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

**Washington, D.C. 20549**

 

**FORM10-QSB**

 

**(Mark One)**

 

**ý****                                ****QUARTERLY REPORT UNDERSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For thequarterly period ended June 30, 2005**

 

**o****                                ****TRANSITION REPORT UNDERSECTION 13 OR 15(d) OF THE EXCHANGE ACT**

 

**For the transition periodfrom         to         **

 

**Commission file number 001-15757**

 

**IMAGEWARESYSTEMS, INC.**

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

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

 

**10883 Thornmint RoadSan Diego, CA 92127**

(Address of Principal Executive Offices)

 

**(858) 673-8600**

(Issuer’s Telephone Number, Including Area Code)

 

Checkwhether the issuer (1) filed all reports required to be filed bySection 13 or 15(d) of the Exchange Act during the past 12 months (or forsuch shorter period that the registrant was required to file such reports), and(2) has been subject to such filing requirements for the past 90 days.Yes ý  No o

 

Statethe number of shares outstanding of each of the issuer’s classes of commonequity, as of the latest practicable date: As of August 12, 2005, thenumber of outstanding shares of the Registrant’s common stock, par value $.01,was 13,544,537.

 

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

 

 

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**IMAGEWARE SYSTEMS, INC. INDEX**

 
| PART I.    | FINANCIAL INFORMATION |                                                                                                                              |
|------------|-----------------------|-----------------------------------------------------------------------------------------------------------------------------------|
|       | ITEM 1.               | FINANCIAL STATEMENTS (UNAUDITED)                                                                                                  |   |
|       |                  | Condensed Consolidated  Balance Sheets as of June 30, 2005 and December 31, 2004                                        |   |
|       |                  | Condensed Consolidated  Statements of Operations for the three and six months ended June 30,  2005 and 2004                  |   |
|       |                  | Condensed Consolidated  Statements of Cash Flows for the six months ended June 30, 2005 and 2004                             |   |
|       |                  | Condensed Consolidated  Statements of Comprehensive Income (Loss) for the three and six months ended  June 30, 2005 and 2004 |   |
|       |                  | Notes to Condensed  Consolidated Financial Statements                                                                             |   |
|       | ITEM 2.               | Management’s Discussion and Analysis or Plan of  Operation                                                                   |   |
|       | ITEM 3.               | Controls and Procedures                                                                                                           |   |
|       |                  |                                                                                                                              |   |
| PART II.   | OTHER INFORMATION     |                                                                                                                              |
|       | ITEM 4.               | SUBMISSION OF MATTERS TO A VOTE OF  SECURITY HOLDERS                                                                              |   |
|       | ITEM 6.               | EXHIBITS AND REPORTS ON FORM 8-K                                                                                                  |   |
|       |                  |                                                                                                                              |   |
| SIGNATURES |                  |                                                                                                                              |

 

2

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**PART I**

**FINANCIAL INFORMATION**

 

**ITEM 1. FINANCIAL STATEMENTS**

 

**IMAGEWARE SYSTEMS, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(IN THOUSANDS)**

 
| ** **                                                                                                                                                                                                                                                                                                                  | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                                                                                                                                                  | ** ** | **(Unaudited)**         | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                                                                                  |       |                    |       |                        |       |
| Current Assets:                                                                                                                                                                                                                                                                                                             |       |                    |       |                        |       |
| Cash                                                                                                                                                                                                                                                                                                                        |       | $                       | 365        |                        | $          | 2,912 |   |
| Restricted cash and cash equivalents                                                                                                                                                                                                                                                                                        |       | 106                     |       | 106                         |       |
| Accounts receivable, net                                                                                                                                                                                                                                                                                                    |       | 1,048                   |       | 1,797                       |       |
| Inventory                                                                                                                                                                                                                                                                                                                   |       | 981                     |       | 1,097                       |       |
| Other current assets                                                                                                                                                                                                                                                                                                        |       | 311                     |       | 247                         |       |
| Total Current Assets                                                                                                                                                                                                                                                                                                        |       | 2,811                   |       | 6,159                       |       |
|                                                                                                                                                                                                                                                                                                                        |       |                    |       |                        |       |
| Property and equipment, net                                                                                                                                                                                                                                                                                                 |       | 482                     |       | 510                         |       |
| Other assets                                                                                                                                                                                                                                                                                                                |       | 684                     |       | 628                         |       |
| Intangible assets, net of accumulated  amortization                                                                                                                                                                                                                                                                         |       | 613                     |       | 764                         |       |
| Goodwill                                                                                                                                                                                                                                                                                                                    |       | 4,661                   |       | 5,298                       |       |
| **Total Assets**                                                                                                                                                                                                                                                                                                            | ** ** | **$**                   | **9,251**  | ** **                  | **$**      | **13,359** | ** ** |
|                                                                                                                                                                                                                                                                                                                        |       |                    |       |                        |       |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                                                                                                                                                                                                              |       |                    |       |                        |       |
|                                                                                                                                                                                                                                                                                                                        |       |                    |       |                        |       |
| Current Liabilities:                                                                                                                                                                                                                                                                                                        |       |                    |       |                        |       |
| Accounts payable                                                                                                                                                                                                                                                                                                            |       | $                       | 864        |                        | $          | 1,229 |   |
| Deferred revenue                                                                                                                                                                                                                                                                                                            |       | 817                     |       | 1,045                       |       |
| Billings in excess of costs and estimated  earnings on uncompleted contracts                                                                                                                                                                                                                                                |       | —                  |       | 424                         |       |
| Accrued expenses                                                                                                                                                                                                                                                                                                            |       | 1,120                   |       | 1,565                       |       |
| Notes & advances payable to bank and  third parties                                                                                                                                                                                                                                                                     |       | 2                       |       | 18                          |       |
| Total Current Liabilities                                                                                                                                                                                                                                                                                                   |       | 2,803                   |       | 4,281                       |       |
|                                                                                                                                                                                                                                                                                                                        |       |                    |       |                        |       |
| Pension obligation                                                                                                                                                                                                                                                                                                          |       | 774                     |       | 812                         |       |
| Total Liabilities                                                                                                                                                                                                                                                                                                           |       | 3,577                   |       | 5,093                       |       |
|                                                                                                                                                                                                                                                                                                                        |       |                    |       |                        |       |
| Shareholders’ equity:                                                                                                                                                                                                                                                                                                  |       |                    |       |                        |       |
| Preferred stock, $.01 par value, authorized  4,000,000 shares Series B convertible redeemable preferred stock, designated  750,000 shares, 389,400 shares issued, and 249,400 shares outstanding at  June 30, 2005 and December 31, 2004, liquidation preference $623,500 at  June 30, 2005 and December 31, 2004 |       | 2                       |       | 2                           |       |
| Common stock, $.01 par value, 50,000,000  shares authorized, 12,117,762 shares issued and 12,111,058 and 11,962,385  shares outstanding at June 30, 2005 and December 31, 2004, respectively                                                                                                                           |       | 120                     |       | 118                         |       |
| Additional paid in capital                                                                                                                                                                                                                                                                                                  |       | 64,284                  |       | 63,789                      |       |
| Treasury stock, at cost - 6,704 shares                                                                                                                                                                                                                                                                                      |       | (64                     | )          | (64                         | )          |
| Accumulated other comprehensive income                                                                                                                                                                                                                                                                                      |       | 80                      |       | 334                         |       |
| Accumulated deficit                                                                                                                                                                                                                                                                                                         |       | (58,748                 | )          | (55,913                     | )          |
| Total shareholders’ equity                                                                                                                                                                                                                                                                                             |       | 5,674                   |       | 8,266                       |       |
|                                                                                                                                                                                                                                                                                                                        |       |                    |       |                        |       |
| **Total Liabilities and Shareholders’ Equity**                                                                                                                                                                                                                                                                         | ** ** | **$**                   | **9,251**  | ** **                  | **$**      | **13,359** | ** ** |

 

The accompanying notes are an integral part of these condensedconsolidated 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,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                               | ** ** | **2005**                              | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                                                     |       |                                  |       |                                |       |   |   |   |   |
| **Revenues:**                                                                                                            |       |                                  |       |                                |       |   |   |   |   |
| Product                                                                                                                  |       | $                                     | 1,448      |                                | $          | 2,085 |   | $ | 3,763 |   | $ | 3,899 |   |
| Maintenance                                                                                                              |       | 527                                   |       | 458                                 |       | 1,022 |   | 902 |   |
|                                                                                                                     |       | 1,975                                 |       | 2,543                               |       | 4,785 |   | 4,801 |   |
| **Cost of revenues:**                                                                                                    |       |                                  |       |                                |       |   |   |   |   |
| Product                                                                                                                  |       | 610                                   |       | 494                                 |       | 1,455 |   | 954 |   |
| Maintenance                                                                                                              |       | 227                                   |       | 206                                 |       | 495 |   | 427 |   |
| Gross profit                                                                                                             |       | 1,138                                 |       | 1,843                               |       | 2,835 |   | 3,420 |   |
|                                                                                                                     |       |                                  |       |                                |       |   |   |   |   |
| **Operating expenses:**                                                                                                  |       |                                  |       |                                |       |   |   |   |   |
| General & administrative                                                                                             |       | 1,279                                 |       | 1,116                               |       | 2,362 |   | 2,242 |   |
| Sales and marketing                                                                                                      |       | 823                                   |       | 858                                 |       | 1,764 |   | 1,514 |   |
| Research & development                                                                                               |       | 796                                   |       | 722                                 |       | 1,487 |   | 1,355 |   |
| Depreciation and amortization                                                                                            |       | 154                                   |       | 176                                 |       | 313 |   | 362 |   |
|                                                                                                                     |       | 3,052                                 |       | 2,872                               |       | 5,926 |   | 5,473 |   |
| Loss from operations                                                                                                     |       | (1,914                                | )          | (1,029                              | )          | (3,091 | ) | (2,053 | ) |
|                                                                                                                     |       |                                  |       |                                |       |   |   |   |   |
| Interest expense (income), net                                                                                           |       | (5                                    | )          | 3,898                               |       | (11 | ) | 5,189 |   |
|                                                                                                                     |       |                                  |       |                                |       |   |   |   |   |
| Other (income) expense, net                                                                                              |       | (5                                    | )          | (9                                  | )          | (49 | ) | (29 | ) |
| Loss from continuing operations before  income taxes                                                                     |       | (1,904                                | )          | (4,918                              | )          | (3,031 | ) | (7,213 | ) |
|                                                                                                                     |       |                                  |       |                                |       |   |   |   |   |
| Income tax expense (benefit)                                                                                             |       | —                                |       | —                              |       | — |   | — |   |
|                                                                                                                     |       |                                  |       |                                |       |   |   |   |   |
| Loss from continuing operations                                                                                          |       | (1,904                                | )          | (4,918                              | )          | (3,031 | ) | (7,213 | ) |
|                                                                                                                     |       |                                  |       |                                |       |   |   |   |   |
| Discontinued operations:                                                                                                 |       |                                  |       |                                |       |   |   |   |   |
| Gain (loss) from operations of discontinued  Digital Imaging Asia Component (including gain on disposal of $233 in 2005) |       | —                                |       | (10                                 | )          | 223 |   | (20 | ) |
| Income tax benefit (expense)                                                                                             |       | —                                |       | —                              |       | — |   | — |   |
| Gain (loss) on discontinued operations                                                                                   |       | —                                |       | (10                                 | )          | 223 |   | (20 | ) |
|                                                                                                                     |       |                                  |       |                                |       |   |   |   |   |
| Net loss                                                                                                                 |       | $                                     | (1,904     | )                                   | $          | (4,928 | ) | $ | (2,808 | ) | $ | (7,233 | ) |
|                                                                                                                     |       |                                  |       |                                |       |   |   |   |   |
| Basic and diluted loss per common share -  see note 2                                                                    |       | $                                     | (0.16      | )                                   | $          | (0.42 | ) | $ | (0.23 | ) | $ | (0.63 | ) |
| Weighted-average shares (basic and diluted)                                                                              |       | 12,109,723                            |       | 11,825,414                          |       | 12,071,861 |   | 11,517,716 |   |

 

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

 

4

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**IMAGEWARE SYSTEMS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(IN THOUSANDS)**

