8          | %          |              |       |   |   |
| Services                                               |       | $                                                | 22         |       | $          | 22                |       | $ | 0 |   | 0 | % |
| Percentage of services product revenue                 |       | 81                                               | %          | 92         | %          |              |       |   |   |
| Total product gross profit                             |       | $                                                | 2,322      |       | $          | 1,062             |       | $ | 1,260 |   | 119 | % |
| Percentage of total product revenues                   |       | 82                                               | %          | 68         | %          |              |       |   |   |

 

Total product gross profit increased 119%, or$1,260,000 due to significantly higher product revenues during the three monthsended September 30, 2007 as compared to the corresponding period in 2006.

Software and royalty gross profit increased 125%, or1,274,000, for the three months ended September 30, 2007 as compared to thecorresponding period in 2006.  Thisincrease is due primarily to higher software and royalty product revenues.  As a percentage of software and royaltyproduct revenue, gross profit increased to 83% for the three months endedSeptember 30, 2007 from 79% for the corresponding period in 2006, as the 2007period contained significant software only solutions with minimal customizationand third party software license costs. Costs of software products can vary as a percentage of product revenuefrom quarter to quarter depending upon product mix and third party softwarelicenses included in software solutions.

Hardware and consumables gross profit decreased due tolower sales of hardware and consumables during the three months ended September30, 2007 as compared to the corresponding period in 2006. 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.

***MaintenanceGross Profit***
| ** **                               | ** ** | **Three Months  Ended  September 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|------------------------------------------|------------|--------------------------------------------------|------------|------------|------------|-------------------|------------|
| **Maintenance gross profit**        | ** ** | **2007**                                         | ** ** | **2006**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**     |       |                                             |       |       |       |              |       |   |   |
| Total maintenance gross profit           |       | $                                                | 397        |       | $          | 363               |       | $ | 34 |   | 9 | % |
| Percentage of total maintenance revenues |       | 59                                               | %          | 59         | %          |              |       |   |   |
|                                          |            |                                                  |            |            |            |                   |            |  |  |  |  |  |

 

Gross profit related to maintenance revenues increaseddue primarily to higher maintenance revenues resulting from our expandinginstalled base.

19

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***                Operating Expenses***

** **
| ** **                           | ** ** | **Three Months Ended  September 30,** | ** ** | ** ** | ** ** | ** ** | ** **       |
|--------------------------------------|------------|------------------------------------------------------|------------|------------|------------|------------|------------------|
| **Operating expenses**          | ** ** | **2007**                                             | ** ** | **2006**   | ** ** | **$**      | ** Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)** |       |                                                 |       |       |       |       |             |   |   |
| General & administrative         |       | $                                                    | 889        |       | $          | 1,053      |             | $ | (164 | ) | (16 | )% |
| Percentage of total net revenue      |       | 25                                                   | %          | 48         | %          |       |             |   |   |
| Sales and marketing                  |       | $                                                    | 607        |       | $          | 851        |             | $ | (244 | ) | (29 | )% |
| Percentage of total net revenue      |       | 17                                                   | %          | 39         | %          |       |             |   |   |
| Research & development           |       | $                                                    | 752        |       | $          | 962        |             | $ | (210 | ) | (22 | )% |
| Percentage of total net revenue      |       | 21                                                   | %          | 44         | %          |       |             |   |   |
| Depreciation and amortization        |       | $                                                    | 60         |       | $          | 57         |             | $ | 3 |   | 5 | % |
| Percentage of total net revenue      |       | 2                                                    | %          | 3          | %          |       |             |   |   |

 

***General and AdministrativeExpenses.***  Generaland administrative expenses are comprised primarily of salaries and otheremployee-related costs for executive, financial, and other infrastructurepersonnel. General legal, accounting and consulting services, insurance,occupancy and communication costs are also included with general andadministrative expenses.  General andadministrative expenses decreased 16%, or $164,000, during the three monthsended September 30, 2007 as compared to the corresponding period in 2006 due tolower stock-based compensation expense of approximately $78,000 recorded in thethree months ended September 30, 2007 as compared to the corresponding periodin 2006 combined with lower costs of approximately $43,000 for professionalservices, consulting, contractor fees and insurance and $63,000 in lower costsresulting from the closure of our German sales office offset by increases of$20,000 for travel expenses.  As apercentage of total net revenues, general and administrative expenses decreasedfrom 48% to 25% due to higher net revenues during the three months endedSeptember 30, 2007 as compared to the corresponding period in 2006.  We continue to focus our efforts on achievingadditional future operating efficiencies by reviewing and improving uponexisting business processes and evaluating our cost structure. We believe theseefforts will allow us to gradually decrease our level of general andadministrative expenses expressed as a percentage of total revenues.

***Sales and Marketing.***  Sales and marketing expenses consistprimarily of the salaries, commissions, other incentive compensation, employeebenefits and travel expenses of our sales, marketing, business development andproduct management functions.   Sales andmarketing expenses decreased 29%, or $244,000, for the three months endedSeptember 30, 2007 as compared to the corresponding period in 2006 due toheadcount reductions resulting from the elimination and consolidation ofvarious sales positions.  As a percentageof net revenues, sales and marketing expenses decreased from 39% to 17% for thethree months ended September 30, 2007 for the corresponding period in 2006 dueto higher product revenues.

