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

**Washington, D.C. 20549**

 

**FORM 10-QSB**

 

**(Mark One)**

** **

| ý |   | **QUARTERLY  REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|--------|--------|----------------------------------------------------------------------------------------|

 

**For the quarterly period ended March 31, 2003**

** **

| o |   | **TRANSITION  REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT** |
|---|--------|----------------------------------------------------------------------|

 

**For the transition periodfrom         to         **

 

**Commission file number 001-15757**

 

**IMAGEWARE SYSTEMS, INC.**

(ExactName 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**

(Addressof Principal Executive Offices)

 

**(858) 673-8600**(Issuer’s TelephoneNumber, Including Area Code)

 

Check whether the issuer (1)filed all reports required to be filed by Section 13 or 15(d) of the ExchangeAct during the past 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes ý  No o

 

State the number of sharesoutstanding of each of the issuer’s classes of common equity, as of the latestpracticable date: As of May 6, 2003, the number of outstanding shares of theRegistrant’s common stock, par value $.01, was 5,489,390.

 

Transitional Small BusinessDisclosure 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 Sheet as of March 31, 2003                                                            |   |
|       |                   | Condensed  Consolidated Statements of Operations for the three months ended  March 31, 2003 and 2002                  |   |
|       |                   | Condensed  Consolidated Statements of Cash Flows for the three months ended  March 31, 2003 and 2002                  |   |
|       |                   | Condensed  Consolidated Statements of Comprehensive Income (Loss) for the  three months ended March 31, 2003 and 2002 |   |
|       |                   | Notes  to Condensed Consolidated Financial Statements                                                                 |   |
|       | ITEM  2.               | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                           |   |
|       | ITEM 3.                | Controls and  Procedures                                                                                              |   |
|       |                   |                                                                                                                  |   |
| PART II.   | OTHER INFORMATION      |                                                                                                                  |
|       | ITEM 2.                | CHANGES IN SECURITIES                                                                                                 |   |
|       | ITEM 3.                | DEFAULTS UPON  SENIOR SECURITIES                                                                                      |   |
|       | ITEM 6.                | EXHIBITS AND  REPORTS ON FORM 8-K                                                                                     |   |
|       |                   |
| SIGNATURES |                   |
|            |                        |                                                                                                                       |  |  |

 

2

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**PART I**

### **FINANCIAL INFORMATION**

 

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

 

**IMAGEWARE SYSTEMS, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEET**

**ASSETS**

**(IN THOUSANDS)**

**(UNAUDITED)**

 
|                                                                                                                                                                                                                               |   | **March 31,  2003** |       |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------|------------|
|                                                                                                                                                                                                                               |   |                |       |
| Current Assets:                                                                                                                                                                                                                    |   |                |       |
| Cash                                                                                                                                                                                                                               |   | $                   | 428        |   |
| Restricted cash and cash equivalents                                                                                                                                                                                               |   | 60                  |       |
| Accounts receivable, net                                                                                                                                                                                                           |   | 1,851               |       |
| Inventory                                                                                                                                                                                                                          |   | 1,902               |       |
| Other current assets                                                                                                                                                                                                               |   | 440                 |       |
| Total Current Assets                                                                                                                                                                                                               |   | 4,681               |       |
|                                                                                                                                                                                                                               |   |                |       |
| Property and equipment, net                                                                                                                                                                                                        |   | 995                 |       |
| Other assets                                                                                                                                                                                                                       |   | 998                 |       |
| Intangible assets, net of accumulated  amortization                                                                                                                                                                                |   | 1,445               |       |
| Goodwill                                                                                                                                                                                                                           |   | 5,298               |       |
| **Total Assets**                                                                                                                                                                                                                   |   | **$**               | **13,417** | ** ** |
|                                                                                                                                                                                                                               |   |                |       |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                                                                                                                      |   |                |       |
|                                                                                                                                                                                                                               |   |                | ** ** |
| Current Liabilities:                                                                                                                                                                                                               |   |                |       |
| Accounts payable                                                                                                                                                                                                                   |   | $                   | 2,706      |   |
| Deferred revenue                                                                                                                                                                                                                   |   | 967                 |       |
| Accrued expenses                                                                                                                                                                                                                   |   | 1,489               |       |
| Accrued interest                                                                                                                                                                                                                   |   | 328                 |       |
| Notes & advances payable to bank and  third parties                                                                                                                                                                            |   | 928                 |       |
| Notes payable to related parties                                                                                                                                                                                                   |   | 254                 |       |
| Total Current Liabilities                                                                                                                                                                                                          |   | 6,672               |       |
|                                                                                                                                                                                                                               |   |                |       |
| Convertible notes payable, net of discount                                                                                                                                                                                         |   | 988                 |       |
| Pension obligation                                                                                                                                                                                                                 |   | 426                 |       |
| Total Liabilities                                                                                                                                                                                                                  |   | 8,086               |       |
|                                                                                                                                                                                                                               |   |                |       |
| Shareholders’ equity (deficit):                                                                                                                                                                                               |   |                |       |
| 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 269,400 shares outstanding, liquidation  preference $673,500 |   | 3                   |       |
| Common stock, $.01 par value, 50,000,000  shares authorized, 5,489,390 shares issued and outstanding                                                                                                                               |   | 54                  |       |
| Additional paid in capital                                                                                                                                                                                                         |   | 42,372              |       |
| Treasury stock, at cost - 6,704 shares                                                                                                                                                                                             |   | (64                 | )          |
| Shareholder note receivable                                                                                                                                                                                                        |   | (150                | )          |
| Accumulated other comprehensive income                                                                                                                                                                                             |   | 144                 |       |
| Accumulated deficit                                                                                                                                                                                                                |   | (37,028             | )          |
| Total shareholders’ equity                                                                                                                                                                                                    |   | 5,331               |       |
|                                                                                                                                                                                                                               |   |                |       |
| **Total Liabilities and  Shareholders’ Equity**                                                                                                                                                                               |   | **$**               | **13,417** | ** ** |

 

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

 

3

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**IMAGEWARE SYSTEMS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS**

**(IN THOUSANDS, EXCEPT SHARE AND PER SHAREAMOUNTS)**

**(UNAUDITED)**

 
|                                                    |   | **THREE MONTHS ENDED   March 31,** |   |
|---------------------------------------------------------|--------|------------------------------------|--------|
|                                                    |   | **2003**                           |   | **2002** |   |
|                                                    |   |                               |   |   |   |
| **Revenues:**                                           |   |                               |   |   |   |
| Product                                                 |   | $                                  | 2,634  |   | $ | 2,996 |   |
| Maintenance                                             |   | 798                                |   | 672 |   |
|                                                    |   | 3,432                              |   | 3,668 |   |
|                                                    |   |                               |   |   |   |
| **Cost of revenues:**                                   |   |                               |   |   |   |
| Product                                                 |   | 1,238                              |   | 1,277 |   |
| Maintenance                                             |   | 355                                |   | 280 |   |
| Gross profit                                            |   | 1,839                              |   | 2,111 |   |
|                                                    |   |                               |   |   |   |
| **Operating expenses:**                                 |   |                               |   |   |   |
| General & administrative                            |   | 1,442                              |   | 1,741 |   |
| Sales and marketing                                     |   | 1,089                              |   | 1,141 |   |
| Research & development                              |   | 494                                |   | 516 |   |
| Depreciation and amortization                           |   | 235                                |   | 218 |   |
|                                                    |   | 3,260                              |   | 3,616 |   |
|                                                    |   |                               |   |   |   |
| Loss from operations                                    |   | (1,421                             | )      | (1,505 | ) |
|                                                    |   |                               |   |   |   |
| Interest (income) expense, net                          |   | 361                                |   | 4 |   |
|                                                    |   |                               |   |   |   |
| Other (income) expense, net                             |   | (81                                | )      | (20 | ) |
|                                                    |   |                               |   |   |   |
| Loss before income taxes                                |   | (1,701                             | )      | (1,489 | ) |
|                                                    |   |                               |   |   |   |
| Income tax expense (benefit)                            |   | —                             |   | — |   |
|                                                    |   |                               |   |   |   |
| Net loss                                                |   | $                                  | (1,701 | ) | $ | (1,489 | ) |
|                                                    |   |                               |   |   |   |
| Basic and diluted (loss) per common share -  see note 2 |   | $                                  | (0.31  | ) | $ | (0.27 | ) |
| Weighted-average shares (basic and diluted)             |   | 5,483,973                          |   | 5,481,311 |   |

 

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

 

4

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**IMAGEWARE SYSTEMS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASHFLOWS**