**(UNAUDITED)**

 
| ** **                                                                      | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                      | ** ** | **2005**                            | ** ** | **2004** | ** ** |
|                                                                            |       |                                |       |   |   |
| **Cash flows from operating activities**                                        |       |                                |       |   |   |
| Net loss                                                                        |       | $                                   | (2,808     | ) | $ | (7,233 | ) |
| Adjustments to reconcile net loss to net  cash used by operating activities     |       |                                |       |   |   |
| Depreciation and amortization                                                   |       | 315                                 |       | 371 |   |
| Gain on sale of subsidiary                                                      |       | (233                                | )          | — |   |
| Non cash interest and amortization of debt  discount and debt issuance costs    |       | —                              |       | 4,472 |   |
| Stock based compensation                                                        |       | 139                                 |       | 82 |   |
| Change in assets and liabilities                                                |       |                                |       |   |   |
| Restricted cash and cash equivalents                                            |       | —                              |       | 48 |   |
| Accounts receivable, net                                                        |       | 670                                 |       | (511 | ) |
| Inventory                                                                       |       | (126                                | )          | 77 |   |
| Other current assets                                                            |       | (82                                 | )          | (184 | ) |
| Intangible and other assets                                                     |       | 47                                  |       | 6 |   |
| Accounts payable                                                                |       | (356                                | )          | (311 | ) |
| Accrued expenses                                                                |       | (367                                | )          | 364 |   |
| Deferred revenue                                                                |       | (228                                | )          | 6 |   |
| Contract costs                                                                  |       | (424                                | )          | — |   |
| Pension obligation                                                              |       | (37                                 | )          | 43 |   |
| Total adjustments                                                               |       | (682                                | )          | 4,463 |   |
| Net cash used by operating activities                                           |       | (3,490                              | )          | (2,770 | ) |
|                                                                            |       |                                |       |   |   |
| **Cash flows from investing activities**                                        |       |                                |       |   |   |
| Purchase of property and equipment                                              |       | (153                                | )          | (63 | ) |
| Proceeds from sale of subsidiary net of  cash sold and direct transaction costs |       | 1,209                               |       | — |   |
| Payment on advances from related stockholders                                   |       |                                |       | (59 | ) |
| Net cash provided (used) by investing  activities                               |       | 1,056                               |       | (122 | ) |
|                                                                            |       |                                |       |   |   |
| **Cash flows from financing activities**                                        |       |                                |       |   |   |
| Repayment of notes payable                                                      |       | (17                                 | )          | (31 | ) |
| Proceeds from issuance of common stock, net  of issuance costs                  |       | —                              |       | 6,054 |   |
| Proceeds from exercised stock options                                           |       | 56                                  |       | 257 |   |
| Dividends paid                                                                  |       | (26                                 | )          | (185 | ) |
|                                                                            |       |                                |       |   |   |
| Net cash provided by financing activities                                       |       | 13                                  |       | 6,095 |   |
| Effect of exchange rate changes on cash                                         |       | (126                                | )          | (54 | ) |
| Net increase (decrease) in cash                                                 |       | (2,547                              | )          | 3,149 |   |
|                                                                            |       |                                |       |   |   |
| Cash at beginning of period                                                     |       | 2,912                               |       | 578 |   |
|                                                                            |       |                                |       |   |   |
| Cash at end of period                                                           |       | $                                   | 365        |   | $ | 3,727 |   |
|                                                                            |       |                                |       |   |   |
| Supplemental disclosure of cash flow  information:                              |       |                                |       |   |   |
| Summary of non-cash investing and financing  activities:                        |       |                                |       |   |   |
| Exchange of common shares for marketable  equity securities                     |       | $                                   | 231        |   | $ | — |   |

 

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

 

5

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**IMAGEWARE SYSTEMS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVEINCOME (LOSS)**

**(IN THOUSANDS)**

**(UNAUDITED)**

 
| ** **                                           | ** ** | **THREE MONTHS ENDED  JUNE 30,** | ** ** | **SIX MONTHS ENDED  JUNE 30,** | ** ** |
|------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                           | ** ** | **2005**                              | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                 |       |                                  |       |                                |       |   |   |   |   |
| Net loss                                             |       | $                                     | (1,904     | )                                   | $          | (4,928 | ) | $ | (2,808 | ) | $ | (7,233 | ) |
| Other comprehensive income (loss):                   |       |                                  |       |                                |       |   |   |   |   |
| Unrealized loss on securities:                       |       |                                  |       |                                |       |   |   |   |   |
| Unrealized holding losses arising during  the period |       | (76                                   | )          | —                              |       | (128 | ) | — |   |
|                                                 |       |                                  |       |                                |       |   |   |   |   |
| Foreign currency translation adjustment              |       | (47                                   | )          | (9                                  | )          | 207 |   | (88 | ) |
| Comprehensive loss                                   |       | $                                     | (2,027     | )                                   | $          | (4,937 | ) | $ | (2,729 | ) | $ | (7,321 | ) |

 

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

 

6

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**IMAGEWARE SYSTEMS, INC.**

 

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE 1.  DESCRIPTION OFBUSINESS AND OPERATIONS**

 

ImageWareSystems, Inc. (the “Company”), formerly known as ImageWareSoftware, Inc., was incorporated in the State of California onFebruary 6, 1987. The Company utilizes digital imaging technology toprovide stand alone, networked and web-based software solutions for securecredentials, biometrics, law enforcement and professional photography.

 

ImageWare’s ID solutionsempower customers to create secure and smart digital identification documentswith complete ID systems. We develop, sell and support software and designsystems which utilize digital imaging in the production of photo identificationcards and credentials and identification systems. Our sales in the digitalidentification market were initially developed through our acquisitions of ITC,Goddard and G & A (discussed below). Our products in this marketconsist of IWS EPI Suite, IWS EPI Builder (SDK), Identifier for Windows, IDCard Maker, and IWS Aviation. 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 with theaddition of our new IWS Biometric Engine to our product line.

 

ImageWare’s biometricproduct is a core software component of an organizations’ securityinfrastructure and includes a multi-biometric identity management solution forenrolling, managing and identifying people by the physical characteristics ofthe human body. We develop, sell and support various identity managementcapabilities within government, law enforcement, corporate organizations andeven entertainment for identification and verification purposes. Our IWSBiometric Engine is a biometric identity management platform formulti-biometric enrollment, management and authentication, managing populationdatabases of unlimited sizes. It’s also offered as a Software Development Kitbased search engine, enabling developers and system integrators to implement abiometric solution or integrate biometric capabilities into existingapplications without having to derive biometric functionality from pre-existingapplications. IWS Biometric Engine combined with our secure credentialplatform, IWS EPI Builder, provides a comprehensive, integrated biometric andsecure credential solution that can be leveraged for high-end applications suchas passports, driver licenses, national IDs, and other secure documents. It canalso be utilized within our law enforcement systems to incorporate any numberof various multiple biometrics into one system, as well as within our digitalimaging products to enable the entertainment industry to help increase photosales.

 

ImageWare’s law enforcementsolutions enable agencies to quickly capture, archive, search, retrieve, andshare digital images and criminal history records on a stand alone, networked,wireless or web-based platform. We develop, sell and support a suite of modularsoftware products used by law enforcement and public safety agencies to createand manage criminal history records and to investigate crime. Our IWS LawEnforcement solution consists of seven software modules: A Capture andInvestigative Module, which provide a criminal booking system and relateddatabase; A Facial Recognition module, which uses biometric facial recognitionto identify suspects; and Suspect ID, which facilitates the creation offull-color, photo-realistic suspect composites. In addition, we offer a Wireless module, which provides access tocentrally stored records over the Internet in a connected or wireless fashion,a PDA add-on module which enables access to centrally stored records while inthe field on a handheld Pocket PC compatible device, and central repositoryservices which allows for inter-agency data sharing on a local, regional,and/or national level.  We recently addeda new Livescan module which incorporates Livescan capabilities into IWS LawEnforcement, providing integrated fingerprint and palmprint biometricmanagement for civil and law enforcement use.

 

ImageWare’sDigital Imaging product line consists of a suite of software for theprofessional photography market. The software provides professionalphotographers with a complete workflow solution

 

7

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whichenables them to digitally capture and manipulate images, create a custompackage or layout and store the images with an associated database. They canthen print the digital images themselves or send them via the Internet or CD toa professional lab for processing. Our products include IWS PC Pro, IWS PCEvent, IWS School Days+, IWS Studio and IWS GreenScreen. Our customers use thesoftware products in a wide variety of ways including retail studioenvironments, on-location event photography and “picture day” at schools andday care centers. Our software products are sold through a dealer network anddirectly to major accounts. We also operate an e-commerce service, IWS Picturemore.com,used by professional photographers, labs and mini-labs to allow their customersto order re-prints and various specialty items. Our sales in the digitalphotography market were initially developed as a result of our acquisition ofCastleworks and E-Focus West in August, 2001.

 

*Liquidity and Capital Resources*

 

As reflected in theaccompanying condensed consolidated financial statements, the Company haslosses and negative cash flows from operations. The condensed consolidated financial statements included in this reporthave been prepared assuming that the Company will continue as a going concern.

 

Asmore fully described in Note 7 to these condensed consolidated financialstatements, in July 2005, the Company completed a private placement of itscommon stock.  The Company received netproceeds of approximately $3.3 million, however, additional financing may berequired to fund working capital and operations should the Company be unable togenerate positive cash flow from operations in the near future. The Company mayconsider the possible sale of equity securities and/or debt financing, and believesthat additional financing, if required, will be available under terms andconditions that are acceptable to the Company. However, there can be no assurancethat additional financing will be available. In the event financing is notavailable in the time frame required, the Company will be forced to reduce itsrate of growth, if any, reduce operating expenses, curtail sales and marketingactivities and reschedule research and development projects. In addition, theCompany might be required to sell certain of its assets or license itstechnologies to others. These actions, while necessary for the continuance ofoperations during a time of cash constraints and a shortage of working capital,could adversely affect the Company’s business.

 

In view of the mattersdescribed in the preceding paragraph, recoverability of a major portion of therecorded asset amounts shown in the accompanying condensed consolidated balancesheet is dependent upon continued operations of the Company, which, in turn, isdependent upon the Company’s ability to continue to raise capital and generatepositive cash flows from operations.  Thecondensed consolidated financial statements do not include any adjustmentsrelating to the recoverability and classification of recorded asset amounts oramounts and classifications of liabilities that might be necessary should theCompany be unable to continue its existence.

 

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

 

*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 Securities andExchange Commission (“SEC”) regarding interim financial reporting. Accordingly,they do not include all of the information and footnotes required by generallyaccepted accounting principles for annual financial statements and should beread in

 

8

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conjunctionwith the consolidated financial statements for the year ended December 31,2004, and notes thereto included in the Company’s Annual Report on Form 10-KSB,filed with the SEC on March 31, 2005. In the opinion of management, theaccompanying condensed consolidated financial statements contain alladjustments, consisting only of adjustments of a normal recurring nature,necessary for a fair presentation of the Company’s financial position as ofJune 30, 2005, 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.

 

Asmore fully explained in Note 5 to these condensed consolidated financialstatements, prior period financial statements for the three and six monthsended June 30, 2004, have been restated to present the operations of theCompany’s wholly-owned subsidiary, Digital Imaging Asia Pacific as a discontinuedoperation due to this subsidiary’s sale in March 2005.

* *

*Stock-Based Compensation*

 

Stock-basedcompensation to employees has been recognized as the difference between the pershare fair value of the underlying stock and the stock option exercise price atthe initial grant date.  The cost ofstock options granted for services, other than those issued to employees, arerecorded at the fair value of the stock option.

 

Hadcompensation cost for the Company’s stock option plan been determined based on thefair value at the grant date for awards consistent with the provisions ofStatement of Financial Accounting Standards. (“SFAS”) No. 123, Accounting forStock-Based Compensation, the Company’s net losses would have been increased tothe pro forma amount indicated below for the three and six months endedJune 30, 2005 and 2004:

 
| ** **                                                       | ** ** | **THREE MONTHS ENDED  JUNE 30,** | ** ** | **SIX MONTHS ENDED  JUNE 30,** | ** ** |
|------------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                                       | ** ** | **2005**                              | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                             |       |                                  |       |                                |       |   |   |   |   |
| Net Loss:                                                        |       |                                  |       |                                |       |   |   |   |   |
| As reported                                                      |       | $                                     | (1,904     | )                                   | $          | (4,928 | ) | $ | (2,808 | ) | $ | (7,233 | ) |
| Stock-based compensation included in net  loss                   |       | 70                                    |       | 82                                  |       | 140 |   | 82 |   |
| Stock based employee compensation under  fair value based method |       | (153                                  | )          | (164                                | )          | (284 | ) | (246 | ) |
| Pro forma net loss                                               |       | $                                     | (1,987     | )                                   | $          | (5,010 | ) | $ | (2,952 | ) | $ | (7,397 | ) |
|                                                             |       |                                  |       |                                |       |   |   |   |   |
| Basic loss per common share:                                     |       |                                  |       |                                |       |   |   |   |   |
| As reported                                                      |       | $                                     | (0.16      | )                                   | $          | (0.42 | ) | $ | (0.23 | ) | $ | (0.63 | ) |
| Pro forma                                                        |       | $                                     | (0.17      | )                                   | $          | (0.42 | ) | $ | (0.25 | ) | $ | (0.64 | ) |

 

OnMarch 30, 2004, the Company entered into a stock option exchange agreementwith certain employees whereby the employees would receive 255,792 shares ofrestricted stock in exchange for 426,321 options previously granted undervarious stock option plans.  Under theterms of the agreement, the employees will receive three shares of restrictedstock for each five options exchanged. The restricted stock will vest over three years on a quarterly basis andwill fully vest upon either a change in control, the sale of the Company, ortermination of employment unless such termination is for cause.