***Research and Development.***  Research and development expenses consistprimarily of salaries, employee benefits and outside contractors for newproduct development, product enhancements and custom integration work.  Research and development expenses decreased22%, or $210,000, for the three months ended September 30, 2007 as compared tothe corresponding period in 2006 due primarily to reductions in our utilizationof contract programming resources.  As apercentage of total net revenues, research and development expenses decreasedfrom 44% to 21% for the three months ended September 30, 2007 as comparedto the corresponding period in 2006 due to higher net revenues.  Our level of expenditures in research anddevelopment reflects our belief that to maintain our competitive position inmarkets characterized by rapid rates of technological advancement, we mustcontinue to invest significant resources in new systems and software as well ascontinue to enhance existing products.

***Depreciation and Amortization.***  During the three months ended September 30,2007, depreciation and amortization expense increased 5% or $3,000 as comparedto the corresponding period in 2006. The increase in depreciation andamortization expense reflects depreciation expense for recently acquired fixedassets.

***Interest Expense (Income), net.***  For the three months ended September 30,2007, we recognized interest income of $9,000 and interest expense of $7,000.For the three months ended September 30, 2006, we recognized interestincome of $4,000 and interest expense of $160,000.  Interest expense for the three months endedSeptember 30, 2007 decreased from the corresponding period in 2006 due tothe payoff in full of our secured notes payable in March 2007.

 

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**Nine Months Ended September 30, 2007 Compared tothe Nine Months Ended September 30, 2006**

** **

***Product Revenues***
| ** **                              | ** ** | **Nine Months  Ended  September 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|-----------------------------------------|------------|-------------------------------------------------|------------|------------|------------|-------------------|------------|
| **Net Product Revenues**           | ** ** | **2007**                                        | ** ** | **2006**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**    |       |                                            |       |       |       |              |       |   |   |
| Software and royalties                  |       | $                                               | 4,178      |       | $          | 4,773             |       | $ | (595 | ) | (12 | )% |
| Percentage of total net product revenue |       | 89                                              | %          | 78         | %          |              |       |   |   |
| Hardware and consumables                |       | $                                               | 227        |       | $          | 1,214             |       | $ | (987 | ) | (81 | )% |
| Percentage of total net product revenue |       | 5                                               | %          | 20         | %          |              |       |   |   |
| Services                                |       | $                                               | 293        |       | $          | 138               |       | $ | 155 |   | 112 | % |
| Percentage of total net product revenue |       | 6                                               | %          | 2          | %          |              |       |   |   |
| Total net product revenues              |       | $                                               | 4,698      |       | $          | 6,125             |       | $ | (1,427 | ) | (23 | )% |

 

Software and royalty revenues decreased 12% or$595,000 during the nine months ended September 30, 2007 as compared to the correspondingperiod in 2006.  The decrease is dueprimarily to lower project-oriented revenues of our Biometric Engine ofapproximately $74,000 combined with lower royalties and license revenues ofapproximately $308,000 and lower project revenues of our law enforcementsoftware solutions of approximately $213,000.

Revenues from the sale of hardware and consumablesdecreased 81% or $987,000 during the nine months ended September 30, 2007 ascompared to the corresponding period in 2006. The decrease reflects lower revenues from project solutions containinghardware and consumable components as well as the repositioning of ourinternational sales office in Germany in order to lower fixed costs and pursuesignificant identity management projects utilizing our software technologies asour primary differentiator.  This officehad historically emphasized the resale of third-party hardware and consumableswhich generated lower gross margins than software (as a percentage of revenue)and required significant fixed costs for sales, service and support.  The resulting effect on hardware andconsumables revenues from the closure of this office was a decrease ofapproximately $184,000 in the nine months ended September 30, 2007 as comparedto the corresponding period in 2006.

Services revenues are comprised primarily of softwareintegration services, system installation services and customer training.  Such revenues increased approximately$155,000 during the nine months ended September 30, 2007 as compared to thecorresponding period in 2006 due primarily to higher service revenues beinggenerated from software integration of our biometric engine into projectsolutions and a decrease in our installation of hardware products.  We expect service revenues to increase in theremainder of 2007 through increased implementations of large-scale high-endsolutions.

We believe that the lower identity management softwarerevenue in project-oriented solutions is largely due to the timing ofgovernment procurement with respect to the various programs we arepursuing.  Based on management’s currentvisibility into the timing of potential government procurements, we believethat we will see a significant increase in government procurement andimplementations with respect to identity management initiatives during theremainder of 2007 and continuing into 2008 and 2009.

We feel that we are well positioned for participationin one or more large-scale domestic or international projects which will enableour company to achieve significant product revenue growth.  In the past eighteen months we havecontinuously retooled our identity management suite of products to meetchanging government specifications and to enable customization for largeproject applications.  Additionally, wereoriented our sales organization to direct our resources and efforts towardestablishing partnerships with large systems integrators as we believe theseintegrators will be the ultimate choice for awards of large-scale secureidentification solutions.