**(IN THOUSANDS)**

**(UNAUDITED**

 
|                                                                        |   | **Three  Months Ended   March 31,** |       |
|-----------------------------------------------------------------------------|--------|-------------------------------------|------------|
|                                                                        |   |                                |       |   |   |
|                                                                        |   | **2003**                            |       | **2002** | ** ** |
|                                                                        |   |                                | ** ** |   | ** ** |
| **Cash flows from operating  activities**                                   |   |                                |       |   |   |
| Net loss                                                                    |   | $                                   | (1,701     | ) | $ | (1,489 | ) |
| Adjustments to reconcile net loss to net  cash used by operating activities |   | 238                                 |       | 218 |   |
| Depreciation and amortization                                               |   |                                |       |   |   |
| Amortization of debt discount and debt  issuance costs                      |   | 223                                 |       | — |   |
| Change in assets and liabilities                                            |   |                                |       |   |   |
| Accounts receivable, net                                                    |   | 1,444                               |       | 1,568 |   |
| Inventory                                                                   |   | (21                                 | )          | 51 |   |
| Other current assets                                                        |   | (17                                 | )          | 118 |   |
| Intangible and other assets                                                 |   | (23                                 | )          | — |   |
| Accounts payable                                                            |   | (527                                | )          | (772 | ) |
| Accrued expenses                                                            |   | (16                                 | )          | 112 |   |
| Accrued interest                                                            |   | 130                                 |       | 2 |   |
| Deferred revenue                                                            |   | (9                                  | )          | 186 |   |
| Pension obligation                                                          |   | 20                                  |       | — |   |
| Total adjustments                                                           |   | 1,442                               |       | 1,483 |   |
| Net cash used by operating activities                                       |   | (259                                | )          | (6 | ) |
|                                                                        |   |                                |       |   |   |
| **Cash flows from investing  activities**                                   |   |                                |       |   |   |
| Purchase of property and equipment                                          |   | (76                                 | )          | (88 | ) |
| Payment on advances from related stockholders                               |   | (8                                  | )          | (45 | ) |
| Net cash used by investing activities                                       |   | (84                                 | )          | (133 | ) |
|                                                                        |   |                                |       |   |   |
| **Cash flows from financing  activities**                                   |   |                                |       |   |   |
| Proceeds from issuance of notes payable                                     |   | 600                                 |       | — |   |
| Repayment of notes payable                                                  |   | —                              |       | (5 | ) |
| Debt issuance costs                                                         |   | (218                                | )          | — |   |
| Proceeds from bank line of credit                                           |   | 142                                 |       | — |   |
|                                                                        |   |                                |       |   |   |
| Net cash provided (used) by financing  activities                           |   | 524                                 |       | (5 | ) |
| Effect of exchange rate changes on cash                                     |   | 32                                  |       | (15 | ) |
| Net increase (decrease) in cash                                             |   | 213                                 |       | (159 | ) |
|                                                                        |   |                                |       |   |   |
| Cash at beginning of period                                                 |   | 215                                 |       | 388 |   |
|                                                                        |   |                                |       |   |   |
| Cash at end of period                                                       |   | $                                   | 428        |   | $ | 229 |   |

 

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

 

5

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**IMAGEWARE SYSTEMS, INC.**

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

**(IN THOUSANDS)**

**(UNAUDITED)**

 
|                                    |   | **THREE  MONTHS ENDED  MARCH 31,** |       |
|-----------------------------------------|--------|------------------------------------|------------|
|                                    |   | **2003**                           |       | **2002** | ** ** |
|                                    |   |                               |       |   |   |
|                                    |   |                               | ** ** |   | ** ** |
| Net income (loss)                       |   | $                                  | (1,701     | ) | $ | (1,489 | ) |
| Other comprehensive income (loss):      |   |                               |       |   |   |
| Foreign currency translation adjustment |   | 32                                 |       | (15 | ) |
| Comprehensive income (loss)             |   | $                                  | (1,669     | ) | $ | (1,504 | ) |

 

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

 

6

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**IMAGEWARE SYSTEMS, INC.**

 

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE1.  DESCRIPTION OF BUSINESS ANDOPERATIONS**

 

ImageWare Systems, Inc.(“we”, “our” or “the Company”), was incorporated in the State of California onFebruary 6, 1987. The Company utilizes its imaging technology to developsoftware used to create booking and investigative 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.

 

*Liquidity and Capital Resources*

 

The condensed consolidatedfinancial statements included in this report have been prepared assuming thatthe Company will be successful in obtaining the additional capital it needs tofund operations and implement its business plan. The Company used approximately$2,086,000 in operations during the year ended December 31, 2002 and $259,000in operations during the three months ended March 31, 2003, suffered recurringlosses from operations and has an accumulated deficit of approximately$37,028,000 at March 31, 2003 which raises substantial doubt about theCompany’s ability to continue as a going concern. The financial statements donot include any adjustments that might result from the outcome of thisuncertainty.

 

The Company operates inmarkets that are emerging and highly competitive. There is no assurance thatthe Company will operate at a profit in the future.

 

New financing will berequired to fund working capital and operations. The Company is exploring thepossible sale of equity securities and/or debt financing, and believes thatadditional financing will be available under terms and conditions that areacceptable to the Company. However, there can be no assurance that additionalfinancing will be available. In the event financing is not available in thetime frame required, the Company will be forced to reduce its rate of growth,if any, reduce operating expenses, curtail sales and marketing activities andreschedule research and development projects. In addition, the Company might berequired to sell certain of its assets or license its technologies to others.These actions, while necessary for the continuance of operations during a timeof cash constraints and a shortage of working capital, could adversely affectthe Company’s business.

 

*Basis of Presentation*

 

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

 

The accompanying condensedconsolidated unaudited financial statements of ImageWare  have been prepared pursuant to the rules andregulations of the Securities and Exchange Commission ("SEC")regarding interim financial reporting. Accordingly, they do not include all ofthe information and footnotes required by generally accepted accountingprinciples for annual financial statements and should be read in conjunctionwith the consolidated financial statements for the year ended December 31, 2002and notes thereto included in the Company’s Annual Report on Form 10-KSB, filedwith the SEC on April 15, 2003. In the opinion of management, the accompanyingcondensed consolidated financial statements contain all adjustments, consistingonly of adjustments of a normal recurring nature, necessary for a fairpresentation of the Company’s financial position as of March 31, 2003, and itsresults of operations for the periods presented. These condensed consolidatedunaudited financial statements are not necessarily indicative of the results tobe expected for the entire year.

 

7

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

 

**NOTE2.  NET LOSS PER COMMON SHARE**

 

Basic loss per common share is calculated bydividing net loss available to common shareholders for the  period by the weighted-average number ofcommon shares outstanding during the period. Diluted earnings per common shareis calculated by dividing net loss available to common shareholders for theperiod by the weighted-average number of common shares outstanding during theperiod, adjusted to include, if dilutive, potential dilutive shares consistingof convertible preferred stock, stock options, convertible notes payable andwarrants, calculated using the treasury stock method. During the periods endedMarch 31, 2003 and 2002, the Company has excluded all convertible preferredstock, outstanding stock options, convertible notes payable and warrants fromthe calculation of diluted loss per share, as their effect would have beenantidilutive due to the Company’s net loss.

 

The following table setsforth the computation of basic and diluted loss per share for the three  month periods ended March 31, 2003 and 2002(amounts in thousands except share and per share amounts):

 
|                                      |   | **THREE MONTHS ENDED  MARCH 31,** |       |
|-------------------------------------------|--------|-----------------------------------|------------|
|                                      |   | **2003**                          |       | **2002** |   |
| Numerator                                 |   |                              | ** ** |   | ** ** |
| Net loss                                  |   | $                                 | (1,701     | ) | $ | (1,489 | ) |
| Less Series B preferred dividends         |   | (15                               | )          | (16 | ) |
| Net loss available to common shareholders |   | $                                 | (1,716     | ) | $ | (1,505 | ) |
|                                      |   |                              |       |   |   |
| Denominator                               |   |                              |       |   |   |
| Weighted-average shares outstanding       |   | 5,489,390                         |       | 5,481,311 |   |
|                                      |   |                              |       |   |   |
| Basic and diluted loss per share          |   | $                                 | (0.31      | ) | $ | (0.27 | ) |

 

8

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**NOTE3.  SEGMENT INFORMATION**

 

Prior to its acquisition ofG & A in March 2001, the Company operated in one business segment. During2002, the Company  reorganized itsreportable segments into geographical groups: Americas, International andDigital Photography. In the Company’s Americas segment, the Company 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 as well as develops, sells and supports softwareand designs systems which utilize digital imaging in the production of photoidentification cards, documents and identification badging systems. TheAmericas segment includes North, Central and South America. The Company’sInternational segment includes all geographic areas other than North, Centraland South America. The Company’s International segment develops, sells and supportssoftware and designs systems utilizing digital imaging in the production ofphoto identification cards, documents and identification badging systems. TheDigital Photography segment develops digital imaging software which enablesprofessional photographers to quickly and easily take photos and create adatabase of information that can be sent to photography laboratories forprocessing.

