**U.S. SECURITIES AND EXCHANGECOMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-QSB**

 

**(Mark One)**

 

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

 

**For the transition periodfrom         to         **

 

**Commission file number 001-15757**

 

**IMAGEWARE SYSTEMS, INC.**

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

 

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

 

**10883 Thornmint RoadSan Diego, CA 92127**

(Address of Principal Executive Offices)

 

**(858) 673-8600**

(Issuer’s Telephone Number, Including Area Code)

 

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

 

Statethe number of shares outstanding of each of the issuer’s classes of commonequity, as of the latest practicable date: As of November 10, 2004, thenumber of outstanding shares of the Registrant’s common stock, par value $.01,was 11,974,719.

 

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

 

 

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**IMAGEWARE SYSTEMS, INC. INDEX**

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

 

2

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**PART I**

 

**FINANCIAL INFORMATION**

 

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

 

**IMAGEWARE SYSTEMS, INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(IN THOUSANDS)**

 
| ** **                                                                                                                                                                                                                                                                               | ** ** | **September 30, 2004** | ** ** | **December 31,  2003** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                                                                                                               | ** ** | **(Unaudited)**             | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                                               |       |                        |       |                        |       |
| Current Assets:                                                                                                                                                                                                                                                                          |       |                        |       |                        |       |
| Cash                                                                                                                                                                                                                                                                                     |       | $                           | 2,932      |                        | $          | 578 |   |
| Restricted cash and cash equivalents                                                                                                                                                                                                                                                     |       | 107                         |       | 155                         |       |
| Accounts receivable, net                                                                                                                                                                                                                                                                 |       | 1,387                       |       | 1,450                       |       |
| Inventory                                                                                                                                                                                                                                                                                |       | 1,125                       |       | 805                         |       |
| Other current assets                                                                                                                                                                                                                                                                     |       | 295                         |       | 203                         |       |
| Total Current Assets                                                                                                                                                                                                                                                                     |       | 5,846                       |       | 3,191                       |       |
|                                                                                                                                                                                                                                                                                     |       |                        |       |                        |       |
| Property and equipment, net                                                                                                                                                                                                                                                              |       | 494                         |       | 635                         |       |
| Other assets                                                                                                                                                                                                                                                                             |       | 587                         |       | 570                         |       |
| Intangible assets, net of accumulated  amortization                                                                                                                                                                                                                                      |       | 840                         |       | 1,121                       |       |
| Goodwill                                                                                                                                                                                                                                                                                 |       | 5,298                       |       | 5,298                       |       |
| **Total  Assets**                                                                                                                                                                                                                                                                        | ** ** | **$**                       | **13,065** | ** **                  | **$**      | **10,815** | ** ** |
|                                                                                                                                                                                                                                                                                     |       |                        |       |                        |       |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                                                                                                                                                                            |       |                        |       |                        |       |
|                                                                                                                                                                                                                                                                                     |       |                        |       |                        |       |
| Current Liabilities:                                                                                                                                                                                                                                                                     |       |                        |       |                        |       |
| Accounts payable                                                                                                                                                                                                                                                                         |       | $                           | 849        |                        | $          | 1,053 |   |
| Deferred revenue                                                                                                                                                                                                                                                                         |       | 898                         |       | 848                         |       |
| Accrued expenses                                                                                                                                                                                                                                                                         |       | 1,248                       |       | 1,067                       |       |
| Accrued interest                                                                                                                                                                                                                                                                         |       | 55                          |       | 103                         |       |
| Notes & advances payable to bank and  third parties                                                                                                                                                                                                                                  |       | 135                         |       | 182                         |       |
| Notes payable to related parties                                                                                                                                                                                                                                                         |       | —                      |       | 59                          |       |
| Total Current Liabilities                                                                                                                                                                                                                                                                |       | 3,185                       |       | 3,312                       |       |
|                                                                                                                                                                                                                                                                                     |       |                        |       |                        |       |
| Warrant liability                                                                                                                                                                                                                                                                        |       | —                      |       | 3,460                       |       |
| Pension obligation                                                                                                                                                                                                                                                                       |       | 816                         |       | 732                         |       |
| Total Liabilities                                                                                                                                                                                                                                                                        |       | 4,001                       |       | 7,504                       |       |
|                                                                                                                                                                                                                                                                                     |       |                        |       |                        |       |
| Shareholders’ equity:                                                                                                                                                                                                                                                               |       |                        |       |                        |       |
| Preferred stock, $.01 par value, authorized  4,000,000 shares Series B convertible redeemable preferred stock, designated  750,000 shares, 389,400 shares issued, and 249,400 shares outstanding at September 30,  2004, liquidation preference $623,500 at September 30, 2004 |       | 2                           |       | 2                           |       |
| Common stock, $.01 par value, 50,000,000  shares authorized, 11,981,423 shares issued and 11,974,719 shares outstanding  at September 30, 2004                                                                                                                                      |       | 119                         |       | 98                          |       |
| Additional paid in capital                                                                                                                                                                                                                                                               |       | 63,903                      |       | 49,222                      |       |
| Treasury stock, at cost - 6,704 shares                                                                                                                                                                                                                                                   |       | (64                         | )          | (64                         | )          |
| Shareholder note receivable                                                                                                                                                                                                                                                              |       | (150                        | )          | (150                        | )          |
| Accumulated other comprehensive income                                                                                                                                                                                                                                                   |       | 237                         |       | 265                         |       |
| Accumulated deficit                                                                                                                                                                                                                                                                      |       | (54,983                     | )          | (46,062                     | )          |
| Total shareholders’ equity                                                                                                                                                                                                                                                          |       | 9,064                       |       | 3,311                       |       |
|                                                                                                                                                                                                                                                                                     |       |                        |       |                        |       |
| **Total  Liabilities and Shareholders’ Equity**                                                                                                                                                                                                                                     | ** ** | **$**                       | **13,065** | ** **                  | **$**      | **10,815** | ** ** |