***Maintenance Revenues***
| ** **                           | ** ** | **Nine Months  Ended  September 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|--------------------------------------|------------|-------------------------------------------------|------------|------------|------------|-------------------|------------|
| **Maintenance Revenues**             | ** ** | **2007**                                        | ** ** | **2006**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)** |       |                                            |       |       |       |              |       |   |   |
| Maintenance revenues                 |       | $                                               | 1,926      |       | $          | 1,683             |       | $ | 243 |   | 14 | % |
|                                      |            |                                                 |            |            |            |                   |            |  |  |  |  |  |

 

 

21

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The increase in maintenance revenues reflects theexpansion of our installed base resulting from the completion of significantproject-oriented work during the year ended December 31, 2006 and the firstnine months of 2007.

We anticipate continued growth of our maintenancerevenues through the retention of existing customers combined with theexpansion of installed base combined resulting from the completion ofproject-oriented work, however, we cannot predict the timing of thisanticipated growth.

***Cost of Product Revenues***
| ** **                                             | ** ** | **Nine Months  Ended  September 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|--------------------------------------------------------|------------|-------------------------------------------------|------------|------------|------------|-------------------|------------|
| **Cost of Product Revenues:**           | ** ** | **2007**                                        | ** ** | **2006**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**                   |       |                                            |       |       |       |              |       |   |   |
| Software and royalties                                 |       | $                                               | 682        |       | $          | 777               |       | $ | (95 | ) | (12 | )% |
| Percentage of software and royalty product revenue     |       | 16                                              | %          | 16         | %          |              |       |   |   |
| Hardware and consumables                               |       | $                                               | 236        |       | $          | 906               |       | $ | (670 | ) | (74 | )% |
| Percentage of hardware and consumables product revenue |       | 104                                             | %          | 75         | %          |              |       |   |   |
| Services                                               |       | $                                               | 74         |       | $          | 6                 |       | $ | 68 |   | 1,133 | % |
| Percentage of services product revenue                 |       | 25                                              | %          | 4          | %          |              |       |   |   |
| Total cost of product revenues                         |       | $                                               | 992        |       | $          | 1,689             |       | $ | (697 | ) | (41 | )% |
| Percentage of total product revenues                   |       | 21                                              | %          | 28         | %          |              |       |   |   |

 

The cost of software and royalty product revenuedecreased 12% or $95,000 during the nine months ended September 30, 2007 ascompared to the corresponding period in 2006 due to lower software and royaltyrevenues during the nine months ended September 30, 2007.  Costs of products can vary as a percentage ofproduct revenue from period to period depending upon level of softwarecustomization and third party software license content included in productsales during a given period.

The cost of product revenues for our hardware andconsumable sales decreased 74% or approximately $670,000 for the nine monthsended September 30, 2007 as compared to the corresponding period in 2006. Thisdecrease was due primarily to the decrease in hardware and consumable revenuesof $987,000 for the nine months ended September 30, 2007 as compared to thecomparable period in 2006, resulting from an increase in software content inproject solutions for the same periods.

Cost of service revenue increased $68,000 during thenine months ended September 30, 2007 as compared to the corresponding period in2006 due to higher software integration revenues of our Biometric Engine intoproject solutions.

***Cost of Maintenance Revenues***
| ** **                               | ** ** | **Nine Months  Ended  September 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|------------------------------------------|------------|-------------------------------------------------|------------|------------|------------|-------------------|------------|
| **Cost of maintenance revenues**    | ** ** | **2007**                                        | ** ** | **2006**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**     |       |                                            |       |       |       |              |       |   |   |
| Total cost of maintenance revenues       |       | $                                               | 871        |       | $          | 826               |       | $ | 45 |   | 5 | % |
| Percentage of total maintenance revenues |       | 45                                              | %          | 49         | %          |              |       |   |   |
|                                          |            |                                                 |            |            |            |                   |            |  |  |  |  |  |

 

Cost of maintenance revenues as a percentage ofmaintenance revenues decreased to 45% during the nine months ended September30, 2007 from 49% for the corresponding period in 2006 due primarily to highermaintenance revenues to absorb fixed maintenance costs combined with a higherpercentage of our maintenance revenues being generated from softwaremaintenance versus hardware maintenance. The dollar increase of $45,000 or 5% during the nine months endedSeptember 30, 2007 as compared to the corresponding period in 2006 reflectshigher costs needed to service our expanding installed base.