 

Subsequent to the nine months ended September30, 2002, the Company has re-evaluated its organizational and internalfinancial reporting structure. Accordingly, the Company has realigned its business segments alongproduct and service lines for operating decision purposes and to better assessperformance.  Financial reportingsegments have been changed to reflect this alignment.

 

The table below summarizes information aboutreportable segments for the three months ended March 31, 2003 and 2002:

 

 
|                         |   | **THREE MONTHS ENDED** |   |
|------------------------------|--------|------------------------|--------|
|                         |   | **March 31,**          |   |
|                         |   | **2003**               |   | **2002** |   |   |
|                         |   | *(in thousands)*       |   |   |
| Net Revenue:                 |   |                   |   |   | * * |   |
| Law Enforcement              |   | $                      | 791    |   | $ | 1,022 |   |   |
| Identification               |   | 2,380                  |   | 2,349 |   |   |
| Digital Photography          |   | 261                    |   | 297 |   |   |
| Total consolidated net sales |   | $                      | 3,432  |   | $ | 3,668 |   |   |
|                         |   |                   |   |   |   |   |
| Operating loss:              |   |                   |   |   |   |   |
| Law Enforcement              |   | $                      | (180   | ) | $ | 75 |   |   |
| Identification               |   | (1,099                 | )      | (1,341 | ) |   |
| Digital Photography          |   | (142                   | )      | (239 | ) |   |
|                         |   |                   |   |   |   |   |
| Other unallocated amounts:   |   |                   |   |   |   |   |
| Interest expense (income)    |   | 361                    |   | 4 |   |   |
| Other expense (income)       |   | (81                    | )      | (20 | ) |   |
|                         |   |                   |   |   |   |   |
| Income (loss) before taxes   |   | $                      | (1,701 | ) | $ | (1,489 | ) |   |
|                         |   |                   |   |   |   |   |

 

 
|                                 |   | **March 31,**      |     |
|--------------------------------------|--------|--------------------|----------|
| Total Assets by Segment**:**         |   | **2003**           |     |
|                                 |   | **(in thousands)** | * * |
| Law Enforcement                      |   | $                  | 1,008    |   |
| Identification                       |   | 9,348              |     |
| Digital Photography                  |   | 1,752              |     |
| Total assets for reportable segments |   | 12,108             |     |
| Corporate                            |   | 1,309              |     |
| Total consolidated assets            |   | $                  | 13,417   |   |

 

 

9

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**NOTE4.  NOTES PAYABLE AND LINES OF CREDIT**

 

In May 2002, the Company issued a senior secured convertible promissorynote for $2,000,000 at an interest rate of 12.5%, due May 22, 2004 (the"Note").  The Note initiallywas convertible into common shares of the Company at $4.31 per share.  In conjunction with the note, the Companyissued a warrant to purchase 150,000 shares of common stock at $4.74 pershare.  The Company recorded the notenet of a discount equal to the fair value allocated to the warrants issued ofapproximately $537,000.

 

The Note also contained abeneficial conversion feature, which resulted in additional debt discount of$537,000.  The beneficial conversionamount was measured using the accounting intrinsic value, i.e. the excess ofthe aggregate fair value of the common stock into which the debt is convertibleover the proceeds allocated to the security. The Company is accreting thebeneficial conversion feature as interest expense over the life of thenote.  For the three months ended March 31,2003, the Company recorded $134,000 as interest expense from the amortizationof the discount related to fair value of the warrants and from the accretion ofthe beneficial conversion feature.

 

The issuance by the Companyof $600,000 in convertible subordinated promissory notes in March 2003(described below) triggered certain anti-dilution provisions contained in theNote.  This resulted in the conversionprice of the note being reduced to $1.90 per share.  Similar provisions also reduced the warrant exercise price to$1.90 per share.  These reductionsresulted in the recognition of an additional beneficial conversion feature inthe amount of $926,000 which has been recorded as additional debt discount.  The Company is accreting this additionalbeneficial conversion feature as interest expense over the remaining life ofthe note.  For the three months endedMarch 31, 2003, the Company recorded $36,000 as interest expense from theamortization of the additional discount related to the additional beneficialconversion feature.

 

The Company also granted theholder of the Note an option to acquire an additional senior securedconvertible promissory note with an aggregate principal amount of up to$3,000,000, together with an additional warrant to acquire a proportionatenumber of shares of the common stock of the Company based upon the actualamount of money invested in the additional note.  The terms of the additional note and additional warrant would besubstantially identical to the initial note and warrant.

 

A foreign subsidiary of theCompany has two line of credit facilities with commercial banks totaling$606,000.  As of March 31, 2003,the Company had utilized $308,000 of these facilities.  Borrowings under these line of creditfacilities bear interest at between 8.0% and 8.4% per annum and arecollateralized by the subsidiary’s accounts receivable.

 

In September 2002, theCompany issued a secured demand promissory note for $500,000 at an interestrate of 12.5%  to the holder of theNote.  This note is due and payable upondemand given by the holder.

 

In March 2003, the Company issued to certain accredited investorsconvertible subordinated promissory notes ("the Subordinated Notes").  The Subordinated Notes have an aggregate principal amount of $600,000, bearan interest rate of 8.5% per annum, payable semi-annually in arrears, have amaturity date of April 15, 2005 and are convertible into shares of theCompany’s common stock at a conversion price of $1.90 per share.

 

TheSubordinated Notes contained an embedded beneficial conversion feature which resulted in debt discount of$111,000.  The beneficial conversionamount was measured using the accounting intrinsic value, i.e. the excess ofthe aggregate fair value of the common stock into which the debt is convertibleover the proceeds allocated to the security. The Company is accreting thebeneficial conversion feature as interest expense over the life  of the note.  For the three months ended March 31, 2003, the Company recorded$2,000 as interest expense from the amortization of the discount related to theaccretion of this beneficial conversion feature.

 

10

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**NOTE5.  RECENTLY ISSUED ACCOUNTING STANDARDS**

 

In January2003, the FASB issued SFAS No. 148, *Accounting for Stock Based Compensation — Transitionand Disclosure. *Thisstatement provides alternative methods of transition for a voluntary change tothe fair value-based method of accounting for stock-based employeecompensation.  In addition, this statementalso amends the disclosure requirements of SFAS No. 123 to require moreprominent and frequent disclosures in the financial statements about theeffects of stock-based compensation. The transitional guidance and annual disclosure provisions of this statementwas effective for the December 31, 2002 financial statements.  The interim reporting disclosurerequirements are effective for the Company’s March 31, 2003 Form 10-QSB.Because the Company continues to account for employee stock-based compensationunder APB Opinion No. 25, the transitional guidance of SFAS No. 148 has noeffect on the financial statements at this time. The December 31, 2002 andMarch 31, 2003 financial statements have incorporated the enhanced disclosurerequirements of SFAS No. 148, as presented below under the caption “Stock-BasedCompensation.”

** **

In November2002, the FASB issued FASB Interpretation No. 45 (“FIN 45”), *— “Guarantor’s Accounting and Disclosure Requirementsfor Guarantees, Including Indirect Guarantees of Indebtedness of Others.”*FIN45 requires that a liability be recorded in the guarantor’s balance sheet uponissuance of a guarantee. In addition, FIN 45 requires disclosures about theguarantees that an entity has issued, including a rollforward of the entity’sproduct warranty liabilities. The Company will apply the recognition provisionsof FIN 45 prospectively to guarantees issued after December 31, 2002. Thedisclosure provisions of FIN 45 are effective for the 2002 financialstatements; however no new disclosures were deemed necessary. The adoption ofFIN 45 did not have a material effect on the Company’s results of operations orfinancial condition.