 

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

 

3

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**IMAGEWARE SYSTEMS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

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

**(UNAUDITED)**

 
| ** **                                            | ** ** | **THREE MONTHS ENDED  SEPTEMBER 30,** | ** ** | **NINE MONTHS ENDED  SEPTEMBER 30,** | ** ** |
|-------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                            | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                  |       |                                       |       |                                      |       |   |   |   |   |
| **Revenues:**                                         |       |                                       |       |                                      |       |   |   |   |   |
| Product                                               |       | $                                          | 1,437      |                                      | $          | 4,167 |   | $ | 5,516 |   | $ | 10,636 |   |
| Maintenance                                           |       | 571                                        |       | 590                                       |       | 1,533 |   | 2,180 |   |
|                                                  |       | 2,008                                      |       | 4,757                                     |       | 7,049 |   | 12,816 |   |
| **Cost of  revenues:**                                |       |                                       |       |                                      |       |   |   |   |   |
| Product                                               |       | 304                                        |       | 1,405                                     |       | 1,373 |   | 4,482 |   |
| Maintenance                                           |       | 264                                        |       | 270                                       |       | 733 |   | 939 |   |
| Gross profit                                          |       | 1,440                                      |       | 3,082                                     |       | 4,943 |   | 7,395 |   |
|                                                  |       |                                       |       |                                      |       |   |   |   |   |
| **Operating  expenses:**                              |       |                                       |       |                                      |       |   |   |   |   |
| General & administrative                          |       | 1,145                                      |       | 1,461                                     |       | 3,422 |   | 4,343 |   |
| Sales and marketing                                   |       | 1,021                                      |       | 883                                       |       | 2,593 |   | 3,020 |   |
| Research & development                            |       | 615                                        |       | 509                                       |       | 1,969 |   | 1,439 |   |
| Depreciation and amortization                         |       | 176                                        |       | 219                                       |       | 547 |   | 692 |   |
|                                                  |       | 2,957                                      |       | 3,072                                     |       | 8,531 |   | 9,494 |   |
|                                                  |       |                                       |       |                                      |       |   |   |   |   |
| Income (loss) from operations                         |       | (1,517                                     | )          | 10                                        |       | (3,588 | ) | (2,099 | ) |
|                                                  |       |                                       |       |                                      |       |   |   |   |   |
| Interest expense (income), net                        |       | (1                                         | )          | 69                                        |       | 5,188 |   | 2,323 |   |
|                                                  |       |                                       |       |                                      |       |   |   |   |   |
| Other (income) expense, net                           |       | (12                                        | )          | 57                                        |       | (41 | ) | (116 | ) |
| Loss before income taxes                              |       | (1,504                                     | )          | (116                                      | )          | (8,735 | ) | (4,306 | ) |
|                                                  |       |                                       |       |                                      |       |   |   |   |   |
| Income tax expense (benefit)                          |       | —                                     |       | —                                    |       | — |   | — |   |
|                                                  |       |                                       |       |                                      |       |   |   |   |   |
| Net loss                                              |       | $                                          | (1,504     | )                                         | $          | (116 | ) | $ | (8,735 | ) | $ | (4,306 | ) |
|                                                  |       |                                       |       |                                      |       |   |   |   |   |
| Basic and diluted loss per common share -  see note 2 |       | $                                          | (0.13      | )                                         | $          | (0.02 | ) | $ | (0.75 | ) | $ | (0.79 | ) |
| Weighted-average shares (basic and diluted)           |       | 11,940,359                                 |       | 5,489,390                                 |       | 11,659,626 |   | 5,489,390 |   |

