**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 June 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)

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

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the Exchange Act.(Check one):
| o  Large accelerated filer |   | o  Accelerated filer |   | x  Non-accelerated filer |
|----------------------------|--------|----------------------|--------|--------------------------|

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-12 of the Exchange Act).  Yes o  No x

The number of shares ofCommon Stock, with $0.01 par value, outstanding on August 10, 2007 was14,680,473.

 

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**IMAGEWARE SYSTEMS, INC. INDEX**
| PART I.    |   | FINANCIAL INFORMATION |   |
|------------|--------|-----------------------|--------|
|       |   | ITEM 1.               |   | FINANCIAL STATEMENTS  (UNAUDITED) |   |
|       |   |                  |   | Condensed  Consolidated Balance Sheets as of June 30, 2007 and December 31, 2006 |   |
|       |   |                  |   | Condensed  Consolidated Statements of Operations for the three and six months ended  June 30, 2007 and 2006 |   |
|       |   |                  |   | Condensed  Consolidated Statements of Cash Flows for the six months ended June 30,  2007 and 2006 |   |
|       |   |                  |   | Condensed  Consolidated Statements of Comprehensive Loss for the three and six months  ended June 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 CONSOLIDATED BALANCE SHEETS**

**(in thousands, except share data)**
| ** **                                                                                                                                                                                                                                                                                                               | ** ** | **June 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                                                                                                                                               | ** ** | **(Unaudited)**         | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                                                                               | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Current Assets:                                                                                                                                                                                                                                                                                                          |       |                    |       |                        |       |
| Cash                                                                                                                                                                                                                                                                                                                     |       | $                       | 228        |                        | $          | 939 |   |
| Accounts  receivable, net of allowance for doubtful accounts of $498 (unaudited) and  $483 at June 30, 2007 and December 31, 2006, respectively                                                                                                                                                                |       | 1,043                   |       | 1,722                       |       |
| Inventory                                                                                                                                                                                                                                                                                                                |       | 239                     |       | 58                          |       |
| Other current  assets                                                                                                                                                                                                                                                                                                    |       | 180                     |       | 138                         |       |
| Total Current  Assets                                                                                                                                                                                                                                                                                                    |       | 1,690                   |       | 2,857                       |       |
|                                                                                                                                                                                                                                                                                                                     |       |                    |       |                        |       |
| Property and equipment,  net                                                                                                                                                                                                                                                                                             |       | 277                     |       | 352                         |       |
| Other assets                                                                                                                                                                                                                                                                                                             |       | 130                     |       | 174                         |       |
| Pension assets                                                                                                                                                                                                                                                                                                           |       | 632                     |       | 609                         |       |
| Intangible assets, net  of accumulated amortization                                                                                                                                                                                                                                                                      |       | 133                     |       | 141                         |       |
| Goodwill                                                                                                                                                                                                                                                                                                                 |       | 3,416                   |       | 3,416                       |       |
| **Total  Assets**                                                                                                                                                                                                                                                                                                        | ** ** | **$**                   | **6,278**  | ** **                  | **$**      | **7,549** | ** ** |
|                                                                                                                                                                                                                                                                                                                     |       |                    |       |                        |       |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                                                                                                                                                                                                           | ** ** | ** **              | ** ** | ** **                  | ** ** |
|                                                                                                                                                                                                                                                                                                                     |       |                    |       |                        |       |
| Current Liabilities:                                                                                                                                                                                                                                                                                                     |       |                    |       |                        |       |
| Accounts payable                                                                                                                                                                                                                                                                                                         |       | $                       | 2,336      |                        | $          | 1,719 |   |
| Deferred revenue                                                                                                                                                                                                                                                                                                         |       | 1,210                   |       | 1,258                       |       |
| Accrued expenses                                                                                                                                                                                                                                                                                                         |       | 1,375                   |       | 1,139                       |       |
| Notes payable to  third parties, net of discount                                                                                                                                                                                                                                                                         |       | —                  |       | 1,097                       |       |
| Total Current  Liabilities                                                                                                                                                                                                                                                                                               |       | 4,921                   |       | 5,213                       |       |
|                                                                                                                                                                                                                                                                                                                     |       |                    |       |                        |       |
| Pension obligation                                                                                                                                                                                                                                                                                                       |       | 1,055                   |       | 1,016                       |       |
| Total Liabilities                                                                                                                                                                                                                                                                                                        |       | 5,976                   |       | 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  June 30, 2007 and December 31, 2006; liquidation preference $599 at June  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  June 30, 2007 and December 31, 2006, respectively; liquidation  preference $2,200 and $2,500 at June 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  June 30, 2007 and December 31, 2006, respectively; liquidation  preference $1,500 and $0 at June 30, 2007 and December 31, 2006, respectively          |       | —                  |       | —                      |       |
| Common stock,  $.01 par value, 50,000,000 shares authorized; 14,760,119 (unaudited) and  13,700,849 shares issued at June 30, 2007 and December 31, 2006,  respectively, and 14,753,415 (unaudited) and 13,694,145 shares outstanding at  June 30, 2007 and December 31, 2006, respectively          |       | 146                     |       | 136                         |       |
| Additional paid  in capital                                                                                                                                                                                                                                                                                              |       | 74,706                  |       | 71,554                      |       |
| Treasury stock,  at cost - 6,704 shares                                                                                                                                                                                                                                                                                  |       | (64                     | )          | (64                         | )          |
| Accumulated  other comprehensive income                                                                                                                                                                                                                                                                                  |       | 39                      |       | 25                          |       |
| Accumulated  deficit                                                                                                                                                                                                                                                                                                     |       | (74,527                 | )          | (70,333                     | )          |
| Total  Shareholders’ equity                                                                                                                                                                                                                                                                                         |       | 302                     |       | 1,320                       |       |
|                                                                                                                                                                                                                                                                                                                     |       |                    |       |                        |       |
| **Total Liabilities and  Shareholders’ Equity**                                                                                                                                                                                                                                                                     | ** ** | **$**                   | **6,278**  | ** **                  | **$**      | **7,549** | ** ** |

 

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

3

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**IMAGEWARE SYSTEMS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

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

**(unaudited)**
| ** **                                                                 | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                 | ** ** | **2007**                                        | ** ** | **2006**                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| **Revenues:**                                                              | ** ** | ** **                                      | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Product                                                                    |       | $                                               | 1,157      |                                          | $          | 2,311 |   | $ | 1,866 |   | $ | 4,565 |   |
| Maintenance                                                                |       | 621                                             |       | 556                                           |       | 1,247 |   | 1,067 |   |
|                                                                       |       | 1,778                                           |       | 2,867                                         |       | 3,113 |   | 5,632 |   |
| **Cost of  revenues:**                                                     | ** ** | ** **                                      | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Product                                                                    |       | 296                                             |       | 664                                           |       | 482 |   | 1,190 |   |
| Maintenance                                                                |       | 296                                             |       | 256                                           |       | 590 |   | 572 |   |
| Gross profit                                                               |       | 1,186                                           |       | 1,947                                         |       | 2,041 |   | 3,870 |   |
|                                                                       |       |                                            |       |                                          |       |   |   |   |   |
| **Operating  expenses:**                                                   | ** ** | ** **                                      | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| General & administrative                                               |       | 957                                             |       | 1,080                                         |       | 2,100 |   | 2,219 |   |
| Sales and marketing                                                        |       | 674                                             |       | 888                                           |       | 1,367 |   | 1,891 |   |
| Research & development                                                 |       | 803                                             |       | 961                                           |       | 1,989 |   | 1,935 |   |
| Depreciation and amortization                                              |       | 79                                              |       | 63                                            |       | 139 |   | 188 |   |
|                                                                       |       | 2,513                                           |       | 2,992                                         |       | 5,595 |   | 6,233 |   |
| Loss from  operations                                                      |       | (1,327                                          | )          | (1,045                                        | )          | (3,554 | ) | (2,363 | ) |
|                                                                       |       |                                            |       |                                          |       |   |   |   |   |
| Interest expense  (income), net                                            |       | (5                                              | )          | 157                                           |       | 238 |   | 184 |   |
|                                                                       |       |                                            |       |                                          |       |   |   |   |   |
| Other expense  (income), net                                               |       | 82                                              |       | (37                                           | )          | 44 |   | (106 | ) |
| Loss from continuing operations before income taxes                        |       | (1,404                                          | )          | (1,165                                        | )          | (3,836 | ) | (2,441 | ) |
|                                                                       |       |                                            |       |                                          |       |   |   |   |   |
| Income tax expense (benefit)                                               |       | —                                          |       | —                                        |       | — |   | — |   |
|                                                                       |       |                                            |       |                                          |       |   |   |   |   |
| Loss from continuing operations                                            |       | (1,404                                          | )          | (1,165                                        | )          | (3,836 | ) | (2,441 | ) |
|                                                                       |       |                                            |       |                                          |       |   |   |   |   |
| Discontinued operations:                                                   |       |                                            |       |                                          |       |   |   |   |   |
| Gain (loss) from operations of discontinued Digital  Photography component |       | 11                                              |       | (159                                          | )          | 11 |   | (232 | ) |
| Income tax benefit (expense)                                               |       | —                                          |       | —                                        |       | — |   | — |   |
| Gain (loss) on discontinued operations                                     |       | 11                                              |       | (159                                          | )          | 11 |   | (232 | ) |
|                                                                       |       |                                            |       |                                          |       |   |   |   |   |
| Net loss                                                                   |       | (1,393                                          | )          | (1,324                                        | )          | (3,825 | ) | (2,673 | ) |
| Preferred dividends                                                        |       | (88                                             | )          | (13                                           | )          | (503 | ) | (25 | ) |
| Net loss available to common shareholders                                  |       | $                                               | (1,481     | )                                             | $          | (1,337 | ) | $ | (4,328 | ) | $ | (2,698 | ) |
|                                                                       |       |                                            |       |                                          |       |   |   |   |   |
| Basic and diluted loss per common share - see note 2                       |       |                                            |       |                                          |       |   |   |   |   |
| Loss from continuing operations                                            |       | $                                               | (0.09      | )                                             | $          | (0.09 | ) | $ | (0.27 | ) | $ | (0.18 | ) |
| Discontinued operations                                                    |       | —                                          |       | (0.01                                         | )          | — |   | (0.02 | ) |
| Preferred dividends                                                        |       | (0.01                                           | )          | —                                        |       | (0.04 | ) | — |   |
| Basic and diluted loss per share available to common  shareholders         |       | $                                               | (0.10      | )                                             | $          | (0.10 | ) | $ | (0.31 | ) | $ | (0.20 | ) |
|                                                                       |       |                                            |       |                                          |       |   |   |   |   |
| Weighted-average  shares (basic and diluted)                               |       | 14,669,170                                      |       | 13,571,525                                    |       | 14,218,699 |   | 13,559,659 |   |