 

In November2002, the Emerging Issues Task Force (EITF) issued Issue No. 00-21,“Accounting for Revenue Arrangements with Multiple Deliverables.” This issueaddresses determination of whether an arrangement involving more than onedeliverable contains more than one unit of accounting and how arrangementconsideration should be measured and allocated to the separate units ofaccounting. EITF Issue No. 00-21 will be effective for revenuearrangements entered into in fiscal periods beginning after June 15, 2003or the Company may elect to report the change in accounting as acumulative-effect adjustment. The Company is reviewing EITF IssueNo. 00-21 and has not yet determined the impact this issue will have onits results of operations and financial condition.

** **

**NOTE6.  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 at theinitial grant date.  The cost of stockoptions 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 onthe fair 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 months ended March 31, 2003and 2002.

 

 
|                                                             |   | **THREE  MONTHS ENDED  MARCH 31,** |   |
|------------------------------------------------------------------|--------|------------------------------------|--------|
|                                                             |   |                               |
|                                                             |   | **2003**                           |   | **2002** |   |
| Net Loss:                                                        |   |                               |   |   |   |
| As reported                                                      |   | $                                  | (1,701 | ) | $ | (1,489 | ) |
| Stock based employee compensation under  fair value based method |   | (146                               | )      | (224 | ) |
| Pro forma net loss                                               |   | $                                  | (1,847 | ) | $ | (1,713 | ) |
|                                                             |   |                               |   |   |   |
| Basic loss per common share:                                     |   |                               |   |   |   |
| As reported                                                      |   | $                                  | (0.31  | ) | $ | (0.27 | ) |
| Pro forma                                                        |   | $                                  | (0.34  | ) | $ | (0.32 | ) |
|                                                             |   |                               |   |   |   |

 

**ITEM2.  MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.**

 

This Quarterly Report onForm 10-QSB contains forward-looking statements within the meaning of Section27A of the Securities Act of 1933, and Section 21E of the Securities ExchangeAct of 1934. All forward-looking statements included in this report are basedon information available to us as of the date hereof and we assume noobligation to update any forward-looking statements. Forward-looking statementsinvolve known or unknown risks, uncertainties and other factors, which maycause our actual results, performance or achievements, or industry results tobe materially different from any future results, performance or achievementsexpressed or implied by such forward-looking statements. Factors that couldcause or contribute to such differences include but are not limited to thoseitems discussed under “Risk Factors” and elsewhere in this Quarterly Report.

 

The following discussion ofthe financial condition and results of operations should be read in conjunctionwith the condensed consolidated financial statements included elsewhere withinthis quarterly report. Fluctuations in annual and quarterly results may occuras a result of factors affecting demand for the Company’s products such as thetiming of new product introductions by us and by our competitors and ourcustomers’ political and budgetary constraints. Due to

 

11

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suchfluctuations, 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 develop software used to create booking andinvestigative software, smart and secure identification systems and documents,and software for professional photographers. Our software systems andassociated hardware enable our customers to quickly capture, archive, search,retrieve and share digital photographs and associated text records.

 

**RESULTS OFOPERATIONS**

 

***THREE MONTHS ENDED MARCH 31, 2003 AND 2002.***

 
|                                              |   | **THREE MONTHS  ENDED  MARCH 31,** |   |     |   |            |   |
|---------------------------------------------------|--------|------------------------------------|--------|----------|--------|-----------------|--------|
| **Net  Product Revenues  (dollars in thousands)** |   | **2003**                           |   | **2002** |   | **$****Change** |   | **% Change** |   |
|                                              |   |                               |   |     |   |            |   |   |   |
| **Product revenues:**                             |   |                               |   |     |   |            |   |   |   |
| Law Enforcement                                   |   | $                                  | 204    |     | $      | 513             |   | $ | (309 | ) | -60 | % |
| Percentage of total net product revenue           |   | 8                                  | %      | 17       | %      |            |   |   |   |
| Identification                                    |   | $                                  | 2,169  |     | $      | 2,198           |   | $ | (29 | ) | -1 | % |
| Percentage of total net product revenue           |   | 82                                 | %      | 73       | %      |            |   |   |   |
| Digital Photography                               |   | $                                  | 261    |     | $      | 285             |   | $ | (24 | ) | -8 | % |
| Percentage of total net product revenue           |   | 10                                 | %      | 10       | %      |            |   |   |   |
| Total net product revenues                        |   | $                                  | 2,634  |     | $      | 2,996           |   | $ | (362 | ) | -12 | % |

 

Product revenues decreased12% from $2,996,000 for the three months ended March  31, 2002 to $2,634,000 for the corresponding period in 2003.Revenues related to law enforcement systems and software decreased $309,000 forthe three months ended March 31, 2003 as compared to the corresponding periodin 2002. We believe that the decrease in law enforcement product revenues isreflective of a decrease in government procurement. We believe that theincrease in terrorism has created heightened interest in the ability of lawenforcement and other government agencies to be able to efficiently retrieve,analyze and share information from their respective criminal databases.  We anticipate that these factors willincrease overall demand for the Company’s law enforcement products, however, wecannot predict the timing of the shift in demand.

 

Identification productrevenues decreased 1% from $2,198,000 for the three months ended March 31, 2002to $2,169,000 for the corresponding period in 2003.  We believe that government agencies and private entities willreact to the increased terrorism by re-evaluating and upgrading their ability topositively identify and track their employees, consultants and visitors. Weanticipate that these factors will increase overall demand for the Company’sidentification  products, however, wecannot predict the timing of the shift in demand.

 

12

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Digital Photography productrevenues decreased 8% from $285,000 for the three months ended March 31, 2002to $261,000 for the corresponding period in 2003.  This decrease is reflective of our decision to sell software onlysolutions beginning late in the first quarter of 2002.  The three months ended March 31, 2002contains both software and hardware products as compared to our selling ofsoftware only during the three months ended March 31, 2003.

 

Our backlog of productorders as of March 31, 2003 was approximately $1,416,000.

 
|                                              |   | **THREE MONTHS  ENDED  MARCH 31,** |   |     |   |      |             |
|---------------------------------------------------|--------|------------------------------------|--------|----------|--------|-----------|------------------|
| **Maintenance  Revenues  (dollars in thousands)** |   | **2003**                           |   | **2002** |   | **$**     | ** Change** |   | **% Change** |   |
|                                              |   |                               |   |     |   |      |             |   |   |
| **Maintenance revenues:**                         |   |                               |   |     |   |      |             |   |   |   |
| Law Enforcement                                   |   | $                                  | 587    |     | $      |  508 |             | $ |  79 |   | 16 | % |
| Percentage of total net maintenance revenue       |   | 74                                 | %      | 76       | %      |      |             |   |   |
| Identification                                    |   | $                                  | 211    |     | $      | 152       |             | $ | 59 |   | 39 | % |
| Percentage of total net maintenance revenue       |   | 26                                 | %      | 23       | %      |      |             |   |   |
| Digital Photography                               |   | $                                  | — |     | $      | 12        |             | $ | (12 | ) | -100 | % |
| Percentage of total net maintenance revenue       |   | 0                                  | %      | 2        | %      |      |             |   |   |
| Total net maintenance revenues                    |   | $                                  | 798    |     | $      | 672       |             | $ | 126 |   | 19 | % |

 

Maintenance revenuesincreased 19% from $672,000 for the three months ended March 31, 2002 to$798,000 for the corresponding period in 2003. This increase is due to theexpansion of our installed base of both law enforcement and identificationsystems.  Law enforcement maintenancerevenues increased 16% or $79,000 for the three months ended March 31, 2003from $508,000 for the three months ended March 31, 2002 to $587,000 for thecorresponding period in 2003. This increase is due primarily to the expansionof our installed base of law enforcement systems.