 

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)**

 
| ** **                                                                   | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                   | ** ** | **2004**                                  | ** ** | **2003** | ** ** |
|                                                                         |       |                                      |       |   |   |
| **Cash  flows from operating activities**                                    |       |                                      |       |   |   |
| Net loss                                                                     |       | $                                         | (8,735     | ) | $ | (4,306 | ) |
| Adjustments to reconcile net loss to net  cash used by operating activities  |       |                                      |       |   |   |
| Depreciation and amortization                                                |       | 547                                       |       | 696 |   |
| Non cash interest and amortization of debt  discount and debt issuance costs |       | 4,472                                     |       | 1,779 |   |
| Stock based compensation                                                     |       | 269                                       |       | — |   |
| Change in assets and liabilities                                             |       |                                      |       |   |   |
| Accounts receivable, net                                                     |       | 63                                        |       | 1,920 |   |
| Inventory                                                                    |       | (321                                      | )          | 190 |   |
| Other current assets                                                         |       | (91                                       | )          | (27 | ) |
| Intangible and other assets                                                  |       | (16                                       | )          | (66 | ) |
| Accounts payable                                                             |       | (202                                      | )          | (1,108 | ) |
| Accrued expenses                                                             |       | 144                                       |       | (162 | ) |
| Accrued interest                                                             |       | (48                                       | )          | 55 |   |
| Deferred revenue                                                             |       | 50                                        |       | (174 | ) |
| Pension obligation                                                           |       | 83                                        |       | 59 |   |
| Total adjustments                                                            |       | 4,950                                     |       | 3,162 |   |
| Net cash used by operating activities                                        |       | (3,785                                    | )          | (1,144 | ) |
|                                                                         |       |                                      |       |   |   |
| **Cash  flows from investing activities**                                    |       |                                      |       |   |   |
| Purchase of property and equipment                                           |       | (126                                      | )          | (162 | ) |
| Restricted cash and cash equivalents                                         |       | 48                                        |       | 60 |   |
| Payment on advances from related  stockholders                               |       | (59                                       | )          | (158 | ) |
| Sale of property and equipment                                               |       | —                                    |       | 59 |   |
| Net cash used by investing activities                                        |       | (137                                      | )          | (201 | ) |
|                                                                         |       |                                      |       |   |   |
| **Cash  flows from financing activities**                                    |       |                                      |       |   |   |
| Proceeds from issuance of notes payable  with warrants                       |       | —                                    |       | 4,856 |   |
| Repayment of notes payable                                                   |       | (47                                       | )          | (2,500 | ) |
| Debt issuance costs                                                          |       | —                                    |       | (554 | ) |
| Proceeds from issuance of common stock, net  of issuance costs               |       | 6,054                                     |       | — |   |
| Proceeds from exercised stock options and  stock purchase warrants           |       | 483                                       |       | — |   |
| Dividends paid                                                               |       | (185                                      | )          | — |   |
| Proceeds from bank line of credit                                            |       | —                                    |       | (166 | ) |
|                                                                         |       |                                      |       |   |   |
| Net cash provided by financing activities                                    |       | 6,305                                     |       | 1,636 |   |
| Effect of exchange rate changes on cash                                      |       | (29                                       | )          | 128 |   |
| Net increase in cash                                                         |       | 2,354                                     |       | 419 |   |
|                                                                         |       |                                      |       |   |   |
| Cash at beginning of period                                                  |       | 578                                       |       | 215 |   |
|                                                                         |       |                                      |       |   |   |
| Cash at end of period                                                        |       | $                                         | 2,932      |   | $ | 634 |   |