 

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***                Product GrossProfit***

** **
| ** **                                             | ** ** | **Nine Months  Ended  September 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|--------------------------------------------------------|------------|-------------------------------------------------|------------|------------|------------|-------------------|------------|
| **Product gross profit**                     | ** ** | **2007**                                        | ** ** | **2006**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**                   |       |                                            |       |       |       |              |       |   |   |
| Software and royalties                                 |       | $                                               | 3,496      |       | $          | 3,996             |       | $ | (500 | ) | (13 | )% |
| Percentage of software and royalty product revenue     |       | 84                                              | %          | 84         | %          |              |       |   |   |
| Hardware and consumables                               |       | $                                               | (9         | )          | $          | 308               |       | $ | (317 | ) | (103 | )% |
| Percentage of hardware and consumables product revenue |       | (4                                              | )%         | 25         | %          |              |       |   |   |
| Services                                               |       | $                                               | 219        |       | $          | 132               |       | $ | 87 |   | 66 | % |
| Percentage of services product revenue                 |       | 75                                              | %          | 96         | %          |              |       |   |   |
| Total product gross profit                             |       | $                                               | 3,706      |       | $          | 4,436             |       | $ | (730 | ) | (16 | )% |
| Percentage of total product revenues                   |       | 79                                              | %          | 72         | %          |              |       |   |   |
|                                                        |            |                                                 |            |            |            |                   |            |  |  |  |  |  |  |

 

Total product gross profit decreased 16% or $730,000,during the nine months ended September 30, 2007 as compared to thecorresponding period in 2006 due to significantly lower product revenues.

Software and royalty gross profit decreased 13% or$500,000 for the nine months ended September 30, 2007 as compared to thecorresponding period in 2006 due to lower software sales of our BiometricEngine, royalties and law enforcement software solutions.

Hardware and consumables gross profit decreased 103%or $317,000 during the nine months ended September 30, 2007 as compared to thecorresponding period in 2006 due to lower sales of hardware and consumables of$987,000 during the nine months ended September 30, 2007 as compared to thecorresponding period in 2006. Hardware and consumables gross profit as apercentage of hardware and consumables product revenue decreased to (4%) from25% and reflects the 2007 period containing expenses charged to cost of salesfor restocking fees. Costs of products can vary as a percentage of productrevenue from quarter to quarter depending upon product mix and hardware contentand print media consumable content included in systems installed during a givenperiod.

Services gross profit increased approximately 66% or$87,000 for the nine months ended September 30, 2007 as compared to thecorresponding period of 2006 due to higher project revenues for the integrationof our Biometric Engine into project solutions.

***MaintenanceGross Profit***
| ** **                               | ** ** | **Nine Months  Ended  September 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|------------------------------------------|------------|-------------------------------------------------|------------|------------|------------|-------------------|------------|
| **Maintenance gross profit**   | ** ** | **2007**                                        | ** ** | **2006**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**     |       |                                            |       |       |       |              |       |   |   |
| Total maintenance gross profit           |       | $                                               | 1,055      |       | $          | 857               |       | $ | 198 |   | 23 | % |
| Percentage of total maintenance revenues |       | 55                                              | %          | 51         | %          |              |       |   |   |
|                                          |            |                                                 |            |            |            |                   |            |  |  |  |  |  |

 

Gross margins related to maintenance revenuesincreased due primarily to higher maintenance revenues to absorb fixedmaintenance costs.

 

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            ***Operating Expenses***

*** ***
| ** **                           | ** ** | **Nine Months Ended  September 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|--------------------------------------|------------|-----------------------------------------------------|------------|------------|------------|-------------------|------------|
| **Operating expenses**          | ** ** | **2007**                                            | ** ** | **2006**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)** |       |                                                |       |       |       |              |       |   |   |
| General & administrative         |       | $                                                   | 2,989      |       | $          | 3,271             |       | $ | (282 | ) | (9) | % |
| Percentage of total net revenue      |       | 45                                                  | %          | 42         | %          |              |       |   |   |
| Sales and marketing                  |       | $                                                   | 1,974      |       | $          | 2,742             |       | $ | (768 | ) | (28) | % |
| Percentage of total net revenue      |       | 30                                                  | %          | 35         | %          |              |       |   |   |
| Research & development           |       | $                                                   | 2,741      |       | $          | 2,898             |       | $ | (157 | ) | (5) | % |
| Percentage of total net revenue      |       | 41                                                  | %          | 37         | %          |              |       |   |   |
| Depreciation and amortization        |       | $                                                   | 199        |       | $          | 245               |       | $ | (46 | ) | (19) | % |
| Percentage of total net revenue      |       | 3                                                   | %          | 3          | %          |              |       |   |   |

 

***General and AdministrativeExpenses.***  Generaland administrative expenses are comprised primarily of salaries and otheremployee-related costs for executive, financial, and other infrastructurepersonnel. General legal, accounting and consulting services, insurance,occupancy and communication costs are also included with general andadministrative expenses.  General andadministrative expenses decreased 9%, or $282,000, due to lower stock-basedcompensation expense of approximately $265,000 and lower professional servicecosts of $39,000 recorded in the nine months ended September 30, 2007 ascompared to the corresponding period in 2006 combined with reduced costs ofapproximately $76,000 due to the closure in 2006 of our sales office inGermany, offset by approximately $98,000 in higher expense for personnel andbad debts.  As a percentage of total netrevenues, general and administrative expenses increased from 42% to 45% duringthe nine months ended September 30, 2007 as compared to the correspondingperiod in 2006 due to lower net revenues. We continue to focus our efforts on achieving additional futureoperating efficiencies by reviewing and improving upon existing businessprocesses and evaluating our cost structure. We believe these efforts willallow us to gradually decrease our level of general and administrative expensesexpressed as a percentage of total revenues.