 

Inaccordance with Financial Accounting Standards Board Interpretation No. 44 —Accounting for Certain Transactions Involving Stock Compensation (“FIN 44”),the Company will recognize stock-based compensation expense ratably over thevesting period of the restricted stock. Such compensation expense was $70,000 and $140,000 for the three and sixmonths ended June 30, 2005, respectively, and $82,000 for the three andsix months ended June 30, 2004.

 

*RecentlyIssued Accounting Standards*

 

In November 2004, theFinancial Accounting Standards Board issued Statement of Financial AccountingStandards No. 151, “Inventory Costs, an amendment of ARB No. 43, Chapter 4” (“SFAS151”), which is effective beginning January 1, 2006.  SFAS 151 requires that abnormal amounts ofidle

 

9

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facilityexpense, freight, handling costs and wasted material be recognized as currentperiod charges.  The Statement alsorequires that the allocation of fixed production overhead be based on thenormal capacity of the production facilities. The effect of this Statement on the Company’s financial position orresults of operations has not yet been determined.

 

In December 2004, theFinancial Accounting Standards Board issued Statement of Financial AccountingStandards No. 123R, “Share-Based Payment (“SFAS 123R”), which is effectivebeginning July 1, 2005.  On April 15,2005, the Securities and Exchange Commission announced that companies mayimplement SFAS No 123R at the beginning of their next fiscal year begins afterJune 15, 2005.  The Company expects toadopt the revised rules on January 1, 2006. SFAS 123R requires all share-based payments to employees to be expensedover the requisite service period based on the grant-date fair value of theawards.  The Statement allows for eitherprospective or retrospective adoption and requires that the unvested portion ofall outstanding awards upon adoption be recognized using the same fair valueand attribution methodologies previously determined under Statement No 123, “Accountingfor Stock-Based Compensation.”  TheCompany is currently evaluating transition alternatives and valuationmethodologies for future grants.  As aresult, pro forma compensation expense, as reflected in Note 1, may not beindicative of future expense to be recognized under SFAS 123R.  The effect of adoption of 123R on the Company’sfinancial position or results of operations has not yet been determined.

 

In December 2004, theFinancial Accounting Standards Board issued Statement of Financial AccountingStandards No. 153, “Exchange of Nonmonetary Assets, an amendment of APR OpinionNo. 29” (“SFAS 153”).  The guidance inAPB Opinion No. 29, “Accounting for Nonmonetary Transactions” is based on theprinciple that exchanges of nonmonetary assets should be measured based on thefair value of the assets exchanged.  Theguidance in that Opinion, however, included certain exceptions to thatprinciple.  SFAS 153 amends Opinion 29 toeliminate the exception for nonmonetary assets that do not have commercialsubstance.  A nonmonetary exchange hascommercial substance if the future cash flows of the entity are expected tochange significantly as a result of the exchange.  The provisions of SFAS 153 shall be effectivefor nonmonetary asset exchanges occurring in fiscal periods beginning afterJune 15, 2005.  The effect of thisStatement on the Company’s financial position or results of operations has notyet been determined.

 

InApril 2005, the FASB issued Interpretation No. 47, “Accounting for ConditionalAsset Retirement Obligations”, which clarifies that an entity is required torecognize a liability for the fair value of a conditional asset retirementobligation when incurred if the liability’s fair value can be reasonablyestimated. The fair value of a liability for the conditional asset retirementobligation should be recognized when incurred, which is generally uponacquisition, construction, or development and (or) through the normal operationof the asset. Uncertainty about the timing and (or) method of settlement of aconditional asset retirement obligation should be factored into the measurementof the liability when sufficient information exists.  Interpretation No. 47 is effective no laterthan the end of fiscal years beginning after December 15, 2005. We are currentlyevaluating the effect of this pronouncement.

 

InJune 2005, the Financial Accounting Standards Board issued Statement ofFinancial Accounting Standards No. 154, “Accounting Changes and ErrorCorrections – a replacement of APB Opinion No. 20 and FASB Statement No. 3”(SFAS154).  This Statement replaces APBOpinion No. 20, “Accounting Changes,” and FASB Statement No. 3, “ReportingAccounting Changes in Interim Financial Statements,” and changes therequirements for the accounting for and reporting of a change in accountingprinciple.  This Statement requiresretrospective application to financial statements of prior periods for changesin accounting principle. This Statement is effective January 1, 2006.  This standard has no impact on the Company’sfinancial statements.

 

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

 

10

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**NOTE 2.  NET LOSS PERCOMMON 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, 2005 and 2004,the Company has excluded the following securities from the calculation ofdiluted loss per share, as their effect would have been antidilutive due to theCompany’s net loss:

 
| **Potential  Dilutive Securities:** | ** ** | **Number of  Common Shares  Convertible into at  June 30, 2005** | ** ** | **Number of  Common Shares  Convertible into at  June 30, 2004** | ** ** |
|-------------------------------------|------------|-----------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
|                                |       |                                                                  |       |                                                                  |       |
| Convertible preferred stock         |       | 47,280                                                                |       | 62,049                                                                |       |
| Stock options                       |       | 535,029                                                               |       | 484,197                                                               |       |
| Warrants                            |       | 3,843,813                                                             |       | 6,305,927                                                             |       |

 

Thefollowing table sets forth the computation of basic and diluted loss per sharefor the three and six month periods ended June 30, 2005 and 2004 (amountsin thousands except share and per share amounts):

 
| ** **                                                            | ** ** | **THREE MONTHS ENDED  JUNE 30,** | ** ** | **SIX MONTHS ENDED  JUNE 30,** | ** ** |
|-----------------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                                            | ** ** | **2005**                              | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| Numerator – loss from continuing  operations:                    |       |                                  |       |                                |       |   |   |   |   |
| Net loss from continuing operations                                   |       | $                                     | (1,904     | )                                   | $          | (4,918 | ) | $ | (3,031 | ) | $ | (7,213 | ) |
| Less Series B preferred dividends                                     |       | (13                                   | )          | (13                                 | )          | (26 | ) | (26 | ) |
| Net loss from continuing operations  available to common shareholders |       | $                                     | (1,917     | )                                   | $          | (4,931 | ) | $ | (3,057 | ) | $ | (7,239 | ) |
|                                                                  |       |                                  |       |                                |       |   |   |   |   |
| Numerator – gain (loss) from discontinued  operations:           |       |                                  |       |                                |       |   |   |   |   |
| Net gain (loss) discontinued operations                               |       | —                                |       | (10                                 | )          | 223 |   | (20 | ) |
|                                                                  |       |                                  |       |                                |       |   |   |   |   |
| Denominator                                                           |       |                                  |       |                                |       |   |   |   |   |
| Weighted-average shares outstanding                                   |       | 12,109,723                            |       | 11,825,414                          |       | 12,071,861 |   | 11,517,716 |   |
|                                                                  |       |                                  |       |                                |       |   |   |   |   |
| Basic and diluted loss per share:                                     |       |                                  |       |                                |       |   |   |   |   |
| Loss from continuing operations                                       |       | $                                     | (0.16      | )                                   | $          | (0.42 | ) | $ | (0.25 | ) | $ | (0.63 | ) |
| Discontinued operations                                               |       | —                                |       | —                              |       | 0.02 |   | — |   |
| Net loss per share                                                    |       | $                                     | (0.16      | )                                   | $          | (0.42 | ) | $ | (0.23 | ) | $ | (0.63 | ) |

 

**NOTE 3.  SEGMENTINFORMATION**

 

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

 

Corporateassets are comprised primarily of cash and other assets providing benefits toall business segments.

 

11

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Thereare no significant intersegment transactions.

 

Thetable below summarizes information about reportable segments for the three andsix months ended June 30, 2005 and 2004:

 
| ** **                   | ** ** | **THREE MONTHS ENDED  JUNE 30,** | ** ** | **SIX MONTHS ENDED  JUNE 30,** | ** ** |
|------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                   | ** ** | **2005**                              | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                   | ** ** | **(in thousands)  (unaudited)**       | ** ** | **(in thousands)  (unuadited)**     | ** ** |
| Net Revenue:                 | * *   | * *                              | * *   | * *                            | * *   | * * | * * | * * | * * |
| Law Enforcement              |       | $                                     | 744        |                                | $          | 1,364 |   | $ | 1,608 |   | $ | 2,578 |   |
| Identification               |       | 1,170                                 |       | 1,032                               |       | 3,021 |   | 1,923 |   |
| Digital Photography          |       | 61                                    |       | 147                                 |       | 156 |   | 300 |   |
| Total consolidated net sales |       | $                                     | 1,975      |                                | $          | 2,543 |   | $ | 4,785 |   | $ | 4,801 |   |
|                         |       |                                  |       |                                |       |   |   |   |   |
| Operating income (loss):     |       |                                  |       |                                |       |   |   |   |   |
| Law Enforcement              |       | $                                     | (831       | )                                   | $          | 247 |   | $ | (1,575 | ) | $ | 409 |   |
| Identification               |       | (888                                  | )          | (1,013                              | )          | (1,128 | ) | (1,972 | ) |
| Digital Photography          |       | (195                                  | )          | (263                                | )          | (388 | ) | (490 | ) |
|                         |       |                                  |       |                                |       |   |   |   |   |
| Other unallocated amounts:   |       |                                  |       |                                |       |   |   |   |   |
| Interest expense (income)    |       | (5                                    | )          | 3,898                               |       | (11 | ) | 5,189 |   |
| Other expense (income)       |       | (5                                    | )          | (9                                  | )          | (49 | ) | (29 | ) |
|                         |       |                                  |       |                                |       |   |   |   |   |
| Income (loss) before taxes   |       | $                                     | (1,904     | )                                   | $          | (4,918 | ) | $ | (3,031 | ) | $ | (7,213 | ) |

 
| ** **                           | ** ** | **June 30,  2005** | ** ** |
|--------------------------------------|------------|-------------------------|------------|
| ** **                           | ** ** | **(in thousands)**      | ** ** |
| Total Assets by Segment:             |       |                    |       |
|                                 |       |                    |       |
| Law Enforcement                      |       | $                       | 680        |   |
| Identification                       |       | 6,587                   |       |
| Digital Photography                  |       | 1,311                   |       |
| Total assets for reportable segments |       | 8,578                   |       |
| Corporate                            |       | 673                     |       |
| Total consolidated assets            |       | $                       | 9,251      |   |

 

**NOTE4.  INVESTMENTS**

 

In conjunction with the saleof the Company’s wholly-owned subsidiary, as more fully described in Note 5 tothese condensed consolidated financial statements, the Company and ArgusSolutions Ltd, each agreed to purchase $250,000 of each others common stock ata per share price equal to 108% of the closing price of each others’ stock asdetermined by the American Stock Exchange and Australian Stock Exchange,respectively.  As legal consideration,each Company paid the other cash of $250,000. The Company and Argus consummated the transaction through the exchangeof common shares.  The Company exchanged71,225 shares of its common stock for 1,929,914 shares of common stock of ArgusSolutions Ltd., which represents approximately one percent of the voting equityof Argus.    In accordance with Statementof Financial Accounting Standards No. 153, “Exchange of Nonmonetary Assets, anamendment of APB Opinion No. 29” (“SFAS 153), the Company has recorded thistransaction as a nonmonetary exchange based on the fair value of the sharesexchanged as determined by the closing price of the Company’s shares on theAmerican Stock Exchange on the transaction date of $3.25 or $231,000.

 

In accordance with Statementof Financial Accounting Standards (“SFAS”) No. 115 “Accounting for CertainInvestments in Debt and Equity Securities” and based on our intentionsregarding these instruments, we classify marketable equity securities intotrading or available-for-sale categories. Marketable securities that are bought and held principally for the purposeof selling them in the near term

 

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areclassified as trading securities and are reported at fair value, withunrealized gains and losses recognized in earnings.  Marketable securities not classified astrading are classified as available-for-sale and are carried at fair marketvalue, with the unrealized gains and losses, net of tax, included in thedetermination of comprehensive income and reported in shareholders’equity.  Marketable equity securities areincluded in other non-current assets.  AtJune 30, 2005, the Company had classified $103,000 as available-for-salemarketable securities.  These securitiesare reported at fair value as determined through quoted market sources.  Unrealized gain or loss on these investmentsis recorded as a component of accumulated other comprehensive income, net oftax and amounted to a loss of $128,000 and $0 at June 30, 2005 and 2004,respectively.