 

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

4

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**IMAGEWARESYSTEMS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(inthousands)**

**(unaudited)**
| ** **                                                                   | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                   | ** ** | **2007**                                      | ** ** | **2006** | ** ** |
| **Cash  flows from operating activities**                                    | ** ** | ** **                                    | ** ** | ** ** | ** ** |
| Net loss                                                                     |       | $                                             | (3,825     | ) | $ | (2,673 | ) |
| Adjustments to reconcile net loss to net cash used  in operating activities  |       |                                          |       |   |   |
| Depreciation and  amortization                                               |       | 139                                           |       | 189 |   |
| Provision for losses in investment in equity  securities                     |       | 85                                            |       | — |   |
| Non-cash interest and amortization of debt discount  and debt issuance costs |       | 229                                           |       | 155 |   |
| Stock based compensation                                                     |       | 356                                           |       | 667 |   |
| Provision for losses on accounts receivable                                  |       | 25                                            |       | 14 |   |
| Reduction in inventory obsolescence reserve                                  |       | (32                                           | )          | — |   |
| Change in assets and liabilities                                             |       |                                          |       |   |   |
| Accounts receivable, net                                                     |       | 654                                           |       | (909 | ) |
| Inventory                                                                    |       | (149                                          | )          | 46 |   |
| Other current assets                                                         |       | (59                                           | )          | 5 |   |
| Pension assets                                                               |       | (23                                           | )          | (58 | ) |
| Accounts payable                                                             |       | 617                                           |       | 844 |   |
| Accrued expenses                                                             |       | 304                                           |       | (107 | ) |
| Deferred revenue                                                             |       | (48                                           | )          | 353 |   |
| Pension obligation                                                           |       | 38                                            |       | 62 |   |
| Total adjustments                                                            |       | 2,136                                         |       | 1,261 |   |
| Net cash used in operating activities                                        |       | (1,689                                        | )          | (1,412 | ) |
|                                                                         |       |                                          |       |   |   |
| **Cash  flows from investing activities**                                    | ** ** | ** **                                    | ** ** | ** ** | ** ** |
| Purchase of property and equipment                                           |       | (56                                           | )          | (79 | ) |
| Net cash used in investing activities                                        |       | (56                                           | )          | (79 | ) |
|                                                                         |       |                                          |       |   |   |
| **Cash  flows from financing activities**                                    | ** ** | ** **                                    | ** ** | ** ** | ** ** |
| Repayment of notes payable                                                   |       | (1,310                                        | )          | (115 | ) |
| Proceeds from issuance of notes payable with  warrants                       |       | —                                        |       | 1,550 |   |
| Debt issuance costs                                                          |       | —                                        |       | (98 | ) |
| 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                                    |       | 1,059                                         |       | 1,311 |   |
| Effect of exchange rate changes on cash                                      |       | (25                                           | )          | (82 | ) |
| Net increase (decrease) in cash                                              |       | (711                                          | )          | (262 | ) |
|                                                                         |       |                                          |       |   |   |
| Cash at  beginning of period                                                 |       | 939                                           |       | 741 |   |
|                                                                         |       |                                          |       |   |   |
| Cash at end of period                                                        |       | $                                             | 228        |   | $ | 479 |   |
|                                                                         |       |                                          |       |   |   |
| Supplemental  disclosure of cash flow information:                           |       |                                          |       |   |   |
| Cash paid for interest                                                       |       | $                                             | 46         |   | $ | 5 |   |
| Summary of  non-cash investing and financing activities:                     |       |                                          |       |   |   |
| Beneficial conversion feature of series D preferred  stock                   |       | $                                             | 344        |   | $ | — |   |
| Conversion of  preferred stock to common                                     |       | $                                             | 2          |   | $ | — |   |

 

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

5

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**IMAGEWARE SYSTEMS, INC**

**CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVELOSS**

**(in thousands)**

**(unaudited)**
| ** **                              | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                              | ** ** | **2007**                                        | ** ** | **2006**                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| Net loss                                |       | $                                               | (1,393     | )                                             | $          | (1,324 | ) | $ | (3,825 | ) | $ | (2,673 | ) |
| Other  comprehensive income (loss):     |       |                                            |       |                                          |       |   |   |   |   |
| Unrealized holding loss on securities   |       | —                                          |       | (28                                           | )          | — |   | (28 | ) |
|                                    |       |                                            |       |                                          |       |   |   |   |   |
| Foreign currency translation adjustment |       | (15                                             | )          | (35                                           | )          | (25 | ) | (82 | ) |
| Comprehensive loss                      |       | $                                               | (1,408     | )                                             | $          | (1,387 | ) | $ | (3,850 | ) | $ | (2,783 | ) |

 

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

6

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**IMAGEWARESYSTEMS, INC.**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

**NOTE1.  DESCRIPTION OF BUSINESS ANDOPERATIONS**

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.

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.

Our biometric technology is a core software componentof an organization’s security infrastructure and includes a multi-biometricidentity management solution for enrolling, managing, identifying and verifyingthe identities of people by the physical characteristics of the human body. Wedevelop, sell and support various identity management capabilities withingovernment (federal, state and local), law enforcement, commercial enterprises,and transportation and aviation markets for identification and verificationpurposes. Our IWS Biometric Engine is a biometric identity management platformfor multi-biometric enrollment, management and authentication, managingpopulation databases of virtually unlimited sizes. It is also offered as aSoftware Development Kit (SDK) based search engine, enabling developers andsystem integrators 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 our secure credential platform,IWS EPI Builder, provides a comprehensive, integrated biometric and securecredential solution that can be leveraged for high-end applications such aspassports, driver licenses, national IDs, and other secure documents. It canalso be utilized within our law enforcement systems to incorporate any numberof various multiple biometrics into one system.

Our law enforcement solutions enable agencies toquickly capture, archive, search, retrieve, and share digital images,fingerprints and criminal history records on a stand-alone, networked, wirelessor Web-based platform. We develop, sell and support a suite of modular softwareproducts used by law enforcement and public safety agencies to create andmanage criminal history records and to investigate crime. Our IWS LawEnforcement solution consists of seven software modules: A Capture andInvestigative module, which provides a criminal booking system and relateddatabase; A Facial Recognition module, which uses biometric facial recognitionto identify suspects; A Suspect ID module, which facilitates the creation offull-color, photo-realistic suspect composites; A wireless module, whichprovides access to centrally stored records over the Internet in a connected orwireless fashion: A PDA add-on module which enables access to centrally storedrecords while in the field on a handheld Pocket PC compatible device combinedwith central repository services which allows for inter-agency data sharing ona local, regional, and/or national level, and a LiveScan module whichincorporates LiveScan capabilities into IWS Law Enforcement, providingintegrated fingerprint and palm print biometric management for civil and lawenforcement use.

Our Secure Credential ID solutions empower customersto create secure and smart digital identification documents with complete IDsystems. We develop, sell and support software and design systems which utilizedigital imaging in the production of photo identification cards and credentialsand identification systems. Our products in this market consist of IWS EPISuite, IWS EPI Builder (SDK), Identifier for Windows and ID Card Maker.  These products allow for the production ofdigital identification cards and related databases and records and can be usedby, among others, schools, airports, hospitals, corporations orgovernments.  We have recently added theability to incorporate multiple biometrics into the ID systems we offer withthe addition of our new IWS Biometric Engine to our product line.

Our enterprise authentication software includes theIWS Desktop Security software solution which is a comprehensive authenticationmanagement infrastructure specifically designed to provide enterprise networkswith the most advanced authentication mechanisms including biometrics, RFIDtechnology, USB flash memory modules, Trusted Platform Module (TPM), and smartcards.

7

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*Basis of Presentation*

Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities, the disclosure of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenue and expensesduring the reporting period. Actual results could differ from those estimates.

Theaccompanying condensed consolidated unaudited financial statements of ImageWarehave been prepared pursuant to the rules and regulations of the Securitiesand Exchange Commission (“SEC”) regarding interim financial reporting.Accordingly, they do not include all of the information and footnotes requiredby generally accepted accounting principles for annual financial statements andshould be read in conjunction with the consolidated financial statements forthe year ended December 31, 2006, and notes thereto included in theCompany’s Annual Report on Form 10-K, filed with the SEC on April 17,2007, as amended on April 30, 2007, May 7, 2007 and May 9, 2007. In the opinionof management, the accompanying condensed consolidated financial statementscontain all adjustments, consisting only of adjustments of a normal recurringnature, necessary for a fair presentation of the Company’s financial positionas of June 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*

Asreflected in the accompanying condensed consolidated financial statements, theCompany has continuing losses, negative working capital and negative cash flowsfrom operations. These matters raise substantial doubt about the Company’sability to continue as a going concern.

Newfinancing will be required to fund working capital and operations should theCompany be unable to generate positive cash flow from operations in the nearfuture. The Company is exploring the possible sale of equity securities and/ordebt financing. However, there can be no assurance that additional financing willbe available. In the event financing is not available in the time framerequired, the Company will be forced to sell certain of its assets or licenseits technologies to others. These actions, while necessary for the continuanceof operations during a time of cash constraints and a shortage of workingcapital, could adversely affect the Company’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 the 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 theCompany, which, in turn, is dependent upon the Company’s ability to continue toraise capital and generate positive cash flows from operations. The condensedconsolidated financial statements do not include any adjustments relating tothe recoverability and classification of recorded asset amounts or amounts andclassifications of liabilities that might be necessary should the Company beunable to continue its existence.