 

Identification maintenancerevenues increased 39% or $59,000 for the three months ended March 31, 2003from $152,000 for the three months ended March 31, 2002 to $211,000 for thecorresponding period in 2003. This increase is due primarily to the expansionof our installed base of identification systems.

 
|                                                   |   | **THREE MONTHS  ENDED  MARCH 31,** |      |     |   |      |             |
|--------------------------------------------------------|--------|------------------------------------|-----------|----------|--------|-----------|------------------|
| **Cost of  Product Revenues:  (dollars in thousands)** |   | **2003**                           |      | **2002** |   | **$**     | ** Change** |   | **% Change** |   |
|                                                   |   |                               |      |     |   |      |             |   |   |
| **Cost of Product Revenues:**                          |   |                               |      |     |   |      |             |   |   |
| Law Enforcement                                        |   | $                                  |  165 |     | $      |  105 |             | $ |  60 |   | 57 | % |
| Percentage of Law Enforcement product  revenue         |   | 81                                 | %         | 21       | %      |      |             |   |   |
| Identification                                         |   | $                                  | 1,057     |     | $      | 1,056     |             | $ | 1 |   | 0 | % |
| Percentage of Identification product  revenue          |   | 49                                 | %         | 48       | %      |      |             |   |   |
| Digital Photography                                    |   | $                                  | 16        |     | $      | 116       |             | $ | (100 | ) | -86 | % |
| Percentage of Digital Photography product  revenue     |   | 6                                  | %         | 41       | %      |      |             |   |   |
| Total net product revenues                             |   | $                                  | 1,238     |     | $      | 1,277     |             | $ | (39 | )  | -3 | % |
| Percentage of total product revenues                   |   |                               | 47        | %        |   | 43        | %                |   |   |   |   |   |

 

13

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Cost of product revenues asa percentage of product revenues increased from 43% for the three month periodended March 31, 2002 to 47% of product revenues for the corresponding period in2003. This increase is due primarily to higher sales of hardware and relatedprint media consumables resulting in higher cost of sales as a percentage ofproduct revenues. Cost of product revenues for our Law Enforcement segment increased57%, or $60,000 from $105,000 or 21% of Law Enforcement product revenues forthe three months ended March 31, 2002 to $165,000, or 81% of product revenuesfor the corresponding period in 2003. This increase is due primarily to the smaller revenue base to absorbfixed product costs.  Costs of productsalso can vary as a percentage of product revenue from period to perioddepending upon product mix and the hardware content, print media consumablecontent and software content included in systems installed during a givenperiod.

 

Cost of product revenuesrelated to our Digital Photography segment decreased 86% from $116,000, or  41% of Digital Photography revenues for thethree month period ended March 31, 2002 to $16,000 or 6% of Digital Photographyrevenues for the corresponding period in 2003. This decrease of $100,000 is reflective of our decision to sell softwareonly solutions beginning late in the first quarter of 2002 as compared to ourselling of software only solution for the entire three month period in 2003.

 
|                                                   |   | **THREE MONTHS  ENDED  MARCH 31,** |      |     |   |      |             |
|--------------------------------------------------------|--------|------------------------------------|-----------|----------|--------|-----------|------------------|
| **Maintenance  cost of revenues**                      |   | **2003**                           |      | **2002** |   | **$**     | ** Change** |   | **% Change** |   |
|                                                   |   |                               |      |     |   |      |             |   |   |
| **Maintenance cost of  revenues:**                     |   |                               |      |     |   |      |             |   |   |
| Law Enforcement                                        |   | $                                  |  223 |     | $      |  184 |             | $ |  39 |   | 21 | % |
| Percentage of Law Enforcement maintenance  revenue     |   | 38                                 | %         | 36       | %      |      |             |   |   |
| Identification                                         |   | $                                  | 132       |     | $      | 96        |             | $ | 36 |   | 38 | % |
| Percentage of Identification maintenance  revenue      |   | 63                                 | %         | 63       | %      |      |             |   |   |
| Digital Photography                                    |   | $                                  | —    |     | $      | —    |             | $ | — |   | N/A |   |
| Percentage of Digital Photography  maintenance revenue |   |                               | %         |     | %      |      |             |   |   |
| Total net maintenance revenues                         |   | $                                  | 355       |     | $      | 280       |             | $ | 75 |   | 27 | % |
| Percentage of total maintenance revenues               |   |                               | 44        | %        |   | 42        | %                |   |   |   |   |   |

 

Costs of maintenancerevenues increased 27% from $280,000, or 42% of maintenance revenues, for thethree months ended March 31, 2002 to $355,000, or 44% of maintenance revenues,for the corresponding period in 2003. Cost of maintenance revenues in LawEnforcement increased 21%, from $184,000 or 36% of maintenance revenues for thethree months ended March 31, 2002 to $223,000 or 38% of  maintenance revenues for the correspondingperiod in 2003. This increase in costs of maintenance revenues is due primarilyto higher costs necessary to service the expanding installed base.Identification maintenance cost of revenues increased $36,000 but remainedconstant at 63% of identification maintenance revenues for the three monthsended March 31, 2003 and 2002.

 

14

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|                                               |   | **THREE MONTHS  ENDED  MARCH 31,** |     |     |   |      |             |
|----------------------------------------------------|--------|------------------------------------|----------|----------|--------|-----------|------------------|
| **Product  gross profit  (dollars in thousands)**  |   | **2003**                           |     | **2002** |   | **$**     | ** Change** |   | **% Change** |   |
|                                               |   |                               |     |     |   |      |             |   |   |
| **Product gross profit**                           |   |                               |     |     |   |      |             |   |   |
| Law Enforcement                                    |   | $                                  |  39 |     | $      |  407 |             | $ |  (368 | )  | -90 | % |
| Percentage of Law Enforcement product  revenue     |   | 19                                 | %        | 79       | %      |      |             |   |   |
| Identification                                     |   | $                                  | 1,112    |     | $      | 1,142     |             | $ | (30 | )  | -3 | % |
| Percentage of Identification product  revenue      |   | 51                                 | %        | 52       | %      |      |             |   |   |
| Digital Photography                                |   | $                                  | 246      |     | $      | 169       |             | $ | 77 |   | 45 | % |
| Percentage of Digital Photography product  revenue |   | 94                                 | %        | 59       | %      |      |             |   |   |
| Total net product revenues                         |   | $                                  | 1,397    |     | $      | 1,718     |             | $ | (321 | )  | -19 | % |
| Percentage of total product revenues               |   |                               | 53       | %        |   | 57        | %                |   |   |   |   |   |

 

Total product gross marginsas a percentage of product revenues decreased from 57% for the three monthperiod ended March  31, 2002 to 53% ofproduct revenues for the corresponding period in 2003. The overall decrease isprimarily due to a higher percentage of total revenues coming from the sales ofhardware and print media consumables.

 

Law Enforcement gross profitas a percentage of Law Enforcement product revenue decreased from 79% for thethree months ended March 31, 2002 to 19% for the corresponding period of 2003.This decrease is due primarily to our product mix containing higher percentagesof hardware and print media consumables than the comparable period in 2002, aswell as a lower revenue base to absorb fixed product costs.  Costs of products can vary as a percentageof product revenue from quarter to quarter depending upon product mix andhardware content and print media consumable content included in systemsinstalled during a given period.

 

Gross margins for theDigital Photography product segment increased 45% or $77,000, from $169,000 or59% of Digital Photography product revenues for the three months ended March31, 2002 to $246,000, or 94% of Digital Photography revenues for thecorresponding period in 2003. This increase of $76,000 is reflective of ourdecision to sell software only solutions beginning late in the first quarter of2002 as compared to our selling of software only solution for the entire threemonth period in 2003.

 
|                                                   |   | **THREE MONTHS  ENDED  MARCH 31,** |      |     |   |      |             |
|--------------------------------------------------------|--------|------------------------------------|-----------|----------|--------|-----------|------------------|
| **Maintenance  gross profit  (dollars in thousands)**  |   | **2003**                           |      | **2002** |   | **$**     | ** Change** |   | **% Change** |   |
|                                                   |   |                               |      |     |   |      |             |   |   |
| **Maintenance gross profit**                           |   |                               |      |     |   |      |             |   |   |
| Law Enforcement                                        |   | $                                  |  364 |     | $      |  324 |             | $ |  40 |   | 12 | % |
| Percentage of Law Enforcement maintenance  revenue     |   | 62                                 | %         | 64       | %      |      |             |   |   |
| Identification                                         |   | $                                  | 79        |     | $      | 56        |             | $ | 23 |   | 41 | % |
| Percentage of Identification maintenance  revenue      |   | 37                                 | %         | 37       | %      |      |             |   |   |
| Digital Photography                                    |   | $                                  | —    |     | $      | 12        |             | $ | (12 | ) | 100 | % |
| Percentage of Digital Photography  maintenance revenue |   | N/A                                | %         | 100      | %      |      |             |   |   |
| Total net maintenance revenues                         |   | $                                  | 443       |     | $      | 392       |             | $ | 51 |   | 13 | % |
| Percentage of total maintenance revenues               |   |                               | 56        | %        |   | 58        | %                |   |   |   |   |   |

 

Gross margins related tomaintenance revenues increased $51,000 from $392,000, or 58% of maintenancerevenues for the three months ended March 31, 2002 to $443,000, or 56% ofmaintenance revenues for the corresponding period in 2003. This percentagedecrease is due primarily to increased costs resulting from our expandinginstalled base.