 

**NOTE5.  SALE OF SUBSIDIARY**

 

On March 3, 2005, theCompany sold its wholly-owned Singapore subsidiary, Digital Imaging AsiaPacific Pte. Ltd., for cash of $1,300,000. The Company decided to sell this subsidiary as part of its overallstrategic partnership with Argus Solutions Ltd (“Argus”), as a means ofstrengthening its position in the Asia-Pacific region.  In conjunction with this strategy, theCompany entered into an International Distributor Agreement with Argus pursuantto which Argus will distribute the Company’s biometric engine, law enforcementand secure credential solutions in the Asia-Pacific region, excluding Japan andKorea, for a period of three years. Argus will pay the Company a minimum license fee during the first threeyears of $1,400,000; $200,000 in year one; $400,000 in year two and $800,000 inyear three.  In accordance with theprovisions of Statement of Position 97-2, Software Revenue Recognition (“SOP97-2”) regarding fee determination and collectibility criteria, we recognizedrevenues of $17,000 and $67,000 for the three and six month periods ended June30, 2005, respectively and recorded deferred revenues of $33,000 as of June 30,2005 related to this minimum license fee.

 

Inaccordance with SFAS 144, this subsidiary, previously included in the Company’sIdentification segment, is treated as a discontinued operation.  The net loss for this subsidiary for thethree and six months ended June 30, 2005 and 2004 are reflected in the Company’scondensed Consolidated Statement of Operations as loss from discontinuedoperations.  Included in the 2005 lossresults is a gain on sale of subsidiary of $233,000 net of direct transactioncosts of $49,000 and including the allocation of $637,000 of goodwill.

 

Theassets and liabilities sold as part of the transaction included the following:

 
| Cash                                            |   | $       | 41,000    |   |
|-------------------------------------------------|--------|---------|-----------|--------|
| Accounts receivable                             |   | 80,000  |      |
| Inventories                                     |   | 242,000 |      |
| Prepaid expenses and other current assets       |   | 18,000  |      |
| Property and equipment, net                     |   | 17,000  |      |
| Goodwill                                        |   | 637,000 |      |
|                                            |   | $       | 1,035,000 |   |
|                                            |   |    |      |
| Accounts payable and other current  liabilities |   | $       | 17,000    |   |

 

DigitalImaging Asia Pacific’s sales, reported in discontinued operations, for thethree months ended June 30, 2005 and 2004 were $0 and $137,000,respectively.  Digital Imaging AsiaPacific’s sales for the six months ended June 30, 2005 and 2004 were $42,000and 241,000, respectively.  DigitalImaging Asia Pacific’s pretax loss, reported in discontinued operations, forthe three months ended June 30, 2005 and 2004, were $0 and $10,000respectively.   Digital Imaging AsiaPacific’s pretax loss, reported in discontinued operations for the six monthsended June 30, 2005 and 2004, were $10,000 and $20,000 respectively.   Prior period financial statements for thethree and six months ended June 30, 2004 have been restated to present theoperations of Digital Imaging Asia Pacific as a discontinued operation.

 

**NOTE6.  RELATED PARTIES**

 

Subsequent to the Company’ssale of its wholly-owned subsidiary, Digital Imaging Asia Pacific Pte. Ltd., toArgus Solutions Ltd (“Argus’), as more fully described in Note 5 to thesecondensed consolidated financial statements, the Company’s Chief ExecutiveOfficer accepted an invitation to become a member of Argus’ Board ofDirectors.  Prior to the closing of theCompany’s sale transaction with Argus, the Company had no material relationshipwith Argus Solutions.

 

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**NOTE7.  SUBSEQUENT EVENTS**

 

Subsequentto June 30, 2005, the Company completed a Securities Purchase Agreement for thesale of 1,397,287 units to 18 accredited investors, each unit consisting of oneshare of common stock and a warrant to purchase 0.38 shares of commonstock.  The purchasers paid $2.58 perunit.  The warrants have a five-year termand exercise price of $3.45 per share. At closing, the Company issued an aggregate 1,397,287 new shares of commonstock plus warrants to purchase up to 530,998 shares of common stock.  In connection with these transactions, we arerequired to issue to the finders warrants to purchase an additional 104,796shares of common stock and pay a finder’s fee of approximately $281,000 incash.  The fair value of the warrantsissued to the finders was approximately $170,000 as determined by theBlack-Sholes option pricing model.

 

Weraised approximately $3.6 million from this private placement, and afterpayment of expenses, received net proceeds of approximately $3.3 million.

 

Subsequentto June 30, 2005, the Company issued 36,192 shares of common stock to certainindividuals pursuant to the stock option exchange agreement more fullyexplained in Note 1 to these condensed consolidated financial statements.

 

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**ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION.**

 

ThisQuarterly Report on Form 10-QSB contains forward-looking statements within themeaning of Section 27A of the Securities Act of 1933, and Section 21Eof the Securities Exchange Act of 1934. All forward-looking statements includedin this report are based on information available to us as of the date hereofand we assume no obligation to update any forward-looking statements.Forward-looking statements involve known or unknown risks, uncertainties andother factors, which may cause our actual results, performance or achievements,or industry results to be materially different from any future results, performanceor achievements expressed or implied by such forward-looking statements.Factors that could cause or contribute to such differences include but are notlimited to those items discussed under “Risk Factors” beginning on page 24 andelsewhere 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.

 

**OVERVIEW**

** **

ImageWare Systems, Inc. utilizes its imaging technology to developsoftware used to create booking and invest igative software, smart and secureidentification systems and documents, and software for professionalphotographers. Our software systems and associated hardware enable ourcustomers to quickly capture, archive, search, retrieve and share digitalphotographs and associated text records. The following management’s discussion and analysis is based upon our LawEnforcement, Identification and Digital Photography segments.  Results as presented for our Identificationsegment do not contain the results of our wholly-owned subsidiary, DigitalImaging Asia Pacific, due to this component of our Identification segment beingclassified as discontinued operations due to the sale of this subsidiary duringthe first fiscal quarter of 2005.

 

**RESULTS OF OPERATIONS**

 

***THREE MONTHS ENDED JUNE 30, 2005 AND2004.***

 
| ** **                              | ** ** | **THREE MONTHS  ENDED  JUNE 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|-----------------------------------------|------------|----------------------------------------|------------|------------|------------|-------------------|------------|
| **Net  Product Revenues**               | ** ** | **2005**                               | ** ** | **2004**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**              | ** ** | ** **                             | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                    |       |                                   |       |       |       |              |       |   |   |
| **Product revenues:**                   |       |                                   |       |       |       |              |       |   |   |
| Law Enforcement                         |       | $                                      | 243        |       | $          | 913               |       | $ | (670 | ) | (73 | )% |
| Percentage of total net product revenue |       | 17                                     | %          | 44         | %          |              |       |   |   |
| Identification                          |       | $                                      | 1,156      |       | $          | 1,026             |       | $ | 130 |   | 13 | % |
| Percentage of total net product revenue |       | 80                                     | %          | 49         | %          |              |       |   |   |
| Digital Photography                     |       | $                                      | 49         |       | $          | 146               |       | $ | (97 | ) | (66 | )% |
| Percentage of total net product revenue |       | 3                                      | %          | 7          | %          |              |       |   |   |
| Total net product revenues              |       | $                                      | 1,448      |       | $          | 2,085             |       | $ | (637 | ) | (31 | )% |

 

Webelieve that the decrease in Law Enforcement product revenues is reflective ofa decrease in state and local government procurement.  We further believe that continued incidentsof terrorism has created heightened interest in the ability of law enforcementand other government agencies to be able to efficiently retrieve, analyze andshare information from their respective criminal databases.  We anticipate that these factors willincrease the overall demand for our law enforcement products and software;however, we cannot predict the timing of the shift in demand.

 

Domestically,Identification revenues increased approximately $159,000 or 22% for the threemonths ended June 30, 2005 as compared to the corresponding period in2004.  This increase in domestic revenueis reflective of an increase in project-oriented work.  Internationally, our Identification revenuesdecreased approximately $29,000.  Wecontinue to be of the opinion that government agencies and private entitieswill react to heightened security concerns resulting from acts of terrorism byre-evaluating and

 

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upgradingtheir ability to positively identify and track their citizens, employees,consultants and visitors. We anticipate that these factors will increaseoverall demand for our identification products; however, we cannot predict thetiming of the shift in demand.

 

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

 

Thedecrease in Digital Photography product revenues is due to both lower customcontract programming and lower sales of boxed software during the three monthsended June 30, 2005 as compared to the comparable period of 2004.  We believe this decrease is due to ourcustomers delaying purchasing decisions until the next version of our DigitalPhotography software is released.  TheCompany has devoted substantial research and development resources to upgradingthe Digital Photography software boxed products and remains optimistic that therelease of these enhanced products during the third fiscal quarter of 2005 willpositively impact Digital Photography product revenues.

 

Ourbacklog of product orders as of June 30, 2005 was approximately$838,000.  At June 30, 2005, we alsohad maintenance and support backlog of approximately $636,000 under existingmaintenance agreements.  Product revenueis typically recognized within a three to six month time period depending uponthe required degree of customization, if any. Historically, we have experienced a very minimal risk of ordercancellation.  Our revenue frommaintenance agreements is generally recognized ratably over the respectivemaintenance periods provided no significant obligations remain andcollectibility of the related receivable is probable.

 
| ** **                                  | ** ** | **THREE MONTHS  ENDED  JUNE 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|---------------------------------------------|------------|----------------------------------------|------------|------------|------------|-------------------|------------|
| **Maintenance  Revenues**                   | ** ** | **2005**                               | ** ** | **2004**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**                  | ** ** | ** **                             | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                        |       |                                   |       |       |       |              |       |   |   |
| **Maintenance revenues:**                   |       |                                   |       |       |       |              |       |   |   |
| Law Enforcement                             |       | $                                      | 501        |       | $          | 451               |       | $ | 50 |   | 11 | % |
| Percentage of total net maintenance revenue |       | 95                                     | %          | 98         | %          |              |       |   |   |
| Identification                              |       | $                                      | 14         |       | $          | 6                 |       | $ | 8 |   | 125 | % |
| Percentage of total net maintenance revenue |       | 3                                      | %          | 2          | %          |              |       |   |   |
| Digital Photography                         |       | $                                      | 12         |       | $          | 1                 |       | $ | 11 |   | 1183 | % |
| Percentage of total net maintenance revenue |       | 2                                      | %          | 0          | %          |              |       |   |   |
| Total net maintenance revenues              |       | $                                      | 527        |       | $          | 458               |       | $ | 69 |   | 15 | % |

 

Theincrease in Law Enforcement maintenance revenues is due to the expansion of ourinstalled base in the Law Enforcement market.

 

Theincrease in Identification maintenance revenues is due to software maintenanceon domestic identification projects.  Weshifted our strategy in late 2003 to outsource international service andmaintenance for hardware.  This shift hasenabled us to reduce costs and focus our resources on expanding ourinternational sales effort of Digital Identification, Biometric, LawEnforcement and Digital Photography solutions.

 

Ourincrease in Digital Photography maintenance revenues as compared to the correspondingperiod in 2004 is reflective of software maintenance on custom contractprogramming projects completed subsequent to the second quarter of 2004.

 

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| ** **                                         | ** ** | **THREE MONTHS  ENDED  JUNE 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|----------------------------------------------------|------------|----------------------------------------|------------|------------|------------|-------------------|------------|
| **Cost  of Product Revenues:**                     | ** ** | **2005**                               | ** ** | **2004**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**                         | ** ** | ** **                             | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                               |       |                                   |       |       |       |              |       |   |   |
| **Cost of Product Revenues:**                      |       |                                   |       |       |       |              |       |   |   |
| Law Enforcement                                    |       | $                                      | 214        |       | $          | 158               |       | $ | 56 |   | 35 | % |
| Percentage of Law Enforcement product  revenue     |       | 88                                     | %          | 17         | %          |              |       |   |   |
| Identification                                     |       | $                                      | 395        |       | $          | 319               |       | $ | 76 |   | 24 | % |
| Percentage of Identification product  revenue      |       | 34                                     | %          | 31         | %          |              |       |   |   |
| Digital Photography                                |       | $                                      | 1          |       | $          | 17                |       | $ | (16 | ) | (94 | )% |
| Percentage of Digital Photography product  revenue |       | 2                                      | %          | 12         | %          |              |       |   |   |
| Total net product revenues                         |       | $                                      | 610        |       | $          | 494               |       | $ | 116 |   | 23 | % |
| Percentage of total product revenues               |       | 42                                     | %          | 24         | %          |              |       |   |   |

 

Overallcost of product revenues as a percentage of product revenues increasedprimarily due to higher sales of hardware and consumables (which have highercosts than software only solutions) resulting in higher costs of sales as apercentage of product revenues.