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TheCompany operates in markets that are emerging and highly competitive. There isno assurance that the Company will be able to achieve profitability.

*Recently Issued Accounting Standards*

InSeptember 2006, the Financial Accounting Standards Board (FASB) issuedStatement of Financial Accounting Standards (SFAS) No. 157, “Fair ValueMeasurements” (SFAS No. 157), to increase consistency and comparability in fairvalue measurements and to expand their disclosures. The new standard includes adefinition of fair value as well as a framework for measuring fair value. Thestandard is effective for fiscal periods beginning after November 15, 2007 andshould be applied prospectively, except for certain financial instruments whereit must be applied retrospectively as a cumulative-effect adjustment to thebalance of opening retained earnings in the year of adoption. The Company iscurrently evaluating the impact of SFAS No. 157 on its consolidated financialstatements.

InFebruary 2007, the FASB issued SFAS No. 159, “The Fair Value Option forFinancial Assets and Financial Liabilities, including an amendment of FASBStatement No. 115” (SFAS No. 159). This statement permits entities to choose tomeasure many financial instruments and certain other items at fair value thatare not currently required to be measured at fair value and establishespresentation and disclosure requirements designed to facilitate comparisonsbetween entities that choose different measurement attributes for similar typesof assets and liabilities. SFAS No. 159 is effective on January 1, 2008. TheCompany is currently evaluating the impact of SFAS No. 159 on its consolidatedfinancial statements.

InJune 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertaintyin Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”), whichclarifies the accounting for uncertainty in income taxes recognized in acompany’s financial statements. The interpretation prescribes a recognitionthreshold and measurement attribute criteria for the financial statementrecognition and measurement of an uncertain tax position taken or expected tobe taken in a tax return. The interpretation also provides guidance onderecognition, classification, interest and penalties, accounting in interimperiods, disclosure and transition.

TheCompany adopted the provisions of FIN 48 on January 1, 2007. The implementationof FIN 48 did not have a material impact on the Company’s financial statements.At the adoption date on January 1, 2007, and as of June 30, 2007, the Companyrecorded no cumulative effect adjustments related to the adoption of FIN 48.

Uponadoption of FIN 48 on January 1, 2007, and as of June 30, 2007, the Company hadno unrecognized tax benefits or accruals for the potential payment or interestand penalties. For the six months ended June 30, 2007, no interest or penaltieswere recorded.

TheCompany files tax returns in the U.S. federal jurisdiction, and in variousstates and foreign jurisdictions. The Company is not aware of any jurisdictionscurrently under examination by tax authorities.

*Reclassifications*

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

**NOTE2.  NET LOSS PER COMMON SHARE**

Basicloss per common share is calculated by dividing net loss available to commonshareholders for the period by the weighted-average number of common sharesoutstanding during the period. Diluted earnings per common share is calculatedby dividing net loss available to common shareholders for the period by theweighted-average number of common shares outstanding during the period,adjusted to include, if dilutive, potential dilutive shares consisting ofconvertible preferred stock, stock options and warrants, calculated using thetreasury stock method. During the periods ended June 30, 2007 and 2006,the Company has excluded the following securities from the calculation of dilutedloss per share, as their effect would have been antidilutive due to the Company’snet loss:
| **Potential Dilutive Securities:** | ** ** | **Number of  Common Shares  Convertible into at  June 30, 2007** | ** ** | **Number of  Common Shares  Convertible into at  June 30, 2006** | ** ** |
|----------------------------------------------|------------|------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------|------------|
|                                         |       |                                                                                           |       |                                                                                           |       |
| Convertible  preferred stock                 |       | 2,301,524                                                                                      |       | 47,280                                                                                         |       |
| Stock options                                |       | 1,662,293                                                                                      |       | 1,632,304                                                                                      |       |
| Warrants                                     |       | 4,747,362                                                                                      |       | 4,680,805                                                                                      |       |

 

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Preferreddividends for the six months ended June 30, 2007 contains approximately$344,000 in preferred stock dividends attributable to an embedded beneficialconversion feature recognized in conjunction with the issuance of Series DPreferred Stock as more fully explained in Note 6.

**NOTE3.  SALE OF BUSINESS AND DISCONTINUEDOPERATIONS**

On November 30,2006, the Company completed the sale of its entire Digital Photography (“PDI”)product line and inventory (the “PDI Products”) to an unaffiliated third partyfor a total of $400,000, including an initial cash payment of $25,000.  The purchaser is required to pay up to thefull remaining amount of $375,000 in a series of quarterly installments equalto 12.5% of all newly acquired sales and license revenues relating to the PDIproduct line (the “Percentage Payments”). Until such time when the Company has received the full purchase price of$400,000, during any 12-month period during which the aggregate PercentagePayments to the Company are less than $50,000, the purchaser will pay theCompany the difference between the Percentage Payments and $50,000.  As of June 30, 2007, the purchaser had paidthe Company approximately $11,000 in percentage payments.  This component of the Company’s business waspreviously classified as the Company’s Digital Photography segment.

The Companydecided to sell this component because it has incurred significant operatinglosses in each of the last five years and has lost significant market share inthe last three years.  The assets soldconsisted primarily of a suite of software and related inventory includingsource, copyrights, trademarks, documentation and client base.

At June 30, 2007and December 31, 2006, the Company has recorded the fair value of the remainingamount due of $364,000 and $375,000, respectively, offset by a full valuationallowance due to the uncertainty of the ultimate collectibility of such amounts.This determination was based upon the maximum repayment period of 7 years ofamounts owing the Company at the transaction date combined with the purchaseroperating in a highly competitive business environment evidenced by rapidtechnological change.  Accordingly, theCompany has deferred any remaining gain from the disposal of this componentuntil such time as the Company determines that the realization of the remainingamounts owed is reasonably assured.

DigitalPhotography sales, reported in discontinued operations, for the six monthsended June 30, 2007 and 2006 were $0 and $76,000, respectively.  Digital Photography sales, reported indiscontinued operations, for the three months ended June 30, 2007 and 2006 were$0 and $32,000, respectively.  DigitalPhotography’s pretax income (loss), reported in discontinued operations for thesix months ended June 30, 2007 and 2006 were $11,000 and ($232,000),respectively.  Digital Photography’spretax income (loss), reported in discontinued operations for the three monthsended June 30, 2007 and 2006 were $11,000 and ($159,000), respectively.

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

**NOTE4. INVENTORIES**

At June 30, 2007 the Company had work in processinventories of  $196,000 representingdirect labor costs on in-process projects and finished goods inventories of$43,000 net of reserves for obsolete and slow-moving items of $20,000.  Inventories at December 31, 2006 consisted offinished goods of $58,000 net of reserves of $52,000.

**NOTE5. COMMON STOCK**

During the three months ended June 30, 2007, theCompany issued 206,788 shares of its common stock pursuant to the conversion of300 shares of Series C Preferred Stock. During the three months ended June 30, 2007, the Company also issued10,000 shares of its common stock pursuant to the exercise of common stockpurchase warrants.  The Company receivedgross proceeds of approximately $15,750 from these warrant exercises.  During the three months ended June 30, 2007,the Company also issued 31,620 shares of its common stock pursuant tostock-based compensation agreements with certain employees.

**NOTE6. PREFERRED STOCK**

In March 2007, the Company’s Articles of Incorporationwere amended to authorize 2,000 shares of Series D 8% ConvertiblePreferred Stock (“Series D Preferred Stock”). Each share of Series D PreferredStock has a par value of $0.01, a 

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stated value of $1,000 and is convertible into the Company’s commonstock at an initial conversion price of $1.90 per share. The Series DPreferred Stock does not have voting rights.

Theholders of Series D Preferred Stock are entitled to receive cumulativedividends, at the option of the Company, (i) in common stock upon conversion ofthe Series D Preferred Stock, or (ii) in cash afterthe payment of cash dividends to the holders of Series B Preferred Stock andSeries C Preferred Stock at the rate per share (as a percentage of thestated value per share) of 8% per annum.

The holders of Series D Preferred Stock are entitled to initial distributions of $1,000per share of Series D Preferred Stock outstanding, upon liquidation andin preference to common shares and any other series of preferred stock with theexception of Series B Preferred Stock and Series C Preferred Stock, plus allaccrued but unpaid dividends.

AtMarch 31, 2007, the Company had issued a total of 1,500 shares of Series DPreferred Stock and generated gross proceeds of $1.5 million. In conjunctionwith the issuance of the Series D Preferred Stock, the Company issued warrantsto the holders of the Series D Preferred Stock to purchase 59,207 shares of theCompany’s common stock at $2.33 per share. These warrants have been classifiedas equity instruments on the balance sheet. The proceeds from the Series D Preferred Stock financing were allocatedto the warrants and the Series D Preferred Stock based on the relative fairvalue of each on the date of issuance. This allocation process resulted in the 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.

Inconjunction with the Series D Preferred Stock financing, the Company incurreddirect transaction costs consisting primarily of legal fees and placement agentfees of approximately $173,000. Suchcosts have been recorded as adjustment to additional paid in capital as areduction of net proceeds.

During the three months ended June 30, 2007, certainholders of the Company’s Series C Preferred Stock converted an aggregate of 300shares of Series C Preferred Stock into 206,788 shares of the Company’s commonstock.

AtJune 30, 2007, the Company had cumulative undeclared dividends relating toSeries B, C and D Preferred Stock of approximately $8,000, $120,000 and $38,000respectively.

**NOTE7.  REGISTRATION PAYMENT ARRANGEMENTS**

Aspart of the Series D Preferred Stock financing, the Company entered into aRegistration Payment Arrangement as defined by FASB Staff Position No. EITF00-19-2, “Accounting for Registration Payment Arrangements” (“ EITF 00-19-2”).  EITF 00-19-2 specifies that the contingentobligation to make future payments orotherwise transfer consideration under a registration payment arrangementshould be separately recognized and measured in 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. The Company early adopted the provisions of EITF 00-19-2 in December2006. The Company determined that no loss contingency related to the Series DPreferred Stock registration payment arrangement was required to be recorded asof June 30, 2007.