 

15

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|                                              |   | **THREE MONTHS  ENDED  MARCH 31,** |       |     |       |            |       |
|---------------------------------------------------|--------|------------------------------------|------------|----------|------------|-----------------|------------|
| **Operating expenses****(dollars  in thousands)** |   | **2003**                           |       | **2002** |       | **$****Change** |       | **%****Change** |   |
|                                              |   |                               | ** ** |     | ** ** |            | ** ** |   | ** ** |
| General & administrative                      |   | $                                  | 1,442      |     | $          | 1,741           |       | $ | (299 | ) | -17 | % |
| Percentage of total net revenue                   |   | 42                                 | %          | 47       | %          |            |       |   |   |
| Sales and marketing                               |   | $                                  | 1,089      |     | $          | 1,141           |       | $ | (52 | ) | -5 | % |
| Percentage of total net revenue                   |   | 32                                 | %          | 31       | %          |            |       |   |   |
| Research & development                        |   | $                                  | 494        |     | $          | 516             |       | $ | (22 | ) | -4 | % |
| Percentage of total net revenue                   |   | 14                                 | %          | 14       | %          |            |       |   |   |
| Depreciation and amortization                     |   | $                                  | 235        |     | $          | 218             |       | $ | 17 |   | 8 | % |
| Percentage of total net revenue                   |   | 7                                  | %          | 6        | %          |            |       |   |   |

 

*GENERAL AND ADMINISTRATIVE EXPENSES.* General and administrative expenses are comprised primarily of salariesand other employee-related costs for executive, financial, and otherinfrastructure personnel. General legal, accounting and consulting services,insurance, occupancy and communication costs are also included with general andadministrative expenses. Such expenses decreased 17%, or $299,000 from$1,741,000 for the three months ended March 31, 2002 to $1,442,000 for thecorresponding period in 2003.  Suchexpenses, as a percentage of total net revenues, decreased from  47% for the three months ended March 31,2002 to 42% for the corresponding period in 2003.  We are continuing to focus our efforts on achieving additionalfuture operating efficiencies by reviewing and improving upon existing businessprocesses and evaluating our cost structure. We believe these efforts willallow us to gradually decrease our level of general and administrative expensesexpressed as a percentage of total revenues.

 

*SALES AND MARKETING.* Sales and marketing expenses consist primarily of the salaries,commissions, other incentive compensation, employee benefits and travelexpenses of our sales force. Such expenses decreased 5%, or $52,000 from$1,141,000 for the three months ended March 31, 2002 to $1,089,000 for thecorresponding period in 2003.  Suchexpenses, as a percentage of total net revenues, increased from 31% for thethree months ended March 31, 2002 to 32% for the corresponding period in2003.  The decrease of $52,000 is dueprimarily to reduced headcount.

 

*RESEARCH AND DEVELOPMENT.* Research and development costs consist primarily of salaries, employeebenefits and outside contractors for new product development, product enhancementsand custom integration work. Such expenses decreased 4% or $22,000 from$516,000  for the three months endedMarch 31, 2002 to $494,000 for the corresponding period in 2003.  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 increased $17,000 from $218,000 for thethree months ended March 31, 2002 to $235,000 for the corresponding period in2003. This increase is due primarily to higher amortization of intangibleassets.

 

*INTEREST EXPENSE, NET.*  Forthe three months ended March 31, 2003, we recognized interest income of $1,000and interest expense of $362,000. For the three months ended March 31, 2002, werecognized interest income of $8,000 and interest expense of $12,000.  Interest expense in the three months endedMarch 31, 2003 increased due to our issuance of senior secured and subordinatedconvertible promissory notes payable, short-term demand notes payable  and short-term borrowings under bankinglines of credit.  Interest expense forthe three months ended March 31, 2003 also includes approximately of $156,000of debt discount and deferred financing fee amortization classified  as interest expense.

 

16

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*LIQUIDITY AND CAPITAL RESOURCES*

 

As of March 31, 2003, we had total current assets of $4,681,000 andtotal current liabilities of $6,672,000, or negative working capital of $1,991,000. At March 31, 2003, we hadavailable cash of $428,000 and $60,000 in restricted cash securing our SanDiego, California facility lease.

 

Net cash used in operating activities was $259,000 for the three monthperiod ended March 31, 2003 as compared to $6,000 for the corresponding periodin 2002. We used cash to fund net losses of $1,240,000, excluding non-cashexpenses (depreciation and amortization) of $461,000 for the three months endedMarch 31, 2003.  We used cash to fundnet losses of $1,271,000 , excluding non-cash expenses (depreciation andamortization) of 218,000 for the corresponding period in 2002. For the threemonths ended March 31, 2003, we generated cash of $1,383,000 from reductions incurrent assets and used  cash of$402,000 for reductions in current liabilities, excluding debt. In 2002, weused cash of generated $1,737,000 to fund increases in current assets and usedcash of $472,000 from reductions in current liabilities and deferred revenues,excluding debt.

 

Net cash used by investing activities was $84,000 for the three monthsended March 31, 2003 as compared to $133,000 for the corresponding period in2002. For the three months ended March 31, 2003, we used cash to fund capitalexpenditures of computer equipment and software, furniture and fixtures andleasehold improvements of approximately $76,000. The level of equipment purchasesresulted primarily from continued growth of the business and replacement ofolder equipment. For the three months ended March 31, 2003, we  used cash of approximately $8,000 to repayadvances from related stockholders. For the three months ended March 31, 2002,we used cash of $88,000 to fund capital expenditures of computer equipment,software, furniture and fixtures. We used cash of $45,000 to repay advancesfrom related stockholders.

 

Net cash provided by financing activities was $524,000 for the threemonth period ended March 31, 2003 as compared to net cash used by financingactivities of $5,000 for the corresponding period in 2002. For the three monthsended March 31, 2003, we generated cash of $600,000 from our issuance ofsubordinated convertible promissory notes payable offset by $60,000 in debtissuance costs.  We also used cash of$158,000 to fund increases in capitalized financing fees.  We also generated cash of $142,000 fromshort-term borrowings under bank line of credit agreements. For thecorresponding period in 2002, we used cash of $5,000 for the repayment ofcapital lease obligations.

 

We conduct operations in leased facilitiesunder operating leases expiring at various dates through 2006. Additionally, wehave acquired certain equipment under capital leases which expire at variousdates through 2006. In conjunction with our San Diego, California leasedfacility, we are contingently liable under an irrevocable letter of credit inthe amount of $30,000. The letter of credit expires July 31, 2003 providedthere are no drawings against the outstanding balance. We also have variousshort-term notes payable and capital lease obligations due at various timesduring the next twelve months.

 

The report of the Company’s independent accountants included with ourmost recent Annual Report filed on Form 10-KSB on April 15, 2003 includes anexplanatory paragraph as to the uncertainty that the Company will continue as agoing concern. The Company is seeking additional financing that we believe is necessaryto fund our working capital requirements for at least the next twelve months,assuming the successful implementation of our

 

17

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business plan. Our businessplan includes, among other things, significant increases in revenues in futureperiods, the monitoring and controlling of operating expenses, collection ofsignificant trade and other accounts receivables, and controlling of capitalexpenditures. If we are unable to secure additional financing or successfullyimplement our business plan, we will be required to seek funding from alternatesources and/or institute significant cost reduction plans. We may seek to sellequity or debt securities, secure a bank line of credit, or consider strategicalliances. The sale of equity or equity related securities could result inadditional dilution to our shareholders. There can be no assurance thatadditional financing, in any form, will be available at all or, if available,will be on terms acceptable to the Company. In addition, our ability to raiseadditional capital may be dependent upon the Company’s Common Stock beingquoted on the American Stock Exchange. There can be no assurance that theCompany will be able to satisfy the criteria for continued listing on theAmerican Stock Exchange. Insufficient funds may require us to delay, scale backor eliminate some or all of our activities, and if we are unable to obtainadditional funding there is substantial doubt about our ability to continue asa going concern.

 

 

**RISK FACTORS**

 

**WE CURRENTLY HAVE LIMITED CASH RESOURCES ANDNEED ADDITIONAL FUNDING TO FINANCE OUR WORKING CAPITAL REQUIREMENTS DURING THENEXT TWELVE MONTHS.**

 

We currently require financingto fund our anticipated working capital requirements during the next twelvemonths. We anticipate that our existing resources will not be sufficient toenable us to maintain our current and planned operations for the next twelvemonths and the report of our independent accountants included with our mostrecent report on Form 10-KSB includes an explanatory paragraph regarding ourability to continue as a going concern. We are seeking additional fundingthrough public or private equity or debt financing. There can be no assurancethat additional financing will be available on acceptable terms, or at all. Ifwe are required to sell equity to raise additional funds, our existingshareholders may incur substantial dilution and any shares so issued may haverights, preferences and privileges superior to the rights, preferences andprivileges of our outstanding Common Stock. Also, we may be required to obtainfunds through arrangements with third parties that require us to relinquishrights to certain of our technologies or products that we would seek to developor commercialize ourselves. In addition, our ability to raise additionalcapital may be dependent upon the Company’s Common Stock being listed on theAmerican Stock Exchange. We cannot guarantee that the Company will be able tosatisfy the criteria for continued listing on the American Stock Exchange.