 

Theincrease in the cost of product revenues for our Law Enforcement segmentincreased as a percentage of product revenues due primarily to the smallerrevenue base to absorb fixed product costs and product mix with a higherpercentage of hardware and consumables sales for the three months ended June30, 2005 as compared to the corresponding period in 2004.  The 2004 period contained anuncharacteristically high percentage of software only solutions.  Costs of products can vary as a percentage ofproduct revenue from period to period depending upon product mix and thehardware content, print media consumable content and software content includedin systems installed during a given period.

 

Thedollar increase in the cost of product revenues related to our Identificationsegment is reflective of higher domestic Identification revenues.   The percentage increase in Identificationcost of revenues as a percentage of Identification revenues from 31% for thethree months ended June 30, 2004 to 34% for the corresponding period in2005 is reflective primarily of higher domestic identification revenues fromproject-oriented work which included costs for equipment, third-party softwarelicenses and contract programming fees for software customization than thecomparable three months ended June 30, 2004.  Costs of products can vary as a percentage ofproduct revenue from period to period depending upon product mix and thehardware content, print media consumable content and software content includedin systems installed during a given period.

 

Costof product revenues related to our Digital Photography segment decreased due tolower Digital Photography sales during the three months ended June 30, 2005 ascompared to the corresponding period in 2004 and to the sale of certainhardware components in the 2004 period as compared to software only salesduring the comparable period in 2005.

 
| ** **                                              | ** ** | **THREE MONTHS  ENDED  JUNE 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|---------------------------------------------------------|------------|----------------------------------------|------------|------------|------------|-------------------|------------|
| **Maintenance  cost of revenues**                       | ** ** | **2005**                               | ** ** | **2004**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
|                                                    |       |                                   |       |       |       |              |       |   |   |
| **Maintenance cost of revenues:**                       |       |                                   |       |       |       |              |       |   |   |
| Law Enforcement                                         |       | $                                      | 209        |       | $          | 189               |       | $ | 20 |   | 11 | % |
| Percentage of Law Enforcement  maintenance revenue |       | 42                                     | %          | 42         | %          |              |       |   |   |
| Identification                                          |       | $                                      | 18         |       | $          | 17                |       | $ | 1 |   | 6 | % |
| Percentage of Identification maintenance  revenue       |       | 129                                    | %          | 283        | %          |              |       |   |   |
| Digital Photography                                     |       | $                                      | —     |       | $          | —            |       | $ | — |   | N/A |   |
| Percentage of Digital Photography  maintenance revenue  |       | —                                 | %          | —     | %          | —            |       | N/A |   |
| Total net maintenance revenues                          |       | $                                      | 227        |       | $          | 206               |       | $ | 21 |   | 10 | % |
| Percentage of total maintenance revenues                |       | 43                                     | %          | 45         | %          |              |       |   |   |

 

Thedollar increase in costs of maintenance revenues is reflective of higher costsnecessary to service our expanding installed base.

 

17

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| ** **                                         | ** ** | **THREE MONTHS  ENDED  JUNE 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|----------------------------------------------------|------------|----------------------------------------|------------|------------|------------|-------------------|------------|
| **Product  gross profit (dollars in thousands)**   | ** ** | **2005**                               | ** ** | **2004**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
|                                               |       |                                   |       |       |       |              |       |   |   |
| **Product gross profit**                           |       |                                   |       |       |       |              |       |   |   |
| Law Enforcement                                    |       | $                                      | 30         |       | $          | 755               |       | $ | (725 | ) | (96 | )% |
| Percentage of Law Enforcement product  revenue     |       | 12                                     | %          | 83         | %          |              |       |   |   |
| Identification                                     |       | $                                      | 760        |       | $          | 707               |       | $ | 53 |   | 8 | % |
| Percentage of Identification product  revenue      |       | 66                                     | %          | 69         | %          |              |       |   |   |
| Digital Photography                                |       | $                                      | 48         |       | $          | 129               |       | $ | (81 | ) | (63 | )% |
| Percentage of Digital Photography product  revenue |       | 98                                     | %          | 88         | %          |              |       |   |   |
| Total net product revenues                         |       | $                                      | 838        |       | $          | 1,591             |       | $ | (753 | ) | (47 | )% |
| Percentage of total product revenues               |       | 58                                     | %          | 76         | %          |              |       |   |   |

 

Totalproduct gross profit as a percentage of product revenues decreased primarilydue to lower product sales and a higher percentage of total revenues comingfrom the sales of hardware and consumables which have higher costs thansoftware only solutions.

 

LawEnforcement gross profit as a percentage of Law Enforcement product revenuedecreased due primarily to our product mix containing higher percentages of hardware(which have higher costs than software only solutions than the comparableperiod in 2004 which had an uncharacteristically high percentage ofsoftware.  Also contributing to thisdecrease is a smaller revenue base available to absorb fixed productcosts.  Costs of products can vary as apercentage of product revenue from quarter to quarter depending upon productmix and hardware content and print media consumable content included in systemsinstalled during a given period.

 

Identificationgross profit as a percentage of Identification product revenue decreased dueprimarily to our product mix containing higher percentages of hardware andconsumables (which have higher costs than software only solutions) than thecomparable period in 2004.  Costs of productscan vary as a percentage of product revenue from quarter to quarter dependingupon product mix and hardware content and print media consumable contentincluded in systems installed during a given period.

 

Thedecrease of $81,000 in gross profit from the Digital Photography productsegment is reflective of our lower custom contract programming in the threemonths ended June 30, 2005, as compared to the corresponding period in2004, combined with lower sales of boxed software.  The increase in Digital Photography grossprofit as a percentage of Digital Photography product revenues is reflective ofthe sale of certain hardware components (which have higher costs than softwareonly solutions) during the 2004 period.

 
| ** **                                             | ** ** | **THREE MONTHS  ENDED  JUNE 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|--------------------------------------------------------|------------|----------------------------------------|------------|------------|------------|-------------------|------------|
| **Maintenance  gross profit**                          | ** ** | **2005**                               | ** ** | **2004**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars  in thousands)**                            | ** ** | ** **                             | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                                   |       |                                   |       |       |       |              |       |   |   |
| **Maintenance gross profit**                           |       |                                   |       |       |       |              |       |   |   |
| Law Enforcement                                        |       | $                                      | 292        |       | $          | 262               |       | $ | 30 |   | 11 | % |
| Percentage of Law Enforcement maintenance  revenue     |       | 58                                     | %          | 58         | %          |              |       |   |   |
| Identification                                         |       | $                                      | (4         | )          | $          | -11               |       | $ | 7 |   | 66 | % |
| Percentage of Identification maintenance  revenue      |       | (29                                    | )%         | -183       | %          |              |       |   |   |
| Digital Photography                                    |       | $                                      | 12         |       | $          | 1                 |       | $ | 11 |   | 100 | % |
| Percentage of Digital Photography  maintenance revenue |       | 100                                    | %          | 100        | %          |              |       |   |   |
| Total net maintenance revenues                         |       | $                                      | 300        |       | $          | 252               |       | $ | 48 |   | 19 | % |
| Percentage of total maintenance revenues               |       | 57                                     | %          | 55         | %          |              |       |   |   |

 

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

 

18

----

 
| ** **                      | ** ** | **THREE MONTHS ENDED  JUNE 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|---------------------------------|------------|---------------------------------------|------------|------------|------------|-------------------|------------|
| **Operating  expenses**         | ** ** | **2005**                              | ** ** | **2004**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**      | ** ** | ** **                            | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                            |       |                                  |       |       |       |              |       |   |   |
| General & administrative    |       | $                                     | 1,279      |       | $          | 1,116             |       | $ | 163 |   | 15 | % |
| Percentage of total net revenue |       | 65                                    | %          | 44         | %          |              |       |   |   |
| Sales and marketing             |       | $                                     | 823        |       | $          | 858               |       | $ | (35 | ) | (4 | )% |
| Percentage of total net revenue |       | 42                                    | %          | 34         | %          |              |       |   |   |
| Research & development      |       | $                                     | 796        |       | $          | 722               |       | $ | 74 |   | 10 | % |
| Percentage of total net revenue |       | 40                                    | %          | 28         | %          |              |       |   |   |
| Depreciation and amortization   |       | $                                     | 154        |       | $          | 176               |       | $ | (22 | ) | (13 | )% |
| Percentage of total net revenue |       | 8                                     | %          | 7          | %          |              |       |   |   |

 

*GENERAL AND ADMINISTRATIVE EXPENSES.* General and administrative expenses are comprised primarily of salariesand other employee-related costs for executive, financial, and otherinfrastructure personnel. General legal, accounting and consulting services,insurance, occupancy and communication costs are also included with general andadministrative expenses.  The increase insuch expenses, as a percentage of total net revenues, is reflective of lowertotal net revenues during the three months ended June 30, 2005 as comparedto the corresponding period in 2004.  Thedollar increase of $163,000 is due primarily to fees paid for consultingservices.  We are continuing to focus ourefforts on achieving additional future operating efficiencies by reviewing andimproving upon existing business processes and evaluating our cost structure.We believe these efforts will allow us to gradually decrease our level ofgeneral and administrative expenses expressed as a percentage of totalrevenues.

* *

*SALES AND MARKETING.*  Salesand marketing expenses consist primarily of the salaries, commissions, otherincentive compensation, employee benefits and travel expenses of our sales force.  The increase in such expenses, as apercentage of total net revenues, is reflective of lower total net revenuesduring the three months ended June 30, 2005 as compared to thecorresponding period in 2004.  The dollardecrease of $35,000 is due primarily to reduced headcount.  The headcount reduction reflects theretooling of our sales force and marketing personnel.  We anticipate that expenses for sales andmarketing will increase through 2004 as we add personnel and resources forlarge project solution sales.

* *

*RESEARCH AND DEVELOPMENT.* Research and development costs consist primarily of salaries, employeebenefits and outside contractors for new product development, productenhancements and custom integration work. Such expenses increased due primarilyto the continued development of our Biometric Engine, the web enablement of ourCCS product, and product enhancements to our Digital Photography softwareproduct suite utilizing contract programming services in conjunction withinternal research and development 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.* Depreciation and amortization decrease is due primarily to loweramortization of intangible assets due to such assets being fully amortized.

* *

*INTEREST (INCOME) EXPENSE, NET.*  Forthe three months ended June 30, 2005, we recognized interest income of$6,000 and interest expense of $1,000. For the three months ended June 30,2004, we recognized interest income of $3,000 and interest expense of $3,901,000.  Interest expense for the three months endedJune 30, 2004 contains approximately $3,607,000 of interest expenserelated to fair value accounting for our warrant liability due to theregistration rights agreement associated with the underlying shares of theCompany’s common stock to be issued upon conversion of the warrants.  During the three months ended June 30,2004, we registered the underlying shares of common stock with the Securitiesand Exchange Commission.  In accordancewith EITF 00-19, there will be no further interest expense or income incurredin conjunction with these warrants. Interest expense for the three months ended June 30, 2004 alsocontains $290,000 in liquidated damages, which were classified as interestexpense.  The liquidated damages wereincurred as the Company did not meet certain time requirements for theregistration of shares of the Company’s common stock under the registrationrights agreements for the November 2003 and January 2004 privateplacements.

 

19

----

 

***SIX MONTHS ENDED JUNE 30, 2005 AND2004.***

 
| ** **                              | ** ** | **SIX MONTHS  ENDED  JUNE 30,** | ** ** | ** ** | ** ** | ** ** | ** **       |
|-----------------------------------------|------------|--------------------------------------|------------|------------|------------|------------|------------------|
| **Net Product Revenues**                | ** ** | **2005**                             | ** ** | **2004**   | ** ** | **$**      | ** Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**              | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** **       | ** ** | ** ** |
|                                    |       |                                 |       |       |       |       |             |   |   |
| **Product  revenues:**                  |       |                                 |       |       |       |       |             |   |   |
| Law Enforcement                         |       | $                                    | 630        |       | $          | 1,694      |             | $ | (1,064 | ) | (63 | )% |
| Percentage of total net product revenue |       | 17                                   | %          | 43         | %          |       |             |   |   |
| Identification                          |       | $                                    | 3,002      |       | $          | 1,905      |             | $ | 1,097 |   | 58 | % |
| Percentage of total net product revenue |       | 80                                   | %          | 49         | %          |       |             |   |   |
| Digital Photography                     |       | $                                    | 131        |       | $          | 300        |             | $ | (169 | ) | (56 | )% |
| Percentage of total net product revenue |       | 3                                    | %          | 8          | %          |       |             |   |   |
| Total net product revenues              |       | $                                    | 3,763      |       | $          | 3,899      |             | $ | (136 | ) | (3 | )% |

 

Webelieve that the decrease in Law Enforcement product revenues is reflective ofa decrease in state and local government procurement.  We further believe that continued incidentsof terrorism has created heightened interest in the ability of law enforcementand other government agencies to be able to efficiently retrieve analyze andshare information from their respective criminal databases.  We anticipate that these factors willincrease the overall demand for our law enforcement products and software;however, we cannot predict the timing of the shift in demand.