***Sales and Marketing.***  Sales and marketing expenses consistprimarily of the salaries, commissions, other incentive compensation, employeebenefits and travel expenses of our sales, marketing, business development andproduct management functions.  Sales andmarketing expenses decreased 28%, or $768,000 and as a percentage of netrevenues from 35% to 30% for the nine months ended September 30, 2007 ascompared to the corresponding period in 2006 due to headcount reductionsresulting from the elimination and consolidation of various sales positions, areduction in stock compensation expense, advertising and contractor fees.

***Research and Development.***  Research and development expenses consistprimarily of salaries, employee benefits and outside contractors for newproduct development, product enhancements and custom integration work.  Research and development expenses decreased5%, or $157,000, for the nine months ended September 30, 2007 as compared tothe corresponding period in 2006 due primarily to reduced contract programmingfees offset by increased headcount necessary for the continued development ofour Biometric Engine, the development of our Personal Identity Verification(PIV) solution, the web enablement of our CCS product line, and the developmentof our IWS desktop security solution.  Asa percentage of total net revenues, such expenses increased from 37% to 41% forthe nine months ended September 30, 2007 as compared to the correspondingperiod in 2006 due to lower net revenues in the 2007 period. Our level ofexpenditures in research and development reflects our belief that to maintainour 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.***  During the nine months ended September 30,2007, depreciation and amortization expense decreased 19% or $46,000 ascompared to the corresponding period in 2006. The decrease in depreciation andamortization expense reflects lower amortization of certain intangible assets dueto such assets being fully amortized.

***Interest Expense (Income), net.***  For the nine months ended September 30,2007, we recognized interest income of $23,000 and interest expense of$259,000. For the nine months ended September 30, 2006, we recognized interestincome of $13,000 and interest expense of $352,000.  Interest expense for the nine months endedSeptember 30, 2006 contains three components approximating $342,000related to our secured notes payable issued in March 2006: $58,000 of couponinterest, $227,000 in note discount amortization and $57,000 in deferredfinancing fee amortization classified as interest expense. Interest expense forthe nine months ended September 30, 2007 decreased from the correspondingperiod in 2006 due to the payoff in full of our secured notes payable in March2007.

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**LIQUIDITY AND CAPITAL RESOURCES**

As of September 30, 2007, we had total currentassets of $4,247,000 and total current liabilities of $4,298,000, or negativeworking capital of $51,000.  At September30, 2007, we had available cash of $3,438,000 and $145,000 in restricted cashsecuring our performance on certain software implementation contracts.

Net cash used in operating activities was $1,080,000for the nine month period ended September 30, 2007 as compared to $1,494,000for the corresponding period in 2006. We used cash to fund net losses of$2,381,000, excluding non-cash expenses (depreciation, amortization, debtissuance costs, debt discount, stock-based compensation and provision forlosses on accounts receivable and investment in marketable securities lessreductions in inventory obsolescence reserves) of $1,018,000 for the ninemonths ended September 30, 2007.  We usedcash to fund net losses of $2,980,000, excluding non-cash expenses(depreciation, amortization, debt issuance costs, debt discount and stock-basedcompensation) of $1,458,000 for the nine months ended September 30, 2006.  For the nine months ended September 30, 2007,we generated cash of $998,000 through reduction in current assets and generatedcash of $303,000 through increases in current liabilities and deferredrevenues, excluding debt.  For the ninemonths ended September 30, 2006, we generated cash of $50,000 throughreductions in current assets and generated cash of $1,436,000 through increasesin current liabilities and deferred revenues, excluding debt.

Net cash used in investing activities was $68,000 forthe nine months ended September 30, 2007. Net cash used in investing activities was $113,000 for the nine monthsended September 30, 2006.  For thenine months ended September 30, 2007, we used cash to fund capital expendituresof computer equipment, software and furniture and fixtures of approximately$68,000.  The level of equipmentpurchases resulted primarily from the replacement of older equipment.  For the nine months ended September 30,2006, we used cash to fund capital expenditures of computer equipment andsoftware, furniture and fixtures and leasehold improvements of approximately$113,000.

Net cash provided by financing activities was$3,680,000 for the nine month period ended September 30, 2007 as comparedto $1,211,000 for the corresponding period in 2006.  For the nine months ended September 30,2007, we generated cash of $1,327,000 from our issuance of preferred stock in aprivate placement net of direct transaction costs of $173,000.  We also generated cash of $1,121,000 from ourissuance of common stock pursuant to warrant exercises and $2,621,000 from ourissuance of common stock in a private placement net of direct transaction costsof $404,000. For the nine months ended September 30, 2007, we used cash of$1,310,000 for the repayment of our secured notes payable and used cash of$54,000 from the incurrence of financing related expenses.   We also used cash of $25,000 for the paymentof dividends on our Series B Preferred Stock. For the nine months ended September 30, 2006, we generated cash of$1,550,000 from the issuance of secured notes payable and incurred debtissuance costs of $98,000.  For the ninemonths ended September 30, 2006, we used cash of $215,000 for the repayment ofour secured notes payable and used cash of $26,000 for the payment of dividendson our Series B Preferred Stock.