Aspart of the registration payment arrangement, the Company agreed to registerthe shares of common stock the Series D Preferred Stock is convertible into andthe shares of common stock underlying the warrants issued to the investors inthe Series D Preferred Stock financing with the SEC within certaincontractually 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 March 9, 2007, between the Company and certainaccredited investors, the Company is subject to a liquidated damages penaltyequal to 1% of the aggregate purchase price paid for each month theregistration statement is not effective, provided that such liquidated damagesshall not exceed 12% of the aggregate purchase price.  The maximum exposure at June 30, 2007 isapproximately $180,000. The Company has met the requirements of the RegistrationPayment Arrangement by filing the required registration statement with the SECwithin 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 the prescribedperiod.

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Aspart of the Series C Preferred Stock financing consummated in November andDecember of 2006, the Company entered into a Registration Payment Arrangementas defined by EITF 00-19-2.  EITF 00-19-2specifies that the contingent obligation to make future payments or otherwisetransfer consideration under a registration payment arrangement should beseparately recognized and measured in accordance with SFAS No. 5, “Accountingfor Contingencies”.   EITF 00-19-2 iseffective for registration payment arrangements entered into after December 21,2006 or for the fiscal year beginning after December 15, 2006, however earlyadoption is permitted for interim or annual periods for which financialstatements have not been issued.  TheCompany adopted the provisions of FSP EITF 00-19-2 for the annual period endingDecember 31, 2006.  The Companydetermined that no loss contingency related to the Series C registrationpayment arrangement was required to be recorded as of June 30, 2007.

Aspart of the registration payment arrangement, the Company agreed to registerthe shares of common stock the Series C Preferred Stock is convertible into andthe shares of common stock underlying the warrants issued to the Series Cinvestors with the SEC within 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 fifth 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.  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 Agreement,the Company is subject to a liquidated damages penalty equal to 1% of theaggregate purchase price paid for each month the registration statement is noteffective, provided that such liquidated damages shall not exceed 12% of theaggregate purchase price.  The maximumexposure at June 30, 2007 is approximately $300,000. The Company has met therequirements of the Registration Payment Arrangement by registering the sharesof common stock with the SEC within the time frame specified by the agreementand 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.

Aspart of a private placement in July 2005 (the “July 2005 private placement”),the Company entered into a registration payment arrangement, whereby theCompany agreed to register the shares of common stock 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 the warrantshave been sold.  If the Company is unableto register the shares of common stock with the SEC or keep the registrationstatement continuously effective in accordance with the Securities PurchaseAgreement, 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. The maximum exposure at June 30, 2007 is approximately$162,000. The Company determined that no loss contingency related to the July 2005private placement registration payment arrangement was required to be recordedas of June 30, 2007.

 The Company has met the requirements of theRegistration Payment Arrangement by registering the shares of common stock withthe SEC within the time frame specified by the agreement and has kept theregistration continuously effective thereafter. Company management believes that it will be able to maintain currentfiling status with the SEC over the prescribed period.

**ITEM2.  Management’s Discussion and Analysisof Financial Condition and Results of Operations**

ThisQuarterly Report on Form 10-Q contains forward-looking statements within themeaning of Section 27A of the Securities Act of 1933, as amended, andSection 21E of the Securities Exchange Act of 1934, as amended. Allforward-looking statements included in this report are based on informationavailable to us as of the date hereof and we assume no obligation to update anyforward-looking statements. Forward-looking statements involve known or unknownrisks, uncertainties and other factors, which may cause our actual results,performance or achievements, or industry results to be materially differentfrom any future results, performance or achievements expressed or implied bysuch forward-looking statements. Factors that could cause or contribute to suchdifferences include but are not limited to those items discussed under “RiskFactors” beginning on page 23 and elsewhere in this Quarterly Report.

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

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**OVERVIEW**

ImageWareSystems, Inc. is a leader in the emerging market for software-basedidentity management solutions, providing biometric, secure credential and lawenforcement technologies.  Our “flagship”product is the IWS Biometric EngineTM. Scalable for small city business or worldwide deployment, our biometricengine is a multi-biometric platform that is hardware and algorithmindependent, enabling the enrollment and management of unlimited populationsizes.  Our identification products areused to manage and issue secure credentials including national IDs, passports,driver licenses, smart cards and access control credentials. Our lawenforcement products provide law enforcement with integrated mug shot,fingerprint LiveScan and investigative capabilities.  The biometric technology is now an integralpart of all markets we address, and all of our products are integrated into theBiometric Engine Platform.  Elements of the biometric engine can beused as investigative tools to law enforcement potentially utilizing multiplebiometrics and forensic data elements, and to enhance security and authenticityof public and private sector credentials.

CRITICALACCOUNTING ESTIMATES

Thediscussion and analysis of our financial condition and results of operationsare based on our consolidated financial statements, which have been prepared inaccordance with accounting principals generally accepted in the United Statesof America, or U.S. GAAP. The preparation of these financial statements inaccordance with U.S. GAAP requires us to utilize accounting policies and makecertain estimates and assumptions that affect the reported amounts of assetsand liabilities, the disclosure of contingencies as of the date of thefinancial statements and the reported amounts of revenue and expenses during afiscal period. The SEC considers an accounting policy to be critical if it isimportant to a company’s financial condition and results of operations, and ifit requires significant judgment and estimates on the part of managementin its application. Although we believe that our judgments and estimates areappropriate and correct, actual results may differ from those estimates.

Thefollowing are our critical accounting policies because we believe they are bothimportant to the portrayal of our financial condition and results of operationsand require critical management judgments and estimates about matters that areuncertain. If actual results or events differ materially from thosecontemplated by us in making these estimates, our reported financial conditionand results of operations for future periods could be materially affected.

***Revenue Recognition***

Ourrevenue recognition policy is significant because our revenue is a keycomponent of our consolidated results of operations. We recognize revenue fromthe following major revenue sources:

·                  Long-termfixed-price contracts involving significant customization

·                  Fixed-pricecontracts involving minimal customization

·                  Softwarelicensing

·                  Salesof computer hardware and identification media

·                  Postcontractcustomer support (PCS)

TheCompany’s revenue recognition policies are consistent with U. S. GAAP includingStatements of Position 97-2 “Software Revenue Recognition” and 98-9 “Modificationof SOP 97-2, Software Revenue Recognition With Respect to Certain Transactions”,SEC Staff Accounting Bulletin 104 , Emerging Issues Task Force (“EITF”) Issue00-21 “Revenue Arrangements 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.

Werecognize revenue and profit as work progresses on long-term, fixed-pricecontracts involving significant amounts of hardware and software customizationusing the percentage of completion method based on costs incurred to datecompared to total estimated costs at completion. Revenue from contracts forwhich we cannot reliably estimate total costs or which do not involvesignificant amounts of customization are recognized upon completion.Determining when a contract 

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should beaccounted for using the percentage of completion method involves judgment.Critical items that are considered in this process are the degree ofcustomization and related labor hours necessary to complete the required workas well as ongoing estimates of the future labor hours needed to complete thecontract. We also generate non-recurring revenue from the licensing of oursoftware. Software license revenue is recognized upon the execution of alicense agreement, upon deliverance, fees are fixed and determinable,collectibility is probable and when all other significant obligations have beenfulfilled. We also generate revenue from the sale of computer hardware andidentification media. Revenue for these items is recognized upon delivery ofthese products to the customer. Our revenue from periodic maintenanceagreements is generally recognized ratably over the respective maintenanceperiods provided no significant obligations remain and collectibility of therelated receivable is probable.

***Allowance for Doubtful Accounts***

Ourmanagement must make estimates of the uncollectibility of our accountsreceivable. Management specifically analyzes accounts receivable and analyzeshistorical bad debts, customer concentrations, customer creditworthiness,current economic trends, the age of the accounts receivable balances, andchanges in our customer payment terms when evaluating the adequacy of theallowance for doubtful accounts. Our accounts receivable balance wasapproximately $1,541,000 and our allowance for doubtful accounts wasapproximately $498,000 as of June 30, 2007.

***Valuation Of Goodwill And Other Intangible Assets***

Weassess impairment of goodwill and identifiable intangible assets wheneverevents or changes in circumstances indicate that the carrying valuemay not be recoverable. Factors we consider important which could triggeran impairment review include the following:

·                                          Significantunderperformance relative to historical or expected future operating results;

·                                          Significantchanges in the manner of our use of the acquired assets or the strategy of ouroverall business;

·                                          Significantnegative industry or economic trends;

Whenwe determine that the carrying value of goodwill and other intangible assetsmay not be recoverable based upon the existence of one or more of theabove indicators of impairment, we measure any impairment based upon fair valuemethodologies. Goodwill and other net intangible assets amounted to approximately$3,549,000 as of June 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.

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 where previously distinct,mutually exclusive technologies.  Thishas resulted in changes in the manner by which the Company’s chief decisionmaker assesses performance and makes decisions concerning resourceallocation.  As a result of our operationin one market segment, such segment being identity management, our 2006goodwill impairment review consisted of the comparison of the fair value of ouridentity management segment as determined by the quoted market prices of ourcommon stock to the carrying amount of the segment. As the fair value exceededthe carrying value by a substantial margin, we determined that our goodwill wasnot impaired.  Using the same methodologies,we determined that as of June 30, 2007 there were no indicators of potentialimpairment.

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.

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Weaccount for long-lived assets in accordance with the provisions of SFASNo. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”  This statement requires that long-livedassets and certain identifiable intangible assets be reviewed for impairmentwhenever events or changes in circumstances indicate that the carrying amountof an asset may not be recoverable. Recoverability of assets to be heldand used is measured by a comparison of the carrying amount of an asset tofuture net undiscounted cash flows expected to be generated by the asset. Ifsuch assets are considered to be impaired, the impairment to be recognized ismeasured by the amount which the carrying amount of the assets exceeds the fairvalue of the assets. Fair value is determined based on discounted cash flows orappraised values, depending upon the nature of the asset. Assets to be disposedof are reported at the lower of the carrying amount of fair value less costs tosell. We determined that as of June 30, 2007 there were no indicators ofpotential 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 ourestimates and assumptions. There can be no assurance that intangible assetimpairment will not occur in the future.