 

Domestically,Identification revenues increased approximately $1,183,000, or 86%.  This increase in domestic Identificationproduct revenue is reflective of sales of our Biometric Engine andidentification software products into project-oriented work and an increase inboxed software and consumables sold through distribution channels.  In June of 2004, we terminated ourmaster distributor model because it did not produce the results we anticipatedand we re-established direct sales to our distribution channel.  Internationally, our Identification revenuesdecreased approximately $86,000, or 16%.  This decrease is reflective of the repositioning of our internationalsales office in Germany to lower fixed costs and this office’s pursuit ofsignificant Identification projects utilizing the Company’s softwaretechnologies as our primary differentiator. This office had historically emphasized the resale of third partymerchandise (hardware and consumables) which generated lower gross margins thansoftware (as a percentage of revenue) and required significant fixed costs forsales, service and support.  We feel thatthe foreign markets served by this office will embrace our identification andbiometric solutions for large-scale high-end installations.  We continue to be of the opinion thatgovernment agencies and private entities will react to heightened securityconcerns resulting from acts of terrorism by re-evaluating and upgrading theirability to positively identify and track their citizens, employees, consultantsand visitors. We anticipate that these factors will increase overall demand forour identification products; however, we cannot predict the timing of the shiftin demand.

 

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

 

DigitalPhotography product revenues decreased due to our customers delaying purchasingdecisions until the next version of our Digital Photography software isreleased.  We have devoted substantialresearch and development resources to upgrading the Digital Photographysoftware boxed products and remains optimistic that the release of theseenhanced products during the third fiscal quarter of 2005 will positivelyimpact Digital Photography product revenues.

 

20

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| ** **                                  | ** ** | **SIX MONTHS  ENDED  JUNE 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|---------------------------------------------|------------|--------------------------------------|------------|------------|------------|-------------------|------------|
| **Maintenance Revenues**                    | ** ** | **2005**                             | ** ** | **2004**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**                  | ** ** | ** **                           | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                        |       |                                 |       |       |       |              |       |   |   |
| **Maintenance  revenues:**                  |       |                                 |       |       |       |              |       |   |   |
| Law Enforcement                             |       | $                                    | 978        |       | $          | 883               |       | $ | 95 |   | 11 | % |
| Percentage of total net maintenance revenue |       | 96                                   | %          | 98         | %          |              |       |   |   |
| Identification                              |       | $                                    | 19         |       | $          | 18                |       | $ | 1 |   | 6 | % |
| Percentage of total net maintenance revenue |       | 2                                    | %          | 2          | %          |              |       |   |   |
| Digital Photography                         |       | $                                    | 25         |       | $          | 1                 |       | $ | 24 |   | N/A |   |
| Percentage of total net maintenance revenue |       | 2                                    | %          | 0          | %          |              |       |   |   |
| Total net maintenance revenues              |       | $                                    | 1,022      |       | $          | 902               |       | $ | 120 |   | 13 | % |

 

Lawenforcement maintenance revenues increased due to the expansion of ourinstalled base in the Law Enforcement market.

 

Identificationmaintenance revenues increased due to software maintenance on domesticidentification projects.  We shifted ourstrategy in late 2003 to outsource international service and maintenance forhardware.  This shift has enabled us toreduce costs and focus our resources on expanding our international saleseffort of Digital Identification, Biometric, Law Enforcement and DigitalPhotography solutions.

 

Ourincrease in Digital Photography maintenance revenues is reflective of softwaremaintenance on custom contract programming projects completed subsequent to thesecond quarter of 2004.

 
| ** **                                         | ** ** | **SIX MONTHS  ENDED  JUNE 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|----------------------------------------------------|------------|--------------------------------------|------------|------------|------------|-------------------|------------|
| **Cost of Product Revenues:**                      | ** ** | **2005**                             | ** ** | **2004**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**                         | ** ** | ** **                           | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                               |       |                                 |       |       |       |              |       |   |   |
| **Cost of  Product Revenues:**                     |       |                                 |       |       |       |              |       |   |   |
| Law Enforcement                                    |       | $                                    | 406        |       | $          | 341               |       | $ | 65 |   | 19 | % |
| Percentage of Law Enforcement product  revenue     |       | 64                                   | %          | 20         | %          |              |       |   |   |
| Identification                                     |       | $                                    | 1,045      |       | $          | 580               |       | $ | 465 |   | 80 | % |
| Percentage of Identification product  revenue      |       | 35                                   | %          | 30         | %          |              |       |   |   |
| Digital Photography                                |       | $                                    | 4          |       | $          | 33                |       | $ | (29 | ) | (88 | )% |
| Percentage of Digital Photography product  revenue |       | 3                                    | %          | 11         | %          |              |       |   |   |
| Total net product revenues                         |       | $                                    | 1,455      |       | $          | 954               |       | $ | 501 |   | 53 | % |
| Percentage of total product revenues               |       | 39                                   | %          | 24         | %          |              |       |   |   |

 

Totalcost of product revenues as a percentage of product revenues increased from dueprimarily to product mix with a greater percentage of product revenues beingfrom sales of hardware and consumables (which have higher costs than softwareonly solutions) resulting in higher cost of sales as a percentage of productrevenues.

 

Costof product revenues for our Law Enforcement segment increased as a percentageof product revenues due primarily to the smaller revenue base to absorb fixedproduct costs and product mix with a higher percentage of hardware sales.  The dollar increase of $65,000 for the sixmonth period ended June 30, 2005, as compared with the correspondingperiod of 2004, despite lower law enforcement revenues for the six month ended June 30,2005, is reflective of an uncharacteristically high percentage of software onlysolutions for the six months ended June 30, 2004.   Costs of products also can vary as apercentage of product revenue from period to period depending upon product mixand the hardware content, print media consumable content and software contentincluded in systems installed during a given period.

 

Costof product revenues related to our Identification segment increased because ofhigher 

 

21

----

 

domesticIdentification revenues.  The percentageincrease in Identification cost of revenues as a percentage of Identificationrevenues is reflective primarily of higher domestic Identification revenuesfrom project-oriented work which included costs for equipment, third-partysoftware licenses and contract programming fees for software customization thanthe comparable six months ended June 30, 2004.    Costs of products also can vary as a percentageof product revenue from period to period depending upon product mix and thehardware content, print media consumable content and software content includedin systems installed during a given period.

 

Costof product revenues related to our Digital Photography segment decreased due tolower Digital Photography sales during the six months ended June 30, 2005,as compared to the corresponding period in 2004 and to the sale of certainhardware components in the 2004 period as compared to software only salesduring the comparable period in 2005.

 
| ** **                                              | ** ** | **SIX MONTHS  ENDED  JUNE 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|---------------------------------------------------------|------------|--------------------------------------|------------|------------|------------|-------------------|------------|
| **Maintenance cost of revenues**                        | ** ** | **2005**                             | ** ** | **2004**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                                              | ** ** | ** **                           | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| **Maintenance  cost of revenues:**                      |       |                                 |       |       |       |              |       |   |   |
| Law Enforcement                                         |       | $                                    | 461        |       | $          | 385               |       | $ | 76 |   | 20 | % |
| Percentage of Law Enforcement  maintenance revenue |       | 47                                   | %          | 44         | %          |              |       |   |   |
| Identification                                          |       | $                                    | 34         |       | $          | 42                |       | $ | (8 | ) | (19 | )% |
| Percentage of Identification maintenance  revenue       |       | 179                                  | %          | 233        | %          |              |       |   |   |
| Digital Photography                                     |       | $                                    | —     |       | $          | —            |       | $ | — |   | N/A |   |
| Percentage of Digital Photography  maintenance revenue  |       | —                               | %          | —     | %          |              |       |   |   |
| Total net maintenance revenues                          |       | $                                    | 495        |       | $          | 427               |       | $ | 68 |   | 16 | % |
| Percentage of total maintenance revenues                |       | 48                                   | %          | 47         | %          |              |       |   |   |

 

Costof maintenance revenues in Law Enforcement increased because of higher costsnecessary to service our expanding installed base.

 
| ** **                                         | ** ** | **SIX MONTHS  ENDED  JUNE 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|----------------------------------------------------|------------|--------------------------------------|------------|------------|------------|-------------------|------------|
| **Product gross profit (dollars  in thousands)**   | ** ** | **2005**                             | ** ** | **2004**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| ** **                                         | ** ** | ** **                           | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| **Product  gross profit**                          |       |                                 |       |       |       |              |       |   |   |
| Law Enforcement                                    |       | $                                    | 224        |       | $          | 1,353             |       | $ | (1,129 | ) | (83 | )% |
| Percentage of Law Enforcement product  revenue     |       | 36                                   | %          | 80         | %          |              |       |   |   |
| Identification                                     |       | $                                    | 1,957      |       | $          | 1,325             |       | $ | 632 |   | 48 | % |
| Percentage of Identification product  revenue      |       | 65                                   | %          | 70         | %          |              |       |   |   |
| Digital Photography                                |       | $                                    | 127        |       | $          | 267               |       | $ | (140 | ) | (52 | )% |
| Percentage of Digital Photography product  revenue |       | 97                                   | %          | 89         | %          |              |       |   |   |
| Total net product revenues                         |       | $                                    | 2,308      |       | $          | 2,945             |       | $ | (637 | ) | (22 | )% |
| Percentage of total product revenues               |       | 61                                   | %          | 76         | %          |              |       |   |   |

 

Totalproduct gross profit as a percentage of product revenues decreased primarilydue to a higher percentage of total revenues coming from the sales of hardwareand consumables (which have higher costs than software only solutions)resulting in higher cost of sales as a percentage of product revenues.

 

LawEnforcement gross profit decreased due primarily to the smaller revenue base toabsorb fixed product costs and product mix with a higher percentage of hardwaresales.  The six month period ended June 30,2004 contained an uncharacteristically high percentage of software.  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.

 

22

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Identificationgross profit as a percentage of Identification product revenue increased dueprimarily to higher domestic Identification revenues from project-oriented workwhich included costs for equipment, third party software licenses and contractprogramming fess for software customization incurred in the six months ended June 30,2005, than the comparable six months ended June 30, 2004.

 

Grossmargins for the Digital Photography product segment decreased due to lowersales of Digital Photography software during the six month period ended June 30,2005 as compared to the comparable period in 2004.  The percentage increase from 89% of DigitalPhotography product revenues for the six months ended June 30, 2004 to 97%of Digital Photography product revenues for the six months ended June 30,2005 results from the sale of certain hardware components in the 2004 period ascompared to the corresponding period in 2005.

 
| ** **                                             | ** ** | **SIX MONTHS  ENDED  JUNE 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|--------------------------------------------------------|------------|--------------------------------------|------------|------------|------------|-------------------|------------|
| **Maintenance gross profit**                           | ** ** | **2005**                             | ** ** | **2004**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**                             | ** ** | ** **                           | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                                   |       |                                 |       |       |       |              |       |   |   |
| **Maintenance  gross profit**                          |       |                                 |       |       |       |              |       |   |   |
| Law Enforcement                                        |       | $                                    | 517        |       | $          | 498               |       | $ | 19 |   | 4 | % |
| Percentage of Law Enforcement maintenance  revenue     |       | 53                                   | %          | 56         | %          |              |       |   |   |
| Identification                                         |       | $                                    | (15        | )          | $          | -24               |       | $ | 9 |   | (30 | )% |
| Percentage of Identification maintenance  revenue      |       | (79                                  | )%         | -133       | %          |              |       |   |   |
| Digital Photography                                    |       | $                                    | 25         |       | $          | 1                 |       | $ | 24 |   | N/A |   |
| Percentage of Digital Photography  maintenance revenue |       | 100                                  | %          | 100        | %          |              |       |   |   |
| Total net maintenance revenues                         |       | $                                    | 527        |       | $          | 475               |       | $ | 52 |   | 11 | % |
| Percentage of total maintenance revenues               |       | 52                                   | %          | 53         | %          |              |       |   |   |

 

Grossprofit related to maintenance revenues due primarily to higher maintenancerevenues to absorb fixed maintenance costs.

 
| ** **                        | ** ** | **SIX MONTHS  ENDED  JUNE 30,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|-----------------------------------|------------|--------------------------------------|------------|------------|------------|-------------------|------------|
| **Operating expenses**            | ** ** | **2005**                             | ** ** | **2004**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**        | ** ** | ** **                           | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                              |       |                                 |       |       |       |              |       |   |   |
| General & administrative |       | $                                    | 2,362      |       | $          | 2,242             |       | $ | 120 |   | 5 | % |
| Percentage of total net revenue   |       | 49                                   | %          | 47         | %          |              |       |   |   |
| Sales and marketing               |       | $                                    | 1,764      |       | $          | 1,514             |       | $ | 250 |   | 17 | % |
| Percentage of total net revenue   |       | 37                                   | %          | 32         | %          |              |       |   |   |
| Research & development   |       | $                                    | 1,487      |       | $          | 1,355             |       | $ | 132 |   | 10 | % |
| Percentage of total net revenue   |       | 31                                   | %          | 28         | %          |              |       |   |   |
| Depreciation and amortization     |       | $                                    | 313        |       | $          | 362               |       | $ | (49 | ) | (14 | )% |
| Percentage of total net revenue   |       | 7                                    | %          | 8          | %          |              |       |   |   |

 

*GENERAL AND ADMINISTRATIVE EXPENSES.* General and administrative expenses are comprised primarily of salariesand other employee-related costs for executive, financial, and otherinfrastructure personnel. General legal, accounting and consulting services,insurance, occupancy and communication costs are also included with general andadministrative expenses. Such expenses increased due primarily to fees paid forconsulting services.  Such expenses, as apercentage of total net revenues, increased because of lower total net revenuesduring the six months ended June 30, 2005, as compared to thecorresponding period in 2004.  We arecontinuing to focus our efforts on achieving additional future operatingefficiencies by reviewing and improving upon existing business processes andevaluating our cost structure. We believe these efforts will allow us togradually decrease our level of general and administrative expenses expressedas a percentage of total revenues.