We conduct operations in leased facilities underoperating leases expiring at various dates through 2009. In conjunction withour performance on various software installation and implementation contracts,we are contingently liable under two irrevocable letters of credit in anaggregate amount of $145,000. The letters of credit expire on March 30, 2008 inthe amount of $39,000 and on December 26, 2008 in the amount of $106,000.

The report of our independent accountants includedwith our Annual Report on Form 10-K as filed with the SEC on April 17,2007, contained an explanatory paragraph regarding our ability to continue as agoing concern.  We are seeking additionalfinancing that we believe is necessary to fund our working capital requirementsfor at least the next twelve months in conjunction with the successfulimplementation of our business plan. Our business plan includes, among otherthings, the monitoring and controlling of operating expenses, collection ofsignificant trade and other accounts receivable, and controlling of capitalexpenditures. We may seek to sell equity or debt securities, secure a bankline of credit, or consider strategic alliances. The sale of equity orequity-related securities could result in additional dilution to ourshareholders. There can be no assurance that additional financing, in any form,will be available at all or, if available, will be on terms acceptable to us.In addition, our ability to raise additional capital may be dependent uponour common stock continuing to be quoted on the American Stock Exchange (“AMEX”).There can be no assurance that we will be able to satisfy the criteria forcontinued listing on AMEX. Insufficient funds will require us to sellcertain of our assets or license or technologies to others and if we are unableto obtain additional funding there is substantial doubt about our ability tocontinue as a going concern.

**ITEM 3. Quantitative andQualitative Disclosures About Market Risk**

***Foreign Currency Exchange Risk.***Marketrisk is the potential loss arising from adverse changes in market rates andprices, such as interest rates and foreign currency exchange rates.  Changes in foreign currency exchange rateshave an 

 

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impact on our results ofoperations. Our exposure to adverse movements in foreign currency exchangerates is primarily related to our subsidiaries operating expense, primarily inCanada, denominated in the respective local currency. We currently do not enterinto forward exchange contracts to hedge exposures denominated in foreigncurrencies and do not use derivative financial instruments for trading orspeculative purposes. The effect of an immediate 10% change in foreign currencyexchange rates should not have a material effect on our future operatingresults or cash flows; however, a long term change in foreign currency rateswould likely result in increased technical support and engineering expenses.The vast majority of our sales are transacted in U. S. dollars.

**ITEM 4. Controls andProcedures**

***Conclusions Regarding theEffectiveness of Disclosure Controls and Procedures.**** *Underthe supervision and with the participation of our management, including ourprincipal executive officer and principal financial officer, we conducted anevaluation of our disclosure controls and procedures as such term is definedunder Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, asamended.  Based on this evaluation, ourprincipal executive officer and principal financial officer have concluded,based upon their evaluation as of the end of the period covered by this report,that our disclosure controls and procedures are effective in ensuring thatinformation required to be disclosed in the reports that we file or submitunder the Securities Exchange Act of 1934 is recorded, processed, summarizedand reported within the time periods specified in the SEC’s rules and forms.

***Changes in Internal Control OverFinancial Reporting*.** There has been no change in our internal control over financialreporting during the fiscal quarter ended September 30, 2007, that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

**PART II**

**ITEM 1A.  Risk Factors**

Ourresults of operations and financial condition are subject to numerous risks anduncertainties described in our Annual Report on Form 10-K for our fiscal yearended December 31, 2006, filed on April 17, 2007 and as amended on April 30,2007, May 7, 2007 and May 9, 2007 and incorporated herein by reference.  You should carefully consider these riskfactors in conjunction with the other information contained in thisreport.  Should any of these risksmaterialize, our business, financial condition and future prospects could benegatively impacted.  As of September 30,2007, there have been no material changes to the disclosures made on theabove-referenced Form 10-K, as amended, except as follows:

**Wehave had net losses in our five most recent fiscal years and currently havestockholder’s equity of less than $6,000,000, and as a result, AMEXmay consider suspending or delisting our securities from the exchange.**