***Stock-Based Compensation***

Uponadoption of SFAS 123R on January 1, 2006, we began estimating the value ofemployee stock options on the date of grant using the Black-Scholes model.Prior to the adoption of SFAS 123R, the value of each employee stock option wasestimated on the date of grant using the Black-Scholes model for the purpose ofthe pro forma financial disclosure in accordance with SFAS 123. Thedetermination of fair value of stock-based payment awards on the date of grantusing an option-pricing model is affected by our stock price as well asassumptions regarding a number of highly complex and subjective variables.These variables include, but are not limited to the expected stock pricevolatility over the term of the awards and the actual and projected employeestock option exercise behaviors. The expected term of options granted isderived from historical data on employee exercises and post-vesting employmenttermination behavior. We calculated our expected volatility assumption requiredin the Black-Scholes model based on the historical volatility of our stock. Inaddition to the key assumptions used in the Black-Scholes model, the estimatedforfeiture rate at the time of valuation is a critical assumption.  The Company has estimated an annualizedforfeiture rate of 5.7% for corporate officers, 2.4% for members of the Company’sBoard of Directors and 25% for all other employees.  The Company reviews the expected forfeiturerate annually to determine if that percent is still reasonable based onhistorical experience.

As ofJanuary 1, 2006 we have adopted the modified prospective transition methodand its effect is included in our Condensed Consolidated Statements ofOperations for all periods presented.

**RESULTSOF OPERATIONS**

Resultsas presented do not contain the results of our Digital Photography component dueto this component being classified as discontinued operations as a result ofits sale in November 2006.

**Three Months Ended June 30, 2007 Compared to theThree Months Ended June 30, 2006**

***Product Revenues***
| ** **                              | ** ** | **Three Months  Ended  June 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|-----------------------------------------|------------|---------------------------------------------|------------|------------|------------|-------------------|------------|
| **Net Product Revenues**      | ** ** | **2007**                                    | ** ** | **2006**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**    | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| ** **                              | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| Software and  royalties                 |       | $                                           | 798        |       | $          | 1,922             |       | $ | (1,124 | ) | (58 | )% |
| Percentage of total net product revenue |       | 69                                          | %          | 83         | %          |              |       |   |   |
| Hardware and  consumables               |       | $                                           | 116        |       | $          | 361               |       | $ | (245 | ) | (68 | )% |
| Percentage of total net product revenue |       | 10                                          | %          | 16         | %          |              |       |   |   |
| Services                                |       | $                                           | 243        |       | $          | 28                |       | $ | 215 |   | 768 | % |
| Percentage of total net product revenue |       | 21                                          | %          | 1          | %          |              |       |   |   |
| Total net product  revenues             |       | $                                           | 1,157      |       | $          | 2,311             |       | $ | (1,154 | ) | (50 | )% |

 

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Softwareand royalty revenues decreased 58% or $1,124,000 during the three months endedJune 30, 2007 as compared to the corresponding period in 2006.  The decrease is due primarily to lowerproject-oriented revenues of our Biometric Engine of approximately $1,086,000combined with lower royalties and license revenues of approximately $145,000offset by increased sales of our boxed identity management software through ourdistribution channel and sales of our Crime Capture System.

Revenuesfrom the sale of hardware and consumables decreased 68% or $245,000 during thethree months ended June 30, 2007 as compared to the corresponding period in2006.  The decrease reflects lowerrevenues from project work containing hardware and consumable components.  Also contributing to the decrease was the2006 period containing sales of approximately $65,000 of discontinued printmedia consumables to international customers as the Company disposed of certaincomponents of its print media inventories.

Servicesrevenues are comprised primarily of software integration services, systeminstallation services and customer training. Such revenues increased approximately $215,000 during the three monthsended June 30, 2007 as compared to the corresponding period in 2006 dueprimarily to higher revenues being generated from software integration projectwork of our Biometric Engine offset by a decrease in our installation ofhardware products.  We expect servicerevenues to increase in the remainder of 2007 through increased implementationsof large-scale high-end solutions.

Webelieve that the lower identity management software revenue in project-orientedsolutions is largely due to the timing of government procurement with respectto the various programs we are pursuing. Based on management’s current visibility into the timing of potentialgovernment procurements, we believe that we will see a significant increase ingovernment procurement and implementations with respect to identity managementinitiatives during the remainder of 2007 and continuing into 2008 and 2009.

We feelthat we are well positioned for participation in one or more large-scaledomestic or international projects which will enable our company to achievesignificant product revenue growth.  Inthe past eighteen months we have continuously retooled our identity managementsuite of products to meet changing government specifications and to enablecustomization for large project applications. Additionally, we reoriented our sales organization to direct ourresources and efforts toward establishing partnerships with large systemsintegrators as we believe these integrators will be the ultimate choice forawards of large-scale secure identification solutions.

Ourbacklog of product orders as of June 30, 2007 was approximately$1,852,000.  Approximately $1 million ofthis product backlog was in backlog at December 31, 2006 and due to customerimplementation scheduling, could not be recognized within the first six monthsended June 30, 2007.  At June 30, 2007,we also had maintenance and support backlog of approximately $1,060,000 underexisting maintenance agreements.  Productrevenue is typically recognized within a three to six month time perioddepending upon the required degree of customization, if any and customer implementationschedules.  Historically, we haveexperienced a very minimal risk of order cancellation.  Our revenue from maintenance agreements isgenerally recognized ratably over the respective maintenance periods providedno significant obligations remain and collectibility of the related receivableis probable.

***Maintenance Revenues***
| ** **                           | ** ** | **Three Months  Ended  June 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|--------------------------------------|------------|---------------------------------------------|------------|------------|------------|-------------------|------------|
| **Maintenance Revenues**        | ** ** | **2007**                                    | ** ** | **2006**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)** | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                 |       |                                        |       |       |       |              |       |   |   |
| Maintenance revenues                 |       | $                                           | 621        |       | $          | 556               |       | $ | 65 |   | 12 | % |
|                                      |            |                                             |            |            |            |                   |            |  |  |  |  |  |

 

Theincrease in maintenance revenues reflects the expansion of our installed baseresulting from the completion of project-oriented work during the year ended December 31, 2006 and thefirst three months of 2007.

Weanticipate continued growth of our maintenance revenues through the retentionof existing customers combined with the expansion of installed base combinedresulting from the completion of project-oriented work, however, we cannotpredict the timing of this anticipated growth.

16

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***Cost of Product Revenues***
| ** **                                              | ** ** | **Three Months  Ended  June 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|---------------------------------------------------------|------------|---------------------------------------------|------------|------------|------------|-------------------|------------|
| **Cost of Product Revenues:**            | ** ** | **2007**                                    | ** ** | **2006**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**                    | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| ** **                                              | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| Software and  royalties                                 |       | $                                           | 111        |       | $          | 420               |       | $ | (309 | ) | (74 | )% |
| Percentage of software and royalty product revenue      |       | 14                                          | %          | 22         | %          |              |       |   |   |
| Hardware and  consumables                               |       | $                                           | 118        |       | $          | 242               |       | $ | (124 | ) | (51 | )% |
| Percentage of hardware and consumables product  revenue |       | 102                                         | %          | 67         | %          |              |       |   |   |
| Services                                                |       | $                                           | 67         |       | $          | 2                 |       | $ | 65 |   | 3,250 | % |
| Percentage of services product revenue                  |       | 28                                          | %          | 7          | %          |              |       |   |   |
| Total cost of  product revenues                         |       | $                                           | 296        |       | $          | 664               |       | $ | (368 | ) | (55 | )% |
| Percentage of  total product revenues                   |       | 26                                          | %          | 29         | %          |              |       |   |   |

 

Thecost of software and royalty product revenue decreased 74% during the threemonths ended June 30, 2007 as compared to the corresponding period in 2006 dueprimarily to the 2006 period containing significant third-party softwarelicense costs of approximately $264,000. Such costs were lower for the threemonths ended June 30, 2007 due to lower project sales of software solutionsrequiring such licenses.  Costs ofproducts can vary as a percentage of product revenue from period to perioddepending upon level of software customization and third party software licensecontent included in product sales during a given period.

Thedecrease in the cost of product revenues for our hardware and consumable salesof $124,000 for the three months ended June 30, 2007 as compared to thecorresponding period in 2006 reflects the decrease in hardware and consumablerevenues of $182,000 for the three months ended June 30, 2007 as compared tothe comparable period in 2006.

Costof service revenue increased $65,000 during the three months ended June 30,2007 as compared to the corresponding period in 2006 due to higher softwareintegration revenues of our Biometric Engine into project solutions.

***Costof Maintenance Revenues***
| ** **                                      | ** ** | **Three Months  Ended  June 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|-------------------------------------------------|------------|---------------------------------------------|------------|------------|------------|-------------------|------------|
| **Maintenance cost of revenues** | ** ** | **2007**                                    | ** ** | **2006**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**            | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                            |       |                                        |       |       |       |              |       |   |   |
| Total  maintenance cost of revenues             |       | $                                           | 296        |       | $          | 256               |       | $ | 40 |   | 16 | % |
| Percentage of  total maintenance revenues       |       | 48                                          | %          | 46         | %          |              |       |   |   |
|                                                 |            |                                             |            |            |            |                   |            |  |  |  |  |  |

 

Thedollar increase of 16% or $40,000 during the three months ended June 30, 2007as compared to the corresponding period in 2006 reflects higher costs needed toservice our expanding installed base.