 

*SALES AND MARKETING.*  Salesand marketing expenses consist primarily of the salaries, 

 

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commissions,other incentive compensation, employee benefits and travel expenses of oursales force. Such expenses increased as a percentage of total net revenues dueprimarily to increases in headcount and payments to sales consultants(including lobbyists).  The increase inheadcount and amounts paid to sales consultants reflects required resourcesneeded to pursue large project solution opportunities.  We anticipate that this level of expensesincurred for sales and marketing during the six months ended June 30, 2005will continue as we pursue large project solution opportunities.

 

*RESEARCH AND DEVELOPMENT.* Research and development costs consist primarily of salaries, employeebenefits and outside contractors for new product development, productenhancements and custom integration work. Such expenses increased due primarilyto the accelerated development of our new ImageWare Biometric Engine, the webenablement of our CCS product line, and product enhancements to our DigitalPhotography software product suite utilizing contract programming services inconjunction with internal research and development resources.   Our level of expenditures in research anddevelopment reflects our belief that to maintain our competitive position inmarkets characterized by rapid rates of technological advancement, we mustcontinue to invest significant resources in new systems and software as well ascontinue to enhance existing products.

 

*DEPRECIATION AND AMORTIZATION.* Depreciation and amortization decreased due primarily to loweramortization of intangible assets due to such assets being fully amortized.

 

*INTEREST (INCOME) EXPENSE, NET.*  Forthe six months ended June 30, 2005, we recognized interest income of$13,000 and interest expense of $2,000. For the six months ended June 30,2004, we recognized interest income of $3,000 and interest expense of$5,192,000.  Interest expense for the sixmonths ended June 30, 2004 contains approximately $4,472,000 of interestexpense related to fair value accounting for our warrant liability due to theregistration rights agreement associated with the underlying shares of theCompany’s common stock to be issued upon conversion of the warrants.  During the three months ended June 30,2004, the Company registered the underlying shares of common stock with theSecurities and Exchange Commission.  Inaccordance with EITF 00-19, there will be no further interest expense or incomeincurred in conjunction with these warrants. Interest expense for the six months ended June 30, 2004 alsocontains $713,000 in liquidated damages, which were classified as interestexpense.  The liquidated damages wereincurred as the Company did not meet certain time requirements for theregistration of shares of the Company’s common stock under the registrationrights agreements for our November 2003 and January 2004 privateplacements.

 

*LIQUIDITY AND CAPITAL RESOURCES*

 

Asof June 30, 2005, we had total current assets of $2,811,000 and totalcurrent liabilities of $2,803,000, or working capital of $8,000. At June 30,2005, we had available cash of $365,000 and $106,000 in restricted cashsecuring our performance on certain software implementation contracts.

 

Netcash used in operating activities was $3,490,000 for the six month period endedJune 30, 2005 as compared to $2,770,000 for the corresponding period in2004. We used cash to fund net losses of $2,587,000, excluding non-cashexpenses (depreciation, amortization and stock-based compensation) of $455,000,offset by non-operating income (gain on sale of subsidiary) of $233,000 for thesix months ended June 30, 2005.  Weused cash to fund net losses of $2,308,000, excluding non-cash expenses(depreciation, amortization, stock-based compensation and change in warrantliability) of $4,925,000 for the corresponding period in 2004. For the sixmonths ended June 30, 2005, we generated cash of $509,000 from decreasesin current assets and used cash of $1,412,000 for reductions in currentliabilities and deferred revenues, excluding debt.  In the first six months of 2004, we used cashof $564,000 to fund increases in current assets and generated cash of $102,000from increases in current liabilities and deferred revenues, excluding debt.

 

Netcash provided by investing activities was $1,056,000 for the six months ended June 30,2005.  Net cash used by investingactivities for the six month ended June 30, 2004 was $122,000.  For the six months ended June 30, 2005,we used cash to fund capital expenditures of computer equipment and software,furniture and fixtures and leasehold improvements of approximately $153,000.The level of equipment purchases resulted primarily from the replacement ofolder equipment.  For the six monthsended June 30, 2005, we generated cash of $1,300,000 from the sale of outwholly-owned Singapore subsidiary, Digital imaging Asia Pacific, offset by cashsold and direct transaction costs of $91,000. For 

 

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thesix months ended June 30, 2004, we used cash of approximately $59,000 torepay advances from related stockholders and used cash of $63,000 to fundcapital expenditures of computer equipment, software, furniture and fixtures.

 

Netcash provided by financing activities was $13,000 for the six month periodended June 30, 2005 as compared to $6,095,000 for the corresponding periodin 2004.  For the six months ended June 30,2005, we generated cash of $56,000 from the exercise of stock options and usedcash of $17,000 for the repayments of notes payable.  Wee also used cash of $26,000 for the paymentof dividends on our Series B Preferred Stock.  For the six months ended June 30, 2004,we generated cash of $6,054,000 from our issuance of common stock in a privateplacement.  We also generated cash of$257,000 from the exercise of stock options.  For the six month period ended June 30, 2004, we used cash of$185,000 for the payment of dividends on our Series B Preferred Stock andused cash of $31,000 for the repayment of notes payable.

 

Weconduct operations in leased facilities under operating leases expiring atvarious dates through 2006. 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. We also have various short-term notes payable due at various timesduring the next twelve months.

 

Asmore fully described in Note 7 to these condensed consolidated financialstatements, in July 2005, we completed a private placement of our commonstock in July 2005.  We raisedapproximately $3.6 million, and after payment of expenses, we received totalnet proceeds of approximately $3.3 million.

 

Additionalnew financing may be required to fund working capital and operations should theCompany be unable to generate positive cash flow from operations in the nearfuture.  The Company may be required toseek additional financing that we believe is necessary to fund our workingcapital requirements for at least the next twelve months, assuming thesuccessful implementation of our business plan. Our business plan includes, among other things, significant increases inrevenues in future periods, the monitoring and controlling of operatingexpenses, collection of significant trade accounts receivables, and controllingof capital expenditures.  If we areunable to secure additional financing or successfully implement our businessplan, we will be required to seek funding from alternate sources and/or institutesignificant cost reduction plans.  We mayseek to sell equity or debt securities, secure a bank line of credit, orconsider strategic alliances. The sale of equity or equity related securitiescould result in additional dilution to our shareholders. There can be noassurance that additional financing, in any form, will be available at all or,if available, will be on terms acceptable to the Company. In addition, ourability to raise additional capital may be dependent upon the Company’s CommonStock being quoted on the American Stock Exchange. There can be no assurancethat the Company will be able to satisfy the criteria for continued listing onthe American Stock Exchange. Insufficient funds may require us to delay, scaleback or eliminate some or all of our activities, and if we are unable to obtainadditional funding, either through generation of positive cash flow fromoperations or by obtaining additional funding, there is substantial doubt aboutour ability to continue as a going concern.

 

*RECENTLY ISSUED ACCOUNTING STANDARDS*

 

InNovember 2004, the Financial Accounting Standards Board issued Statementof Financial Accounting Standards No. 151, “Inventory Costs, an amendmentof ARB No. 43, Chapter 4” (“SFAS 151”), which is effective beginning January 1,2006.  SFAS 151 requires that abnormalamounts of idle facility expense, freight, handling costs and wasted materialbe recognized as current period charges. The Statement also requires that the allocation of fixed productionoverhead be based on the normal capacity of the production facilities.  The effect of this Statement on the Company’sfinancial position or results of operations has not yet been determined.

 

InDecember 2004, the Financial Accounting Standards Board issued Statementof Financial Accounting Standards No. 123R, “Share-Based Payment (“SFAS123R”), which is effective beginning July 1, 2005.  On April 15, 2005, the Securities andExchange Commission announced that companies may implement SFAS No 123R at thebeginning of their next fiscal year begins after June 15, 2005.  The Company expects to adopt the revised rules onJanuary 1, 2006.  SFAS 123R requiresall share-based 

 

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paymentsto employees to be expensed over the requisite service period based on thegrant-date fair value of the awards.  TheStatement allows for either prospective or retrospective adoption and requiresthat the unvested portion of all outstanding awards upon adoption be recognizedusing the same fair value and attribution methodologies previously determinedunder Statement No 123, “Accounting for Stock-Based Compensation.”  The Company is currently evaluatingtransition alternatives and valuation methodologies for future grants.  As a result, pro forma compensation expense,as reflected in Note 1, may not be indicative of future expense to berecognized under SFAS 123R.  The effectof adoption of 123R on the Company’s financial position or results ofoperations has not yet been determined.

 

InDecember 2004, the Financial Accounting Standards Board issued Statementof Financial Accounting Standards No. 153, “Exchange of NonmonetaryAssets, an amendment of APR Opinion No. 29” (“SFAS 153”).  The guidance in APB Opinion No. 29, “Accountingfor Nonmonetary Transactions” is based on the principle that exchanges ofnonmonetary assets should be measured based on the fair value of the assetsexchanged.  The guidance in that Opinion,however, included certain exceptions to that principle.  SFAS 153 amends Opinion 29 to eliminate theexception for nonmonetary assets that do not have commercial substance.  A nonmonetary exchange has commercialsubstance if the future cash flows of the entity are expected to changesignificantly as a result of the exchange. The provisions of SFAS 153 shall be effective for nonmonetary assetexchanges occurring in fiscal periods beginning after June 15, 2005.  The effect of this Statement on the Company’sfinancial position or results of operations has not yet been determined.

 

InApril 2005, the FASB issued Interpretation No. 47, “Accounting forConditional Asset Retirement Obligations”, which clarifies that an entity isrequired to recognize a liability for the fair value of a conditional assetretirement obligation when incurred if the liability’s fair value can bereasonably estimated. The fair value of a liability for the conditional assetretirement obligation should be recognized when incurred, which is generallyupon acquisition, construction, or development and (or) through the normal operationof the asset. Uncertainty about the timing and (or) method of settlement of aconditional asset retirement obligation should be factored into the measurementof the liability when sufficient information exists.  Interpretation No. 47 is effective nolater than the end of fiscal years beginning after December 15, 2005. Weare currently evaluating the effect of this pronouncement.

 

InJune 2005, the Financial Accounting Standards Board issued Statement ofFinancial Accounting Standards No. 154, “Accounting Changes and ErrorCorrections – a replacement of APB Opinion No. 20 and FASB Statement No. 3”(SFAS154).  This Statement replaces APBOpinion No. 20, “Accounting Changes,” and FASB Statement No. 3, “ReportingAccounting Changes in Interim Financial Statements,” and changes therequirements for the accounting for and reporting of a change in accountingprinciple.  This Statement requiresretrospective application to financial statements of prior periods for changesin accounting principle. This Statement is effective January 1, 2006.  This standard has no impact on the Company’sfinancial statements.