TheAMEX Company Guide provides that AMEX will normally consider suspendingdealings in, or removing from the list, securities of a company which sustainsnet losses in its five most recent fiscal years and has stockholders’ equity ofless than $6,000,000, unless the company has total market capitalization of atleast $50,000,000, or total assets and revenue of $50,000,000. We havesustained net losses during our five most recent fiscal years, and as of theyear ended December 31, 2006, our stockholders’ equity dropped to$1,319,890, from $3,365,602 for the year ended December 31, 2005. We donot meet the alternative minimum market capitalization or total asset andrevenue requirements. As a result, we may be considered for suspension ordelisting from AMEX. During May 2006, we received notification from AMEX thatwe were not in compliance with certain sections of the AMEX Company Guide.  To maintain an AMEX listing, we were requiredto submit a plan to AMEX which demonstrates our ability to regain compliancewith the continued listing standards within a maximum of 18 months.  We submitted our plan to AMEX during June2006.  The Listing QualificationsDepartment of AMEX evaluated our plan and in September 2006 notified us that wehad made a reasonable demonstration in the plan of an ability to regaincompliance with the continued listing standards by the end of the plan periodswhich AMEX determined to be November 15, 2006 for Section 1003(a)(iv) of theAMEX Company Guide and November 30, 2007 for Sections 1003(a)(i), 10033(a)(ii)and 1003(a)(iii) of the AMEX Company Guide.  Accordingly, in September 2006, AMEX notified us that they wouldcontinue the listing of the Company subject to us making a public announcementdisclosing the fact that we are not in compliance with the continued listingstandards of the Exchange and that our listing is being continued pursuant toan extension and our providing certain supporting documentation of key elementsof our plan.  We made the required publicannouncement and provided the requested information.  We are subject to periodic review todetermine if we are making progress consistent with the plan.  Failure to make progress consistent with theplan or regain compliance with the continued listing standards by the end ofthe applicable extension periods could result in the AMEX initiating delistingproceedings pursuant to Section 1009 of the AMEX Company Guide.  There is no assurance that we will makeprogress consistent with the plan, or that we will be able to continue our listingon AMEX.

 

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**We have ahistory of significant recurring losses totaling approximately $74.6 million,and these losses may continue in the future.**

As of September 30, 2007, we had an accumulateddeficit of $74.6 million, and these losses may continue in thefuture. We will need to raise capital to cover these losses, and financingmay not be available to us on favorable terms. In the event financing isnot available, in the time frame required, we will be forced to sell certain ofour assets or license our technologies to others. We expect to continue toincur significant sales and marketing, research and development, and generaland administrative expenses. As a result, we will need to generate significantrevenues to achieve profitability and we may never achieve profitability.

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

 

•      varying demand for and market acceptance of ourtechnology and products;

 

•      changes in our product or customer mix;

 

•      the gain or loss of one or more key customers or theirkey customers, or significant changes in thefinancial condition of one or more of our keycustomers or their key customers;

 

•      our ability to introduce, certify and deliver newproducts and technologies on a timely basis;

 

•      the announcement or introduction of products andtechnologies by our competitors;

 

•      competitive pressures on selling prices;

 

•      costs associated with acquisitions and the integrationof acquired companies, products and technologies;

 

•      our ability to successfully integrate acquiredcompanies, products and technologies;

 

•      our accounting and legal expenses; and

 

•      general economic conditions.

 

These factors, some of which are not within ourcontrol, may cause the price of our stock to fluctuate substantially. Torespond to these and other factors, we may need to make business decisions thatcould result in failure to meet financial expectations. If our quarterlyoperating results fail to meet or exceed the expectations of securitiesanalysts or investors, our stock price could drop suddenly and significantly.Most of our expenses, such as employee compensation, inventory and debtrepayment obligations, are relatively fixed in the short term. Moreover, ourexpense levels are based, in part, on our expectations regarding future revenuelevels. As a result, if our revenue for a particular period were below ourexpectations, we would not be able to proportionately reduce our operatingexpenses for that period. Any revenue shortfall would have a disproportionatelynegative effect on our operating results for the period.

 

**The holders of our preferred stock have certainrights and privileges that are senior to the common stock and we may issueadditional shares of preferred stock without shareholder approval that couldhave a material adverse effect on the market value of the common stock.**

Our Board of Directors has the authority to issue atotal of up to 4,000,000 shares of preferred stock and to fix the rights,preferences, privileges, and restrictions, including voting rights, of thepreferred stock, which typically are senior to the rights of the common stockholders,without any further vote or action by the common stockholders. The rights ofour common shareholders will be subject to, and may be adversely affected by,the rights of the holders of the preferred stock that have been issued, ormight be issued in the future. Preferred stock also could have the effect ofmaking it more difficult for a third party to acquire a majority of theoutstanding voting stock of ImageWare. This could delay, defer, or prevent achange in control. Furthermore, holders of preferred stock may have otherrights, including economic rights, senior to the common 

 

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stock. As a result, their existence and issuance couldhave a material adverse effect on the market value of the common stock. We havein the past issued and may from time to time in the future issue, preferredstock for financing or other purposes with rights, preferences, or privilegessenior to the common stock. At September 30, 2007 we had three series ofpreferred stock outstanding, Series B Preferred Stock, Series C 8% ConvertiblePreferred Stock and Series D 8% Convertible Preferred Stock.

The provisions of our 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 BPreferred Stock we are obligated to pay cumulative cash dividends on shares ofSeries B Preferred Stock from legally available funds at the annual rate of$0.2125 per share, payable in two semi-annual installments of $0.10625 each,which cumulative dividends must be paid prior to payment of any dividend on ourcommon stock. As of September 30, 2007, the Company had cumulative undeclareddividends on the Series B Preferred Stock of approximately $21,000.