 

**WE HAVE A HISTORY OF SIGNIFICANT RECURRINGLOSSES TOTALLING APPROXIMATELY $37.0 MILLION, AND THESE LOSSES MAY CONTINUE INTHE FUTURE.**

 

As of March 31, 2003, we had anaccumulated deficit of $37.0 million, and these losses may continue in thefuture. We may need to raise capital to cover these losses, and financing maynot be available to us on favorable terms. We expect to continue to incursignificant sales and marketing, research and development, and general andadministrative expenses. As a result, we will need to generate significantrevenues to achieve profitability and may never achieve profitability.

 

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

 

Our Board of Directors has theauthority to issue a total of up to 4,000,000 shares of preferred stock and tofix the rights, preferences, privileges, and restrictions, including votingrights, of the preferred stock, which typically are

 

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senior to the rights of thecommon shareholders, without any further vote or action by you and the othercommon shareholders. Your rights will be subject to, and may be adverselyaffected by, the rights of the holders of the preferred stock that have beenissued, or might be issued in the future. Preferred stock also could have theeffect of making it more difficult for a third party to acquire a majority ofthe outstanding voting stock of ImageWare. This could delay, defer, or preventa change in control. Furthermore, holders of preferred stock may have otherrights, including economic rights, senior to the common stock. As a result,their existence and issuance could have a material adverse effect on the marketvalue of the common stock. We have in the past issued, and, may from time totime in the future issue, preferred stock for financing or other purposes withrights, preferences, or privileges senior to the common stock.

 

The provisions of ouroutstanding Series B Preferred Stock prohibit the payment of dividends onthe common stock unless the dividends on those preferred shares are first paid.In addition, upon a liquidation, dissolution or sale of ImageWare’s business,the holders of the Series B Preferred Stock will be entitled to receive,in preference to any distribution to the holders of common stock, initial distributionsof $2.50 per share, plus all accrued but unpaid dividends.

 

Pursuant to the terms of ourSeries B Preferred Stock we are obligated to pay cumulative cash dividends onshares of Series B Preferred Stock from legally available funds at the annualrate of $0.2125 per share, payable in two semi-annual installments of $0.10625each, which cumulative dividends must be paid prior to payment of any dividendon our Common Stock.  As of March 31,2003, the Company had cumulative undeclared dividends of $162,000.

 

**WE DEPEND UPON ASMALL NUMBER OF LARGE SYSTEM SALES COSTING FROM $300,000 TO $600,000, AND WEMAY FAIL TO ACHIEVE ONE OR MORE LARGE SYSTEM SALES IN THE FUTURE.**

 

In the past three years we havederived a substantial portion of our revenues from a small number of sales oflarge, relatively expensive systems, typically ranging in price from $300,000to $600,000. As a result, if we fail to receive orders for these large systemsin a given sales cycle on a consistent basis, our business could be significantlyharmed. Further, our quarterly results are difficult to predict because wecannot predict in which quarter, if any, large system sales will occur in agiven year. As a result, we believe that quarter-to-quarter comparisons of ourresults of operations are not a good indication of our future performance. Insome future quarters our operating results may be below the expectations ofsecurities analysts and investors, in which case the market price of our commonstock may decrease significantly.

 

 

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

 

When considering the purchase ofa large computerized booking or identification system, a government agency maytake as long as a year to evaluate different systems and obtain approval forthe purchase. If we fail to complete a sale, we will have expended significantresources and received no revenue in return. Generally, agencies consider awide range of issues before committing to purchase our products, includingproduct benefits, ability to operate with their current systems, productreliability and their own budgetary constraints. While potential customers areevaluating our products and before they place an order with us, we may incursubstantial selling costs and expend significant management effort toaccomplish a sale.

 

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

 

A significant number of ourcustomers are government agencies. These agencies often do not set their ownbudgets and therefore have little control over the amount of money they canspend. In addition, these agencies experience political pressure that maydictate the manner in which they spend money. Due to political and budgetaryprocesses and other scheduling delays that may frequently occur relating to thecontract or bidding process, some

 

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government agency orders may becanceled or substantially delayed, and the receipt of revenues or payments maybe substantially delayed. In addition, future sales to government agencies willdepend on our ability to meet government contracting requirements, certain ofwhich may be onerous or impossible to meet, resulting in our inability toobtain a particular contract. Common requirements in government contractsinclude bonding requirements, provisions permitting the purchasing agency tomodify or terminate at will the contract without penalty, and provisionspermitting the agency to perform investigations or audits of our businesspractices.

 

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

 

We believe our future successdepends in part on our ability to develop and market our technology forapplications other than booking systems for the law enforcement market. If wefail in these goals, our business strategy and ability to generate revenues andcash flow would be significantly impaired. We intend to expend significantresources to develop new technology, but the successful development of new technologycannot be predicted and we cannot guarantee we will succeed in these goals.

 

**WE OCCASIONALLY RELYON SYSTEMS INTEGRATORS TO MANAGE OUR LARGE PROJECTS, AND IF THESE COMPANIES DONOT PERFORM ADEQUATELY, WE MAY LOSE BUSINESS.**

 

We are occasionally a subcontractorto systems integrators who manage large projects that incorporate our systems,particularly in foreign countries. We cannot control these companies, and theymay decide not to promote our products, or they may price their services insuch a way as to make it unprofitable for us to continue our relationship withthem. Further, they may fail to perform under agreements with their customers,in which case we might lose sales to these customers. If we lose ourrelationships with these companies, our business may suffer.

 

**WE RELY ON A LICENSE OF TECHNOLOGY FROMIDENTIX, INC., AND THIS LICENSE MAY BE TERMINATED IN THE FUTURE.**

 

We depend on a licensingarrangement with Identix for technology related to the search engine used inour systems. Our current licensing arrangement with Identix terminatesOctober 1, 2003. If Identix becomes unable or unwilling to continue tolicense us this technology or to renew the terms of this license, we will haveto identify or develop acceptable alternative sources of this technology, whichcould take up to three months or longer. Any significant interruption in ourability to identify and contract with alternative providers of similartechnology or to develop our own search engine would result in delivery delays,which could harm our customer relationships and our business and reputation.

 

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

 

Our business is based in largepart on our technology, and our success depends in part on our ability andefforts to protect our intellectual property rights. If we do not adequatelyprotect our intellectual property through copyrights and various trade secretprotections afforded to us by law, our business will be seriously harmed. We donot have patent protection for our products.

 

We license certain elements ofour trademarks, trade dress, copyright and other intellectual property to thirdparties. We attempt to ensure that our rights in our trade names and the qualityof third party uses of our names are maintained by these third parties.However, these third parties may take actions that could significantly impairthe value of our intellectual property and our reputation and goodwill.

 

In addition, internationalintellectual property laws differ from country to country. Any foreign rightswe have in our technology are limited by what has been afforded to us under theapplicable foreign intellectual property laws. Also, under the laws of certainforeign jurisdictions, in order to have recognizable intellectual propertyrights, we may be required to file applications with various foreign agenciesor officials to register our intellectual property. Accordingly, our ability tooperate and exploit our technology overseas could be significantly hindered.

 

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**WE HAVE ACQUIRED SEVERAL BUSINESSES AND FACERISKS ASSOCIATED WITH INTEGRATING THESE BUSINESSES AND POTENTIAL FUTUREBUSINESSES THAT WE MAY ACQUIRE.**

 

We completed the acquisitions ofImaging Technology Corporation (“ITC”), Goddard Technology Corporation(“Goddard”), G & A Imaging, Ltd. (“G & A”), CastleworksLLC (“Castleworks”) and E-Focus West LLC (“E-Focus”). We plan to continue toreview potential acquisition candidates, and our business and our strategyincludes building our business through acquisitions. However, acceptableacquisition candidates may not be available in the future or may not beavailable on terms and conditions acceptable to us.