 

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

 

5

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**IMAGEWARE SYSTEMS, INC.**

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

**(IN THOUSANDS)**

**(UNAUDITED)**

 
| ** **                              | ** ** | **THREE MONTHS ENDED  SEPTEMBER 30,** | ** ** | **NINE MONTHS ENDED  SEPTEMBER 30,** | ** ** |
|-----------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                              | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                    |       |                                       |       |                                      |       |   |   |   |   |
| Net loss                                |       | $                                          | (1,504     | )                                         | $          | (116 | ) | $ | (8,735 | ) | $ | (4,306 | ) |
| Other comprehensive income (loss):      |       |                                       |       |                                      |       |   |   |   |   |
| Foreign currency translation adjustment |       | 26                                         |       | 29                                        |       | (28 | ) | 128 |   |
| Comprehensive loss                      |       | $                                          | (1,478     | )                                         | $          | (87 | ) | $ | (8,763 | ) | $ | (4,178 | ) |

 

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

 

6

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**IMAGEWARE SYSTEMS, INC.**

 

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE 1.  DESCRIPTION OFBUSINESS AND OPERATIONS**

 

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

 

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

 

ImageWare’s ID solutions empower customers to create secure and smartdigital identification documents with complete ID systems. We develop, sell andsupport software and design systems which utilize digital imaging in theproduction of photo identification credentials and identification systems.  Our products in this market consist ofEpiSuite, EpiWeb, EpiWeb Enterprise, EpiBuilder (SDK), Identifier for Windows,ID Card Maker, Winbadge NT and Winbadge Aviation. These products allow for theproduction of digital identification cards and related databases and recordsand can be used by, among others, schools, airports, hospitals, corporations orgovernments.  We have recently added theability to incorporate multiple biometrics into the ID systems we offer withthe addition of our new ImageWare Biometric Engine to our product line.

 

ImageWare’s Digital Photography (“PDI”) product line consists of asuite of software for the professional photography market. The software allowsprofessional photographers to digitally capture images, manipulate them tocreate a custom package or layout, then store the images with an associateddatabase. They can then print the digital images themselves or send them viathe Internet or CD to a professional lab for processing. Our products includePC Pro, PC Event, PDI School Days+, PDI Studio, PDI Pro Lab and PDI GreenScreen. Our customers use the software products in a wide variety of waysincluding retail studio environments, on-location event photography and “pictureday” at schools and day care centers. Our software products are sold through adealer network and directly to major accounts. The PDI group also operates ane-commerce service, Picturemore.com, used by professional photographers toallow their customers to order re-prints and various service items. 