***Product Gross Profit***
| ** **                                              | ** ** | **Three Months  Ended  June 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|---------------------------------------------------------|------------|---------------------------------------------|------------|------------|------------|-------------------|------------|
| **Product gross profit**                      | ** ** | **2007**                                    | ** ** | **2006**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**                    | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                                    |       |                                        |       |       |       |              |       |   |   |
| Software and  royalties                                 |       | $                                           | 687        |       | $          | 1,502             |       | $ | (815 | ) | (54 | )% |
| Percentage of software and royalty product revenue      |       | 86                                          | %          | 78         | %          |              |       |   |   |
| Hardware and  consumables                               |       | $                                           | (2         | )          | $          | 119               |       | $ | (121 | ) | (102 | )% |
| Percentage of hardware and consumables product  revenue |       | (2                                          | )%         | 33         | %          |              |       |   |   |
| Services                                                |       | $                                           | 176        |       | $          | 26                |       | $ | 150 |   | 577 | % |
| Percentage of services product revenue                  |       | 72                                          | %          | 93         | %          |              |       |   |   |
| Total product  gross profit                             |       | $                                           | 861        |       | $          | 1,647             |       | $ | (786 | ) | (48 | )% |
| Percentage of  total product revenues                   |       | 74                                          | %          | 71         | %          |              |       |   |   |

 

17

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Totalproduct gross profit decreased due to significantly lower product revenuesduring the three months ended June 30, 2007 as compared to the correspondingperiod in 2006.

Softwareand royalty gross profit increased as a percentage of software and royaltyproduct revenue to 86% for the three months ended June 30, 2007 from 78% forthe corresponding period in 2006 as the 2006 period contained significant thirdparty software license costs.  The dollardecrease of $815,000 in gross profit for the three months ended June 30, 2007as compared to the corresponding period of 2006 reflects lower software androyalty product revenues. Costs of software products can vary as a percentageof product revenue from quarter to quarter depending upon product mix and thirdparty software licenses included in software solutions.

Hardwareand consumables gross profit decreased due to lower sales of hardware andconsumables during the three months ended June 30, 2007 as compared to thecorresponding period in 2006. Costs of products can vary as a percentage ofproduct revenue from quarter to quarter depending upon product mix and hardwarecontent and print media consumable content included in systems installed duringa given period.

Servicesgross profit increased approximately $150,000 for the three months ended June30, 2007 as compared with the corresponding period in 2006 due to highersoftware integration service revenues related to our Biometric Engine.

***MaintenanceGross Profit***
| ** **                                | ** ** | **Three Months  Ended  June 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|-------------------------------------------|------------|---------------------------------------------|------------|------------|------------|-------------------|------------|
| **Maintenance gross profit**         | ** ** | **2007**                                    | ** ** | **2006**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**      | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| ** **                                | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| Total  maintenance gross profit           |       | $                                           | 325        |       | $          | 300               |       | $ | 25 |   | 8 | % |
| Percentage of  total maintenance revenues |       | 52                                          | %          | 54         | %          |              |       |   |   |
|                                           |            |                                             |            |            |            |                   |            |  |  |  |  |  |

 

Grossmargins related to maintenance revenues increased due primarily to highermaintenance revenues resulting from our expanding installed base.

***Operating Expenses***
| ** **                           | ** ** | **Three Months Ended  June 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|--------------------------------------|------------|-------------------------------------------------|------------|------------|------------|-------------------|------------|
| **Operating expenses**          | ** ** | **2007**                                        | ** ** | **2006**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)** | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| ** **                           | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| General &  administrative        |       | $                                               | 957        |       | $          | 1,080             |       | $ | (123 | ) | (11 | )% |
| Percentage of total net revenue      |       | 52                                              | %          | 38         | %          |              |       |   |   |
| Sales and  marketing                 |       | $                                               | 674        |       | $          | 888               |       | $ | (214 | ) | (24 | )% |
| Percentage of total net revenue      |       | 37                                              | %          | 31         | %          |              |       |   |   |
| Research &  development          |       | $                                               | 803        |       | $          | 961               |       | $ | (158 | ) | (16 | )% |
| Percentage of total net revenue      |       | 44                                              | %          | 34         | %          |              |       |   |   |
| Depreciation and  amortization       |       | $                                               | 79         |       | $          | 63                |       | $ | 16 |   | 25 | % |
| Percentage of  total net revenue     |       | 4                                               | %          | 2          | %          |              |       |   |   |

 

***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.  The increase insuch expenses, as a percentage of total net revenues, is reflective of lowernet revenues during the three months ended June 30, 2007 as compared tothe corresponding period in 2006.  Thedollar decrease of $123,000 is due to lower stock-based compensation expense ofapproximately $121,000 recorded in the three months ended June 30, 2007 as 

18

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compared to thecorresponding period in 2006 combined with lower costs of approximately $26,000for professional services, $14,000 for bad debt expense and $8,000 for traveloffset by increases of $46,000 for salaries and wages and related fringebenefits.  We are continuing to focus ourefforts on achieving additional future operating efficiencies by reviewing andimproving upon existing business processes and evaluating our cost structure.We believe these efforts will allow us to gradually decrease our level ofgeneral and administrative expenses expressed as a percentage of 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. The increase in such expenses as a percentage ofnet revenues to 37% for the three months ended June 30, 2007 from 31% for thecorresponding period in 2006 is due to lower product revenues.  The dollar decrease of $214,000 during thethree months ended June 30, 2007 as compared to the corresponding period in2006 reflects headcount reductions due to the elimination and consolidation ofvarious sales positions.

***Research and Development.***  Research and development expenses consistprimarily of salaries, employee benefits and outside contractors for newproduct development, product enhancements and custom integration work. Suchexpenses decreased 16% or $158,000 for the three months ended June 30, 2007 ascompared to the corresponding period in 2006 due primarily to reductions in ourutilization of contract programming resources. Our level of expenditures in research and development reflects ourbelief that to maintain our competitive position in markets characterized byrapid rates of technological advancement, we must continue to investsignificant resources in new systems and software as well as continue toenhance existing products.

***Depreciation and Amortization.***  During the three months ended June 30, 2007,depreciation and amortization expense increased 25% or $16,000 as compared tothe corresponding period in 2006. The increase in depreciation and amortizationexpense reflects depreciation expense for recently acquired fixed assets.

***Interest Expense (Income), net.***  For the three months ended June 30,2007, we recognized interest income of $6,000 and interest expense of $1,000.For the three months ended June 30, 2006, we recognized interest income of$4,000 and interest expense of $161,000. Interest expense for the three months ended June 30, 2007 decreasedfrom the corresponding period in 2006 due to the payoff in full of our securednotes payable in March 2007.

**Six Months Ended June 30, 2007 Compared to the SixMonths Ended June 30, 2006**

***Product Revenues***
| ** **                              | ** ** | **Six Months  Ended  June 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|-----------------------------------------|------------|-------------------------------------------|------------|------------|------------|-------------------|------------|
| **Net Product Revenues**           | ** ** | **2007**                                  | ** ** | **2006**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**    | ** ** | ** **                                | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                    |       |                                      |       |       |       |              |       |   |   |
| Software and  royalties                 |       | $                                         | 1,409      |       | $          | 3,473             |       | $ | (2,064 | ) | (59 | )% |
| Percentage of total net product revenue |       | 76                                        | %          | 76         | %          |              |       |   |   |
| Hardware and  consumables               |       | $                                         | 190        |       | $          | 978               |       | $ | (788 | ) | (81 | )% |
| Percentage of total net product revenue |       | 10                                        | %          | 21         | %          |              |       |   |   |
| Services                                |       | $                                         | 267        |       | $          | 114               |       | $ | 153 |   | 134 | % |
| Percentage of total net product revenue |       | 14                                        | %          | 3          | %          |              |       |   |   |
| Total net product  revenues             |       | $                                         | 1,866      |       | $          | 4,565             |       | $ | (2,699 | ) | (59 | )% |

 

Softwareand royalty revenues decreased 59% or $2,064,000 during the six months endedJune 30, 2007 as compared to the corresponding period in 2006.  The decrease is due primarily to lowerproject-oriented revenues of our Biometric Engine of approximately $1,686,000combined with lower royalties and license revenues of approximately $391,000offset by increased sales of our boxed identity management software through ourdistribution channel.

Revenuesfrom the sale of hardware and consumables decreased 81% or $788,000 during thesix months ended June 30, 2007 as compared to the corresponding period in2006.  The decrease reflects lowerrevenues from project solutions 

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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 six months ended June 30, 2007 as compared to thecorresponding period in 2006.

Servicesrevenues are comprised primarily of software integration services, systeminstallation services and customer training. Such revenues increased approximately $153,000 during the six monthsended June 30, 2007 as compared to the corresponding period in 2006 dueprimarily to higher service revenues being generated from software integrationof our biometric engine into project solutions and a decrease in ourinstallation of hardware products.  Weexpect service revenues to increase in the remainder of 2007 through increasedimplementations of large-scale high-end solutions.

Webelieve that the lower identity management software revenue in project-orientedsolutions is largely due to the timing of government procurement with respectto the various programs we are pursuing. Based on management’s current visibility into the timing of potentialgovernment procurements, we believe that we will see a significant increase ingovernment procurement and implementations with respect to identity managementinitiatives during the remainder of 2007 and continuing into 2008 and 2009.

Wefeel that we are well positioned for participation in one or more large-scaledomestic or international projects which will enable our company to achievesignificant product revenue growth.  Inthe past eighteen months we have continuously retooled our identity managementsuite of products to meet changing government specifications and to enablecustomization for large project applications. Additionally, we reoriented our sales organization to direct ourresources and efforts toward establishing partnerships with large systemsintegrators as we believe these integrators will be the ultimate choice forawards of large-scale secure identification solutions.

***Maintenance Revenues***
| ** **                           | ** ** | **Six Months  Ended  June 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|--------------------------------------|------------|-------------------------------------------|------------|------------|------------|-------------------|------------|
| **Maintenance Revenues**             | ** ** | **2007**                                  | ** ** | **2006**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)** | ** ** | ** **                                | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                 |       |                                      |       |       |       |              |       |   |   |
| Maintenance revenues                 |       | $                                         | 1,247      |       | $          | 1,067             |       | $ | 180 |   | 17 | % |
|                                      |            |                                           |            |            |            |                   |            |  |  |  |  |  |

 

Theincrease in maintenance revenues reflects the expansion of our installed baseresulting from the completion of significant project-oriented work during theyear ended December 31, 2006 and the first three months of 2007.

Weanticipate continued growth of our maintenance revenues through the retentionof existing customers combined with the expansion of installed base combinedresulting from the completion of project-oriented work, however, we cannotpredict the timing of this anticipated growth.