 

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**RISK FACTORS**

 

**WE CURRENTLY HAVE LIMITED CASH RESOURCES AND WE MAY REQUIREADDITIONAL FUNDING TO FINANCE OUR WORKING CAPITAL REQUIREMENTS DURING THE NEXTTWELVE MONTHS.**

 

Wecurrently have limited cash resources and we may require financing to fund ouranticipated working capital requirements during the next twelve months. Weanticipate that our existing resources will not be sufficient to enable us tomaintain our current and planned operations for the next twelve months.  If we are not able to generate positive cashflows from operations in the near future, we will be required to seekadditional funding through public or private equity or debt financing. Therecan be no assurance that additional financing will be available on acceptableterms, or at all. If we are required to sell equity to raise additional funds,our existing shareholders may incur substantial dilution and any shares soissued may have rights, preferences and privileges superior to the rights,preferences and privileges of our outstanding Common Stock. Also, we may berequired to obtain funds through arrangements with third parties that requireus to relinquish rights to certain of our technologies or products that wewould seek to develop or commercialize ourselves. In addition, our ability toraise additional capital may be dependent upon the Company’s Common Stock beinglisted on the American Stock Exchange. We cannot guarantee that the Companywill be able to satisfy the criteria for continued listing on the AmericanStock Exchange.

 

**WE HAVE A HISTORY OF SIGNIFICANT RECURRING LOSSES TOTALLINGAPPROXIMATELY $58.7 MILLION, AND THESE LOSSES MAY CONTINUE IN THE FUTURE.**

 

Asof June 30, 2005, we had an accumulated deficit of $58.7 million, andthese losses may continue in the future. We may need to raise capital to coverthese losses, and financing may not be available to us on favorable terms. Weexpect to continue to incur significant sales and marketing, research anddevelopment, and general and administrative expenses. As a result, we will needto generate significant revenues to achieve profitability and we may neverachieve profitability.

 

**THE HOLDERS OF OUR PREFERRED STOCK HAVE CERTAIN RIGHTS ANDPRIVILEGES THAT ARE SENIOR TO THE COMMON STOCK, AND WE MAY ISSUEADDITIONAL SHARES OF PREFERRED STOCK WITHOUT SHAREHOLDER APPROVAL THAT COULDHAVE A MATERIAL ADVERSE EFFECT ON THE MARKET VALUE OF THE COMMON STOCK.**

 

OurBoard of Directors has the authority to issue a total of up to 4,000,000 sharesof preferred stock and to fix the rights, preferences, privileges, andrestrictions, including voting rights, of the preferred stock, which typicallyare senior to the rights of the common shareholders, without any further voteor action by you and the other common shareholders. Your rights will be subjectto, and may be adversely affected by, the rights of the holders of thepreferred stock that have been issued, or might be issued in the future.Preferred stock also could have the effect of making it more difficult for athird party to acquire a majority of the outstanding voting stock of ImageWare.This could delay, defer, or prevent a change in control. Furthermore, holdersof preferred stock may have other rights, including economic rights, senior tothe common stock. As a result, their existence and issuance could have amaterial adverse effect on the market value of the common stock. We have in thepast issued, and, may from time to time in the future issue, preferred stockfor financing or other purposes with rights, preferences, or privileges seniorto the common stock.

 

Theprovisions of our outstanding Series B Preferred Stock prohibit thepayment of dividends on the common stock unless the dividends on thosepreferred shares are first paid. In addition, upon a liquidation, dissolutionor sale of ImageWare’s business, the holders of the Series B PreferredStock will be entitled to receive, in preference to any distribution to theholders of common stock, initial distributions of $2.50 per share, plus allaccrued but unpaid dividends.

 

Pursuantto the terms of our Series B Preferred Stock we are obligated to paycumulative cash dividends on shares of Series B Preferred Stock fromlegally available funds at the annual rate of $0.2125 per share, payable in twosemi-annual installments of $0.10625 each, which cumulative dividends must bepaid prior to payment of any dividend on our Common Stock.  As of June 30, 2005, the Company hadcumulative undeclared dividends of approximately $8,000.

 

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**WE DEPEND UPON A SMALL NUMBER OF LARGE SYSTEM SALES RANGINGFROM $500,000 TO IN EXCESS OF $2,000,000, AND WE MAY FAIL TO ACHIEVE ONEOR MORE LARGE SYSTEM SALES IN THE FUTURE.**

 

Inthe past three years we have derived a substantial portion of our revenues froma small number of sales of large, relatively expensive systems, typicallyranging in price from $500,000 to $2,000,000. As a result, if we fail toreceive orders for these large systems in a given sales cycle on a consistentbasis, our business could be significantly harmed. Further, our quarterlyresults are difficult to predict because we cannot predict in which quarter, ifany, large system sales will occur in a given year. As a result, we believethat quarter-to-quarter comparisons of our results of operations are not a goodindication of our future performance. In some future quarters our operatingresults may be below the expectations of securities analysts and investors, inwhich case the market price of our common stock may decrease significantly.

 

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

 

Whenconsidering the purchase of a large computerized booking or identificationsystem, a government agency may take as long as a year to evaluate differentsystems and obtain approval for the purchase. If we fail to complete a sale, wewill have expended significant resources and received no revenue in return.Generally, agencies consider a wide range of issues before committing topurchase our products, including product benefits, ability to operate with theircurrent systems, product reliability and their own budgetary constraints. Whilepotential customers are evaluating our products and before they place an orderwith us, we may incur substantial selling costs and expend significantmanagement effort to accomplish a sale.

 

**A SIGNIFICANT NUMBER OF OUR CUSTOMERS ARE GOVERNMENT AGENCIESTHAT ARE SUBJECT TO UNIQUE POLITICAL AND BUDGETARY CONSTRAINTS AND HAVE SPECIALCONTRACTING REQUIREMENTS WHICH MAY AFFECT OUR ABILITY TO OBTAIN NEWGOVERNMENT CUSTOMERS.**

 

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

 

**WE MAY FAIL TO CREATE NEW APPLICATIONS FOR OUR PRODUCTSAND ENTER NEW MARKETS, WHICH MAY AFFECT OUR FUTURE SUCCESS.**

 

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

 

**WE OCCASIONALLY RELY ON SYSTEMS INTEGRATORS TO MANAGE OURLARGE PROJECTS, AND IF THESE COMPANIES DO NOT PERFORM ADEQUATELY, WE MAY LOSEBUSINESS.**

 

Weare occasionally a subcontractor to systems integrators who manage largeprojects that incorporate our systems, particularly in foreign countries. Wecannot control these companies, and they 

 

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maydecide not to promote our products or may price their services in such a way asto make it unprofitable for us to continue our relationship with them. Further,they may fail to perform under agreements with their customers, in which casewe might lose sales to these customers. If we lose our relationships with thesecompanies, our business may suffer.

 

**WE HAVE U.S. AND FOREIGN PATENT PROTECTION FOR ELEMENTS OFCERTAIN OF OUR PRODUCTS, AND HAVE PATENT APPLICATIONS IN PROCESS, HOWEVER, ACOMPETITOR MAY STILL BE ABLE TO REPLICATE OUR TECHNOLOGY.**

 

Ourbusiness is based in large part on our technology, and our success depends inpart on our ability and efforts to protect our intellectual property rights. Ifwe do not adequately protect our intellectual property through copyrights,patents and various trade secret protections afforded to us by law, ourbusiness will be seriously harmed. We have patent protection for elements ofcertain of our products and patent applications on file.

 

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

 

Inaddition, international intellectual property laws differ from country tocountry. Any foreign rights we have in our technology are limited by what hasbeen afforded to us under the applicable foreign intellectual property laws.Also, under the laws of certain foreign jurisdictions, in order to haverecognizable intellectual property rights, we may be required to fileapplications with various foreign agencies or officials to register ourintellectual property. Accordingly, our ability to operate and exploit ourtechnology overseas could be significantly hindered.

 

**WE HAVE ACQUIRED SEVERAL BUSINESSES AND FACE RISKS ASSOCIATEDWITH INTEGRATING THESE BUSINESSES AND POTENTIAL FUTURE BUSINESSES THAT WE MAY ACQUIRE.**

 

Wecompleted the acquisitions of several companies, and we plan to continue toreview potential acquisition candidates. Our business and our strategy includes building our business throughacquisitions. However, acceptable acquisition candidates may not be availablein the future or may not be available on terms and conditions acceptable to us.

 

Acquisitionsinvolve numerous risks, including among others, difficulties and expensesincurred in the consummation of acquisitions and assimilation of theoperations, personnel and services and products of the acquired companies.Additional risks associated with acquisitions include the difficulties ofoperating new businesses, the diversion of management’s attention from otherbusiness concerns and the potential loss of key employees of the acquiredcompany. If we do not successfully integrate the businesses we may acquire inthe future, our business will suffer.

 

**WE OPERATE IN FOREIGN COUNTRIES AND ARE EXPOSED TO RISKSASSOCIATED WITH FOREIGN POLITICAL, ECONOMIC AND LEGAL ENVIRONMENTS AND WITHFOREIGN CURRENCY EXCHANGE RATES.**

 

Withour acquisition of G & A, we have significant foreign operations andare accordingly exposed to risks, including among others, risks associated withforeign political, economic and legal environments and with foreign currencyexchange rates. Our results may be adversely affected by, among other things,changes in government policies with respect to laws and regulations,anti-inflation measures, currency conversions, remittance abroad and rates andmethods of taxation.

 

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**ITEM3.  CONTROLS AND PROCEDURES**

 

*Evaluation of disclosure controls and procedures*.  OurChief Executive Officer and Chief Financial Officer have concluded, based upontheir evaluation as of the end of theperiod covered by this report, that our disclosure controls and procedures (asdefined in Securities Exchange Act Rule 13a - 15(e) are effective inensuring that information required to be disclosed in the reports that we fileor submit under the Securities Exchange Act of 1934 is recorded, processed,summarized and reported within the time periods specified in the Securities andExchange Commission’s rules and forms.

 

*Changes in internal controls. *There has been no change in our internal control over financialreporting during the fiscal quarter ended June 30, 2005, that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

 

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**PART II**

 

**ITEM4.  SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS**

 

Thefollowing matters were submitted to a vote of the shareholders of ImageWareSystems Inc. at the Annual Meeting of Shareholders held on June 7, 2005.

 

a)                    The following members were elected to and asthe Board of Directors to serve for the ensuing year and until their successorsare elected:

 
| **Nominee**                | ** ** | **Shares Voted For** | ** ** | **Shares Withheld** | ** ** |
|----------------------------|------------|----------------------|------------|---------------------|------------|
| S.  James Miller, Jr. |       | 9,063,171            |       | 440,893             |       |
| John  Callan               |       | 9,319,044            |       | 185,021             |       |
| Patrick  Downs             |       | 9,238,033            |       | 266,032             |       |
| John  Holleran             |       | 9,234,033            |       | 270,032             |       |
| Guy  Steven Hamm           |       | 9,336,344            |       | 167,721             |       |
| David  Loesch              |       | 9,333,794            |       | 170,271             |       |

 

b)                   A proposal to ratify the appointment ofStonefield Josephson, Inc. as independent auditors for our fiscal yearending December 31, 2005 was approved by the following vote: 9,315,670 infavor, 187,295 against, 1,100 abstentions.

 

c)                    A proposal to approve the amendment andrestatement of the 1999 Stock Award Plan was approved by the followingvote:  3,245,785 in favor, 1,021,024against, 34,685 abstentions.

 

Aspecial meeting of shareholders was held in June 2005 for the purpose ofapproving the adjustment of the exercise price for the warrant to purchase1,021,687 shares of commons stock issued to L.F. Global Holdings, LLC dated June 13,2003 and for the warrant to purchase 578,313 shares of common stock issued toLaurus Master Fund, Ltd. dated June 13, 2003.  The matter was not approved due toinsufficient votes cast to reach a quorum.

 

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

 
| **(a)** | ** ** | **EXHIBITS**                                                                                      |
|---------|------------|---------------------------------------------------------------------------------------------------|
|    |       |                                                                                              |
| 10.1    |       | Amended  and Restated 1999 Stock Award Plan(1)                                                    |
| 10.2    |       | Form of  Stock Option Agreement(1)                                                           |
| 31.1    |       | Certification  of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley  Act |
| 31.2    |       | Certification  of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley  Act |
| 32.1    |       | Certification  by Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley  Act |
| 32.2    |       | Certification  by Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley  Act |

 

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(1) Incorporated by reference to the Company’s Form 8-Kfiled on July 14, 2005.

 

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**SIGNATURES**

 

Inaccordance with the requirements of the Exchange Act, the registrant causedthis report to be signed on its behalf by the undersigned, thereunto dulyauthorized.

 

 
|                        | IMAGEWARE  SYSTEMS, INC. |
|-----------------------------|--------------------------|
|                        |                     |   |
|                        |                     |   |
| Date:  August 12, 2005 | 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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