 

Acquisitions involve numerousrisks, including among others, difficulties and expenses incurred in theconsummation of acquisitions and assimilation of the operations, personnel andservices and products of the acquired companies. Additional risks associatedwith acquisitions include the difficulties of operating new businesses, thediversion of management’s attention from other business concerns and thepotential loss of key employees of the acquired company. If we do notsuccessfully integrate the businesses we may acquire in the future, ourbusiness will suffer.

 

**WE OPERATE IN FOREIGNCOUNTRIES AND ARE EXPOSED TO RISKS ASSOCIATED WITH FOREIGN POLITICAL, ECONOMICAND LEGAL ENVIRONMENTS AND WITH FOREIGN CURRENCY EXCHANGE RATES.**

 

With our acquisition ofG & A, we have significant foreign operations and are accordinglyexposed to risks, including among others, risks associated with foreignpolitical, economic and legal environments and with foreign currency exchangerates. Our results may be adversely affected by, among other things, changes ingovernment policies with respect to laws and regulations, anti-inflationmeasures, currency conversions, remittance abroad and rates and methods oftaxation.

 

**Item3.  Controls and Procedures**

 

*Evaluation of disclosure controls and procedures. *ImageWare’s chiefexecutive officer and its chief financial officer, after evaluating theeffectiveness of ImageWare’s disclosure controls and procedures (as defined inExchange Act Rule 13a-14) as of a date within 90 days of the filing date ofthis quarterly report on Form 10-QSB (the “Evaluation Date”), have concludedthat as of such date, ImageWare’s disclosure controls and procedures wereadequate and sufficient to ensure that information required to be disclosed byImageWare in the reports that it files under the Securities Exchange Act of1934 is recorded, processed, summarized and reported within the time periodspecified in the Commission’s rules and forms.

 

*Changes in internal controls. *Therehave been no significant changes in ImageWare’s internal controls since theEvaluation Date.  ImageWare is not awareof any significant change in any other factor that could significantly affectits internal controls subsequent to the Evaluation Date.

 

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**PART II**

**ITEM2. CHANGES IN SECURITIES**

 

**Issuance of Convertible SubordinatedPromissory Notes**

 

On March 13, 2003, we issued to certain accredited investorsConvertible Subordinated Promissory Notes, each in the formattached hereto as Exhibit 10.1 (the ***“Subordinated******Notes”***).  The Subordinated Notes have an aggregate principal amount of $600,000, bear an interest rateof 8.5% (payable semi-annually in arrears), have a maturity date of April 15,2005 and are convertible into shares of our Common Stock at a conversion priceof $1.90 per share.  We may prepay theSubordinated Notes at any time, without penalty, upon five (5) business daysnotice to the holders of the Subordinated Notes.   For this sale and issuance of Subordinated Notes we relied onthe exemption from registration under Section 4(2) of the Securities Act.

 

**Securitiesto be Registered**

 

Pursuant to the RegistrationRights Agreement in the form attached hereto as Exhibit 10.2, we haveagreed, subject to certain conditions, to prepare and file with the Securitiesand Exchange Commission registration statements covering the shares of commonstock issuable upon conversion of the Subordinated Notes.

 

**ITEM 3.DEFAULTS UPON SENIOR SECURITIES**

 

In May 2002,the Company issued a senior secured convertible promissory notefor $2,000,000, due May 22, 2004.  InSeptember 2002, the Company issued to the holder of the May 2004 note a secureddemand promissory note for $500,000, payable upon demand of the holder.  The obligations represented by these notesare secured by substantially all of the assets of the Company and itssubsidiaries, and require that interest be paid quarterly in arrears.  The Company and the holder of these notesagreed to temporarily defer the interest payments otherwise due in October2002, January 2003 and April 2003 until the Company concluded its activitieswith respect to a possible financing. As a result, these three interest payments have not yet been made.   The holder of these notes has not declaredthe existence of an event of default under the notes.

 

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

 

**(a)****                                 ****EXHIBITS**

 

10.1                           Form of Convertible Subordinated PromissoryNote

10.2                           Registration Rights Agreement, dated March13, 2003

99.1                           Certificationby Chief Executive Officer and Chief Financial Officer pursuant to Section 906of the Sarbanes-Oxley Act

 

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**SIGNATURES**

 

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

 
|                | IMAGEWARE  SYSTEMS, INC. |
|---------------------|--------------------------|
|                |                     |   |
|                |                     |   |
| Date:  May 15, 2003 | 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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** **

**CERTIFICATION**

 

I, S. James Miller, the ChiefExecutive Officer of ImageWare Systems, Inc., certify that:

 

1.                                       Ihave reviewed this quarterly report on Form 10-QSB of ImageWare Systems, Inc.;

 

2.                                       Basedon my knowledge, this quarterly report does not contain any untrue statement ofa material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements weremade, not misleading with respect to the period covered by this quarterlyreport;

 

3.                                       Basedon my knowledge, the financial statements, and other financial informationincluded in this quarterly report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant asof, and for, the periods presented in this quarterly report;

 

4.                                       Theregistrant’s other certifying officer and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and have:

 

(a)                                  designedsuch disclosure controls and procedures to ensure that material informationrelating to the registrant, including its consolidated subsidiaries, is madeknown to us by others within those entities, particularly during the period inwhich this quarterly report is being prepared;

 

(b)                                 evaluatedthe effectiveness of the registrant’s disclosure controls and procedures as ofa date within 90 days prior to the filing date of this quarterly report (the“Evaluation Date”); and

 

(c)                                  presentedin this quarterly report, our conclusions about the effectiveness of thedisclosure controls and procedures based on our evaluation as of the EvaluationDate;

 

5.                                       Theregistrant’s other certifying officer and I have disclosed, based on our mostrecent evaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunctions):

 

(a)                                  allsignificant deficiencies in the design or operation of internal controls whichcould adversely affect the registrant’s ability to record, process, summarizeand report financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

(b)                                 anyfraud, whether or not material, that involves management or other employees whohave a significant role in the registrant’s internal controls; and

 

6.                                       Theregistrant’s other certifying officer and I have indicated in this quarterlyreport whether there were significant changes in internal controls or in otherfactors that could significantly affect internal controls subsequent to thedate of our most recent evaluation, including any corrective actions withregard to significant deficiencies and material weaknesses.

 
| Dated: | May 15, 2003 |                     | /s/ S. James  Miller |   |
|--------|--------------|--------------------------|----------------------|--------|
|   |         | S. James  Miller         |                 |
|   |         | Chief  Executive Officer |                 |

 

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** **

**CERTIFICATION**

 

I, Wayne G. Wetherell, the Chief Financial Officer of ImageWareSystems, Inc., certify that:

 

1.                                       Ihave reviewed this quarterly report on Form 10-QSB of ImageWare Systems, Inc.;

 

2.                                       Basedon my knowledge, this quarterly report does not contain any untrue statement ofa material fact or omit to state a material fact necessary to make thestatements made, in light of the circumstances under which such statements weremade, not misleading with respect to the period covered by this quarterlyreport;

 

3.                                       Basedon my knowledge, the financial statements, and other financial informationincluded in this quarterly report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant asof, and for, the periods presented in this quarterly report;

 

4.                                       Theregistrant’s other certifying officer and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and have:

 

(a)                                  designedsuch disclosure controls and procedures to ensure that material informationrelating to the registrant, including its consolidated subsidiaries, is madeknown to us by others within those entities, particularly during the period inwhich this quarterly report is being prepared;

 

(b)                                 evaluatedthe effectiveness of the registrant’s disclosure controls and procedures as ofa date within 90 days prior to the filing date of this quarterly report (the“Evaluation Date”); and

 

(c)                                  presentedin this quarterly report, our conclusions about the effectiveness of thedisclosure controls and procedures based on our evaluation as of the EvaluationDate;

 

5)                                      Theregistrant’s other certifying officer and I have disclosed, based on our mostrecent evaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (or persons performing the equivalentfunctions):

 

(a)                                  allsignificant deficiencies in the design or operation of internal controls whichcould adversely affect the registrant’s ability to record, process, summarizeand report financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

(b)                                 anyfraud, whether or not material, that involves management or other employees whohave a significant role in the registrant’s internal controls; and

 

6.                                       Theregistrant’s other certifying officer and I have indicated in this quarterlyreport whether there were significant changes in internal controls or in otherfactors that could significantly affect internal controls subsequent to thedate of our most recent evaluation, including any corrective actions withregard to significant deficiencies and material weaknesses.

 
| Dated: | May 15, 2003 |                     | /s/ Wayne G.  Wetherell |   |
|--------|--------------|--------------------------|-------------------------|--------|
|   |         | Wayne G.  Wetherell      |                    |
|   |         | Chief  Financial Officer |                    |

 

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