 

*Liquidity and Capital Resources*

 

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

 

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

 

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

 

7

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*Basis of Presentation*

 

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

 

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

 

*Stock-Based Compensation*

 

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

 

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

 
| ** **                                                       | ** ** | **THREE MONTHS ENDED  SEPTEMBER 30,** | ** ** | **NINE MONTHS ENDED  SEPTEMBER 30,** | ** ** |
|------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                       | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Net Loss:                                                        |       |                                       |       |                                      |       |   |   |   |   |
| As reported                                                      |       | $                                          | (1,504     | )                                         | $          | (116 | ) | $ | (8,735 | ) | $ | (4,306 | ) |
| Current period expense calculated under APB  25                  |       | —                                     |       | —                                    |       | — |   | — |   |
| Stock based employee compensation under  fair value based method |       | (96                                        | )          | (159                                      | )          | (362 | ) | (458 | ) |
| Pro forma net loss                                               |       | $                                          | (1,600     | )                                         | $          | (275 | ) | $ | (9,097 | ) | $ | (4,764 | ) |
|                                                             |       |                                       |       |                                      |       |   |   |   |   |
| Basic loss per common share:                                     |       |                                       |       |                                      |       |   |   |   |   |
| As reported                                                      |       | $                                          | (0.13      | )                                         | $          | (0.02 | ) | $ | (0.75 | ) | $ | (0.79 | ) |
| Pro forma                                                        |       | $                                          | (0.14      | )                                         | $          | (0.05 | ) | $ | (0.78 | ) | $ | (0.88 | ) |

 

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

 

In accordance with Financial Accounting Standards Board InterpretationNo. 44 — Accounting for Certain Transactions Involving Stock Compensation (“FIN44”), the Company will recognize stock-based compensation expense ratably overthe vesting period of the restricted stock in an amount of approximately$72,000 per quarter.  Such compensationexpense was $0 for the three months ended March 31, 2004 due to thecommencement of the vesting period on March 30, 2004; $82,000 for thethree months ended June 30, 2004; and $187,000 for the three months ended September 30,2004.  The increase during the threemonths ended September 30, 2004 was due to the immediate vesting of sharesof certain participants due to their termination of employment.

 

The differential between the number of shares underlying the optionsexchanged of 426,321 and the number of restricted shares issued of 255,792 aresubject to variable accounting treatment under the provisions of FIN 44 shouldany option grants be awarded to the participants of this stock exchangeagreement for a six month period beginning March 30,

 

8

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2004.  No options were granted tothe participants of this stock exchange agreement during the period March 30,2004 to September 30, 2004.

 

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

 

**NOTE 2.  NET LOSS PERCOMMON SHARE**

 

Basic loss per common share is calculated by dividing net lossavailable to common shareholders for the period by the weighted-average numberof common shares outstanding during the period. Diluted earnings per commonshare is calculated by dividing net loss available to common shareholders forthe period by the weighted-average number of common shares outstanding duringthe period, adjusted to include, if dilutive, potential dilutive sharesconsisting of convertible preferred stock, stock options, convertible notespayable and warrants, calculated using the treasury stock method. During theperiods ended September 30, 2004 and 2003, the Company has excluded thefollowing securities from the calculation of diluted loss per share, as theireffect would have been antidilutive due to the Company’s net loss:

 
| **Potential  Dilutive Securities:** | ** ** | **Number of  Common Shares  Convertible into at  September 30, 2004** | ** ** | **Number of  Common Shares  Convertible into at  September 30, 2003** | ** ** |
|-------------------------------------|------------|----------------------------------------------------------------------------|------------|----------------------------------------------------------------------------|------------|
|                                |       |                                                                       |       |                                                                       |       |
| Convertible preferred stock         |       | 47,280                                                                     |       | 63,781                                                                     |       |
| Stock options                       |       | 461,993                                                                    |       | 905,313                                                                    |       |
| Convertible notes payable           |       | —                                                                     |       | 2,332,854                                                                  |       |
| Warrants                            |       | 6,319,650                                                                  |       | 4,453,916                                                                  |       |