***Cost of Product Revenues***
| ** **                                              | ** ** | **Six Months  Ended  June 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|---------------------------------------------------------|------------|-------------------------------------------|------------|------------|------------|-------------------|------------|
| **Cost of Product Revenues:**            | ** ** | **2007**                                  | ** ** | **2006**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**                    | ** ** | ** **                                | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| ** **                                              | ** ** | ** **                                | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| Software and  royalties                                 |       | $                                         | 210        |       | $          | 517               |       | $ | (307 | ) | (59 | )% |
| Percentage of software and royalty product revenue      |       | 15                                        | %          | 15         | %          |              |       |   |   |
| Hardware and  consumables                               |       | $                                         | 203        |       | $          | 669               |       | $ | (466 | ) | (70 | )% |
| Percentage of hardware and consumables product  revenue |       | 107                                       | %          | 68         | %          |              |       |   |   |
| Services                                                |       | $                                         | 69         |       | $          | 4                 |       | $ | 65 |   | 1,625 | % |
| Percentage of services product revenue                  |       | 26                                        | %          | 4          | %          |              |       |   |   |
| Total cost of  product revenues                         |       | $                                         | 482        |       | $          | 1,190             |       | $ | (708 | ) | (59 | )% |
| Percentage of  total product revenues                   |       | 26                                        | %          | 26         | %          |              |       |   |   |

 

20

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Thecost of software and royalty product revenue decreased 59% or $307,000 duringthe six months ended June 30, 2007 as compared to the corresponding period in2006 due to lower software and royalty revenues during the six months endedJune 30, 2007.  The 2006 period alsocontained costs of approximately $264,000 in third party software licenses notincurred during the comparable period of 2007. Costs of products can vary as a percentage of product revenue from periodto period depending upon level of software customization and third partysoftware license content included in product sales during a given period.

Thedecrease in the cost of product revenues for our hardware and consumable salesof $466,000 for the six months ended June 30, 2007 as compared to thecorresponding period in 2006 reflects the decrease in hardware and consumablerevenues of $788,000 for the six months ended June 30, 2007 as compared to thecomparable period in 2006.

Costof service revenue increased $65,000 during the six months ended June 30, 2007as compared to the corresponding period in 2006 due to higher softwareintegration revenues of our Biometric Engine into project solutions.

***Cost of Maintenance Revenues***
| ** **                                      | ** ** | **Six Months  Ended  June 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|-------------------------------------------------|------------|-------------------------------------------|------------|------------|------------|-------------------|------------|
| **Maintenance cost of revenues** | ** ** | **2007**                                  | ** ** | **2006**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**            | ** ** | ** **                                | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| ** **                                      | ** ** | ** **                                | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| Total maintenance cost  of revenues             |       | $                                         | 590        |       | $          | 572               |       | $ | 18 |   | 3 | % |
| Percentage of total  maintenance revenues       |       | 47                                        | %          | 54         | %          |              |       |   |   |
|                                                 |            |                                           |            |            |            |                   |            |  |  |  |  |  |

 

Costof maintenance revenues as a percentage of maintenance revenues decreased to47% during the six months ended June 30, 2007 from 54% for the correspondingperiod in 2006 due primarily to higher maintenance revenues to absorb fixedmaintenance costs combined with a higher percentage of our maintenance revenuesbeing generated from software maintenance versus hardware maintenance.  The dollar increase of 3% or $18,000 duringthe six months ended June 30, 2007 as compared to the corresponding period in2006 reflects higher costs needed to service our expanding installed base.

***Product Gross Profit***
| ** **                                              | ** ** | **Six Months  Ended  June 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|---------------------------------------------------------|------------|-------------------------------------------|------------|------------|------------|-------------------|------------|
| **Product gross profit**                      | ** ** | **2007**                                  | ** ** | **2006**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**                    | ** ** | ** **                                | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| ** **                                              |       |                                      |       |       |       |              |       |   |   |
| Software and royalties                                  |       | $                                         | 1,199      |       | $          | 2,956             |       | $ | (1,757 | ) | (59 | )% |
| Percentage of  software and royalty product revenue     |       | 85                                        | %          | 85         | %          |              |       |   |   |
| Hardware and  consumables                               |       | $                                         | (13        | )          | $          | 309               |       | $ | (322 | ) | (104 | )% |
| Percentage of  hardware and consumables product revenue |       | (7                                        | )%         | 32         | %          |              |       |   |   |
| Services                                                |       | $                                         | 198        |       | $          | 110               |       | $ | 88 |   | 80 | % |
| Percentage of  services product revenue                 |       | 74                                        | %          | 96         | %          |              |       |   |   |
| Total product gross  profit                             |       | $                                         | 1,384      |       | $          | 3,375             |       | $ | (1,991 | ) | (59 | )% |
| Percentage of total  product revenues                   |       | 74                                        | %          | 74         | %          |              |       |   |   |

 

Totalproduct gross profit decreased due to significantly lower product revenuesduring the six months ended June 30, 2007 as compared to the correspondingperiod in 2006.

Softwareand royalty gross profit decreased 59% or $1,757,000 for the six months endedJune 30, 2007 as compared to the corresponding period in 2006 due to lowersoftware sales of our Biometric Engine.

Hardwareand consumables gross profit decreased $322,000 during the six months endedJune 30, 2007 as compared to the corresponding period in 2006 due to lowersales of hardware and consumables of $788,000 during the six months ended June30, 2007 as compared to the corresponding period in 2006. Hardware andconsumables gross profit as a percentage of hardware and consumables productrevenue decreased to (7%) from $309,000 and reflects the 2007 period 

21

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containingexpenses charged to cost of sales for restocking fees. 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.

Servicesgross profit increased approximately $88,000 for the six months ended June 30,2007 as compared to the corresponding period of 2006 due to higher projectrevenues for the integration of our Biometric Engine into project solutions.

***MaintenanceGross Profit***
| ** **                                | ** ** | **Six Months  Ended  June 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|-------------------------------------------|------------|-------------------------------------------|------------|------------|------------|-------------------|------------|
| **Maintenance gross profit**    | ** ** | **2007**                                  | ** ** | **2006**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**      | ** ** | ** **                                | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                      |       |                                      |       |       |       |              |       |   |   |
| Total  maintenance gross profit           |       | $                                         | 657        |       | $          | 495               |       | $ | 162 |   | 33 | % |
| Percentage of  total maintenance revenues |       | 53                                        | %          | 46         | %          |              |       |   |   |
|                                           |            |                                           |            |            |            |                   |            |  |  |  |  |  |

 

Grossmargins related to maintenance revenues increased due primarily to highermaintenance revenues to absorb fixed maintenance costs.

***Operating Expenses***
| ** **                           | ** ** | **Six Months Ended  June 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|--------------------------------------|------------|-----------------------------------------------|------------|------------|------------|-------------------|------------|
| **Operating expenses**          | ** ** | **2007**                                      | ** ** | **2006**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)** | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                 |       |                                          |       |       |       |              |       |   |   |
| General &  administrative        |       | $                                             | 2,100      |       | $          | 2,219             |       | $ | (119 | ) | (5 | )% |
| Percentage of total net revenue      |       | 67                                            | %          | 39         | %          |              |       |   |   |
| Sales and  marketing                 |       | $                                             | 1,367      |       | $          | 1,891             |       | $ | (524 | ) | (28 | )% |
| Percentage of total net revenue      |       | 44                                            | %          | 34         | %          |              |       |   |   |
| Research &  development          |       | $                                             | 1,989      |       | $          | 1,935             |       | $ | 54 |   | 3 | % |
| Percentage of total net revenue      |       | 64                                            | %          | 34         | %          |              |       |   |   |
| Depreciation and  amortization       |       | $                                             | 139        |       | $          | 188               |       | $ | (49 | ) | (26 | )% |
| Percentage of  total net revenue     |       | 4                                             | %          | 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.  The increase insuch expenses, as a percentage of total net revenues, is reflective of lowernet revenues during the six months ended June 30, 2007 as compared to thecorresponding period in 2006.  The dollardecrease of $119,000 is due to lower stock-based compensation expense ofapproximately $187,000 recorded in the six months ended June 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 $144,000 in higher expense for personnel,legal, accounting, consulting and bad debts. We are continuing 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.  Theincrease in such expenses, as a percentage of total net revenues, is reflectiveof lower net revenues during the six months ended June 30, 2007 ascompared to the corresponding period in 2006. The dollar decrease of $524,000during the six months ended June 30, 2007 as compared to the corresponding periodin 2006 reflects headcount reductions due to the elimination and consolidationof various sales positions in conjunction with reduced stock compensationexpense, advertising and contractor fees.

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***Research and Development.***  Research and development expenses consistprimarily of salaries, employee benefits and outside contractors for newproduct development, product enhancements and custom integration work. Suchexpenses increased 3% or $54,000 for the six months ended June 30, 2007 ascompared to the corresponding period in 2006 due primarily to increasedheadcount necessary for the continued development of our Biometric Engine, thedevelopment of our Personal Identity Verification (PIV) solution, the webenablement of our CCS product line, and the development of our IWS desktopsecurity solution.  Additional headcountexpenses were offset by reduced contract programming fees.  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 six months ended June 30, 2007, depreciationand amortization expense decreased 26% or $49,000 as compared to thecorresponding period in 2006. The decrease in depreciation and amortizationexpense reflects lower amortization of certain intangible assets due to suchassets being fully amortized.

***Interest Expense (Income), net.***  For the six months ended June 30, 2007,we recognized interest income of $14,000 and interest expense of $252,000. Forthe six months ended June 30, 2006, we recognized interest income of$8,000 and interest expense of $192,000. Interest expense for the six months ended June 30, 2007 containsthree components approximating $248,000 related to our secured notes payableissued in March 2006: $19,000 of coupon interest, $213,000 in note discountamortization and $16,000 in deferred financing fee amortization classified asinterest expense.

**LIQUIDITY AND CAPITAL RESOURCES**

As ofJune 30, 2007, we had total current assets of $1,690,000 and total currentliabilities of $4,921,000, or negative working capital of $3,231,000.  At June 30, 2007, we had available cash of$228,000 and $106,000 in restricted cash securing our performance on certainsoftware implementation contracts.