The Series C Preferred Stock has a liquidationpreference equal to its stated value, plus any accrued and unpaid dividendsthereon and any other fees or liquidated damages owing thereon. The Series CPreferred Stock accrues cumulative dividends at the rate of 8.0% of the statedvalue per share per annum.  At the option of the Company, the dividendpayment may be made in the form of cash, after the payment of cash dividends tothe holders of Series B Preferred Stock, or common stock issuable uponconversion of the Series C Preferred Stock.  Each share of Series CPreferred Stock is convertible at any time at the option of the holder into anumber of shares of common stock equal to the stated value (initially $1,000per share, subject to adjustment), plus any accrued and unpaid dividends,divided by the conversion price (initially $1.50 per share, subject toadjustment). Subject to certain limitations, the conversion price per shareshall be adjusted in the event of certain subsequent stock dividends, splits,reclassifications, dilutive issuances, rights offerings, andreclassifications.  The Series C Preferred Stock generally does not havevoting rights except as required by law, however, certain activities may not beundertaken by the Company without the affirmative vote of a majority of theholders of the outstanding shares of Series C Preferred Stock. As of September30, 2007, the Company had cumulative undeclared dividends on the Series C PreferredStock of approximately $162,000.

The Series D Preferred Stock has a liquidationpreference equal to its stated value, plus any accrued and unpaid dividendsthereon and any other fees or liquidated damages owing thereon. The Series DPreferred Stock accrues cumulative dividends at the rate of 8.0% of the statedvalue per share per annum.  At the option of the Company, the dividendpayment may be made in the form of cash, after the payment of cash dividends tothe holders of Series B and Series C Preferred Stock, or common stock issuableupon conversion of the Series D Preferred Stock.  Each share of Series DPreferred Stock is convertible at any time at the option of the holder into anumber of shares of common stock equal to the stated value (initially $1,000per share, subject to adjustment), plus any accrued and unpaid dividends,divided by the conversion price (initially $1.90 per share subject toadjustment). Subject to certain limitations, the conversion price per shareshall be adjusted in the event of certain subsequent stock dividends, splits,reclassifications, dilutive issuances, rights offerings, andreclassifications.  The Series D Preferred Stock generally does not havevoting rights except as required by law, however, certain activities may not beundertaken by the Company without the affirmative vote of a majority of theholders of the outstanding shares of Series C Preferred Stock. As of September30, 2007, the Company had cumulative undeclared dividends on the Series DPreferred Stock of approximately $68,000.

**ITEM 6. Exhibits**
| **(a)** | ** ** | **EXHIBITS**                                                                                                                                                                                                                                                               |
|---------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1     |       | Certificate  of Incorporation (incorporated by reference to Annex B to the Company’s  Definitive Proxy Statement on Schedule 14A, filed November 15, 2005).                                                                                                           |
| 3.2     |       | Bylaws  (incorporated by reference to Annex C to the Company’s Definitive Proxy  Statement on Schedule 14A, filed November 15, 2005).                                                                                                                       |
| 3.3     |       | Certificate  of Designations of Preferences, Rights and Limitations of Series C 8%  Convertible Preferred Stock dated November 2, 2006, as amended (incorporated  by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K,  filed November 20, 2006). |
| 3.4     |       | Certificate  of Designations of Preferences, Rights and Limitations of Series D 8%  Convertible Preferred Stock dated March 8, 2007 (incorporated by reference to  Exhibit 3.1 to the Company’s Current Report on Form 8-K, filed March 15,  2007).                   |
| 10.1    |       | Securities  Purchase Agreement dated September 25, 2007 by and among the Company and  certain accredited investors (incorporated by reference to Exhibit 10.1 to  the Company’s Current Report on Form 8-K, filed September 26, 2007).                                |

 

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| 10.2 |   | Registration Rights Agreement dated September 25,  2007 by and among the Company and certain accredited investors (incorporated  by reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K,  filed September 26, 2007). |
|------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.3 |   | Form of Warrant to Purchase Common Stock dated  September 25, 2007 (incorporated by reference to Exhibit 10.3 to the  Company’s Current Report on Form 8-K, filed September 26, 2007).                                                 |
| 31.1 |   | Certification of the Principal Executive Officer  pursuant to Rule 13a-14(a) and 15d-14(a)                                                                                                                                                  |
| 31.2 |   | Certification of the Principal Financial and  Accounting Officer pursuant to Rule 13a-14(a) and 15d-14(a)                                                                                                                                   |
| 32.1 |   | Certification by the Principal Executive Officer and  Principal Financial and Accounting Officer pursuant to 18 U.S.C. 1350 as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                           |

 

**SIGNATURES**

Pursuant to the requirements of the SecuritiesExchange Act, the registrant has duly caused this report to be signed on itsbehalf by the undersigned thereunto duly authorized.
|                    |   | IMAGEWARE SYSTEMS, INC. |
|-------------------------|--------|-------------------------|
|                    |   |                    |   |
|                    |   |                    |   |
| Date: November 14, 2007 |   | By:                     | /s/ Wayne Wetherell |
|                    |   |                    | Wayne Wetherell, Chief  Financial  Officer  (on behalf of the Registrant and  as Registrant’s Principal Financial and  Accounting Officer) |
|                         |        |                         |  |  |

 

 

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