Netcash used in operating activities was $1,689,000 for the six month period endedJune 30, 2007 as compared to $1,412,000 for the corresponding period in 2006.We used cash to fund net losses of $3,023,000, excluding non-cash expenses(depreciation, amortization, debt issuance costs, debt discount, stock-basedcompensation and provision for losses on accounts receivable and investment inmarketable securities less reductions in inventory obsolescence reserves) of$802,000 for the six months ended June 30, 2007.  We used cash to fund net losses of$1,649,000, excluding non-cash expenses (depreciation, amortization, debtissuance costs, debt discount and stock-based compensation) of $1,024,000 forthe six months ended June 30, 2006.  Forthe six months ended June 30, 2007, we generated cash of $423,000 throughreduction in current assets and generated cash of $911,000 through increases incurrent liabilities and deferred revenues, excluding debt.  For the six months ended June 31, 2006, weused cash of $916,000 to fund increases in current assets and generated cash of$1,153,000 through increases in current liabilities and deferred revenues,excluding debt.

Netcash used in investing activities was $56,000 for the six months endedJune 30, 2007.  Net cash used ininvesting activities was $79,000 for the six months ended June 30, 2006.  For the six months ended June 30, 2007, weused cash to fund capital expenditures of computer equipment, software andfurniture and fixtures of approximately $56,000.  The level of equipment purchases resultedprimarily from the replacement of older equipment. For the six months endedJune 30, 2006, we used cash to fund capital expenditures of computerequipment and software, furniture and fixtures and leasehold improvements ofapproximately $79,000.

Netcash provided by financing activities was $1,059,000 for the six month periodended June 30, 2007 as compared to $1,311,000 for the corresponding periodin 2006.  For the six months endedJune 30, 2007, we generated cash of $1,327,000 from our issuance ofpreferred stock in a private 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.  For the six months ended June 30, 2007, weused cash of $1,310,000 for the repayment of our secured notes payable and usedcash 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 six months ended June 30, 2006, we generated cash of $1,550,000from the issuance of secured notes payable and incurred debt issuance costs of$98,000.  For the six months ended June30, 2006, we used cash of $115,000 for the repayment of our secured notespayable and used cash of $26,000 for the payment of dividends on our Series BPreferred Stock.

Weconduct operations in leased facilities under operating leases expiring atvarious dates through 2009. In conjunction with our performance on varioussoftware installation and implementation contracts, we are contingently liableunder an irrevocable letter of credit in the amount of $106,000. The letter ofcredit expires on December 26, 2008.

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Thereport of our independent accountants included with our Annual Report on Form10-K as filed with the SEC on April 17, 2007, contained an explanatoryparagraph regarding our ability to continue as a going concern.  We are seeking additional financing that webelieve is necessary to fund our working capital requirements for at least thenext twelve months in conjunction with the successful implementation of ourbusiness plan. Our business plan includes, among other things, the monitoringand controlling of operating expenses, collection of significant trade andother accounts receivable, and controlling of capital expenditures. Wemay seek to sell equity or debt securities, secure a bank line of credit,or consider strategic alliances. The sale of equity or equity-relatedsecurities could result in additional dilution to our shareholders. There canbe no assurance that additional financing, in any form, will be available at allor, if available, will be on terms acceptable to us. In addition, our abilityto raise additional capital may be dependent upon our common stockcontinuing to be quoted on the American Stock Exchange (“AMEX”). There can beno assurance that we will be able to satisfy the criteria for continued listingon AMEX. Insufficient funds will require us to sell certain of our assetsor license or technologies to others and if we are unable to obtain additionalfunding there is substantial doubt about our ability to continue as a goingconcern.

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

***Foreign Currency Exchange Risk.***Market risk isthe potential loss arising from adverse changes in market rates and prices,such as interest rates and foreign currency exchange rates.  Changes in foreign currency exchange rateshave an impact on our results of operations. Our exposure to adverse movementsin foreign currency exchange rates is primarily related to our subsidiariesoperating expense, primarily in Canada, denominated in the respective localcurrency. We currently do not enter into forward exchange contracts to hedgeexposures denominated in foreign currencies and do not use derivative financialinstruments for trading or speculative purposes. The effect of an immediate 10%change in foreign currency exchange rates should not have a material effect onour future operating results or cash flows; however, a long term change inforeign currency rates would likely result in increased technical support andengineering expenses. The vast majority of our sales are transacted in U. S.dollars.

**ITEM 4. Controls andProcedures**

***Conclusions Regarding the Effectiveness of Disclosure Controls andProcedures.**** *Under the supervision and with theparticipation of our management, including our principal executive officer andprincipal financial officer, we conducted an evaluation of our disclosurecontrols and procedures as such term is defined under Rule 13a-15(e)promulgated under the Securities Exchange Act of 1934, as amended.  Based on this evaluation, our principalexecutive officer and principal financial officer have concluded, based upontheir evaluation as of the end of the period covered by this report, that ourdisclosure controls and procedures are effective in ensuring that informationrequired to be disclosed in the reports that we file or submit under theSecurities Exchange Act of 1934 is recorded, processed, summarized and reportedwithin the time periods specified in the SEC’s rules and forms.

***Changes in Internal Control Over Financial Reporting*.**  There has been no change in our internalcontrol over financial reporting during the fiscal quarter ended June 30, 2007,that has materially affected, or is reasonably likely to materially affect, ourinternal control over financial reporting.

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**PART II**

**ITEM1A.  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 June 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.

**Wehave a history of significant recurring losses totaling approximately $74.5million, and these losses may continue in the future.**

As ofJune 30, 2007, we had an accumulated deficit of $74.5 million, andthese losses may continue in the future. We will need to raisecapital to cover these losses, and financing may not be available to us onfavorable terms. In the event financing is not available, in the time framerequired, we will be forced to sell certain of our assets or license ourtechnologies to others. We expect to continue to incur significant sales andmarketing, research and development, and general and administrative expenses.As a result, we will need to generate significant revenues to achieveprofitability and we may never achieve profitability.

**Theholders of our preferred stock have certain rights and privileges that aresenior to the common stock and we may issue additional shares of preferredstock without shareholder approval that could have a material adverse effect onthe market value of the common stock.**

Our Board of Directorshas the authority to issue a total of up to 4,000,000 shares of preferred stockand to fix the rights, preferences, privileges, and restrictions, includingvoting rights, of the preferred stock, which typically are senior to the rightsof the common stockholders, without any further vote or action by the commonstockholders. The rights of our common shareholders will be subject to, and maybe adversely affected by, the rights of the holders of the preferred stock thathave been issued, or

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might be issued in thefuture. Preferred stock also could have the effect of making it more difficultfor a third party to acquire a majority of the outstanding voting stock ofImageWare. This could delay, defer, or prevent a change in control. Furthermore,holders of preferred stock may have other rights, including economic rights,senior to the common 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 June 30, 2007 we had three series of preferredstock outstanding, Series B preferred stock, Series C 8% convertible preferredstock and Series D 8% convertible preferred stock.

The provisions of ourSeries B Preferred Stock prohibit the payment of dividends on the common stockunless the dividends on those preferred shares are first paid. In addition,upon a liquidation, dissolution or sale of ImageWare’s business, the holders ofthe Series B Preferred Stock will be entitled to receive, in preference to anydistribution to the holders of common stock, initial distributions of $2.50 pershare, plus all accrued but unpaid dividends.  Pursuant to the terms ofour Series B Preferred Stock we are obligated to pay cumulative cash dividendson shares of Series B Preferred Stock from legally available funds at theannual 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 anydividend on our common stock. As of June 30, 2007, the Company had cumulativeundeclared dividends on the Series B Preferred Stock of approximately $8,000.

The Series C PreferredStock has a liquidation preference equal to its stated value, plus any accruedand unpaid dividends thereon and any other fees or liquidated damages owingthereon. The Series C Preferred Stock accrues cumulative dividends at the rateof 8.0% of the stated value per share per annum.  At the option of theCompany, the dividend payment may be made in the form of cash, after thepayment of cash dividends to the holders of Series B Preferred Stock, or commonstock issuable upon conversion of the Series C Preferred Stock.  Eachshare of Series C Preferred Stock is convertible at any time at the option ofthe holder into a number of shares of common stock equal to the stated value(initially $1,000 per share, subject to adjustment), plus any accrued andunpaid dividends, divided by the conversion price (initially $1.50 per share,subject to adjustment). Subject to certain limitations, the conversion priceper share shall 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 June 30,2007, the Company had cumulative undeclared dividends on the Series C PreferredStock of approximately $120,000.

The Series D PreferredStock has a liquidation preference equal to its stated value, plus any accruedand unpaid dividends thereon and any other fees or liquidated damages owingthereon. The Series D Preferred Stock accrues cumulative dividends at the rateof 8.0% of the stated value per share per annum.  At the option of theCompany, the dividend payment may be made in the form of cash, after thepayment of cash dividends to the holders of Series B and Series C PreferredStock, or common stock issuable upon conversion of the Series D PreferredStock.  Each share of Series D Preferred Stock is convertible at any timeat the option of the holder into a number of shares of common stock equal tothe stated value (initially $1,000 per share, subject to adjustment), plus anyaccrued and unpaid dividends, divided by the conversion price (initially $1.90per share, subject to adjustment). Subject to certain limitations, theconversion price per share shall be adjusted in the event of certain subsequentstock dividends, splits, reclassifications, dilutive issuances, rightsofferings, and reclassifications.  The Series D Preferred Stock generallydoes not have voting rights except as required by law, however, certainactivities may not be undertaken by the Company without the affirmative vote ofa majority of the holders of the outstanding shares of Series C PreferredStock. As of June 30, 2007, the Company had cumulative undeclared dividends onthe Series D Preferred Stock of approximately $38,000.

**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                             |

 

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|      |   | 15, 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 |

 

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**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.
|                       |   | IMAGEWARE SYSTEMS, INC. |
|-----------------------|--------|-------------------------|
|                  |   |                    |
|                  |   |                    |
| Date: August 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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