 

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

 
| ** **                                | ** ** | **THREE MONTHS ENDED  SEPTEMBER 30,** | ** ** | **NINE MONTHS ENDED  SEPTEMBER 30,** | ** ** |
|-------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| Numerator                                 |       |                                       |       |                                      |       |   |   |   |   |
| Net loss                                  |       | $                                          | (1,504     | )                                         | $          | (116 | ) | $ | (8,735 | ) | $ | (4,306 | ) |
| Less Series B preferred dividends         |       | (13                                        | )          | (15                                       | )          | (40 | ) | (46 | ) |
| Net loss available to common shareholders |       | $                                          | (1,517     | )                                         | $          | (131 | ) | $ | (8,775 | ) | $ | (4,352 | ) |
|                                      |       |                                       |       |                                      |       |   |   |   |   |
| Denominator                               |       |                                       |       |                                      |       |   |   |   |   |
| Weighted-average shares outstanding       |       | 11,940,359                                 |       | 5,489,390                                 |       | 11,659,626 |   | 5,489,390 |   |
|                                      |       |                                       |       |                                      |       |   |   |   |   |
| Basic and diluted loss per share          |       | $                                          | (0.13      | )                                         | $          | (0.02 | ) | $ | (0.75 | ) | $ | (0.79 | ) |

 

**NOTE 3.  SEGMENTINFORMATION**

 

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

 

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

 

There are no significant intersegment transactions.

 

9

----

 

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

 
| ** **                   | ** ** | **THREE MONTHS ENDED  SEPTEMBER 30,** | ** ** | **NINE MONTHS ENDED  SEPTEMBER 30,** | ** ** |
|------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                   | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                   | ** ** | **(in thousands)  (unaudited)**            | ** ** | **(in thousands)  (unuadited)**           | ** ** |
| Net Revenue:                 | * *   | * *                                   | * *   | * *                                  | * *   | * * | * * | * * | * * |
| Law Enforcement              |       | $                                          | 816        |                                      | $          | 691 |   | $ | 3,386 |   | $ | 2,633 |   |
| Identification               |       | 1,022                                      |       | 3,584                                     |       | 3,192 |   | 9,227 |   |
| Digital Photography          |       | 170                                        |       | 482                                       |       | 471 |   | 956 |   |
| Total consolidated net sales |       | $                                          | 2,008      |                                      | $          | 4,757 |   | $ | 7,049 |   | $ | 12,816 |   |
|                         |       |                                       |       |                                      |       |   |   |   |   |
| Operating income (loss):     |       |                                       |       |                                      |       |   |   |   |   |
| Law Enforcement              |       | $                                          | (359       | )                                         | $          | (180 | ) | $ | 45 |   | $ | (255 | ) |
| Identification               |       | (835                                       | )          | 97                                        |       | (2,820 | ) | (1,649 | ) |
| Digital Photography          |       | (323                                       | )          | 93                                        |       | (813 | ) | (195 | ) |
|                         |       |                                       |       |                                      |       |   |   |   |   |
| Other unallocated amounts:   |       |                                       |       |                                      |       |   |   |   |   |
| Interest expense (income)    |       | (1                                         | )          | 69                                        |       | 5,188 |   | 2,323 |   |
| Other expense (income)       |       | (12                                        | )          | 57                                        |       | (41 | ) | (116 | ) |
|                         |       |                                       |       |                                      |       |   |   |   |   |
| Loss before taxes            |       | $                                          | (1,504     | )                                         | $          | (116 | ) | $ | (8,735 | ) | $ | (4,306 | ) |

 
| ** **                           | ** ** | **September 30,  2004** | ** ** |
|--------------------------------------|------------|------------------------------|------------|
| ** **                           | ** ** | **(in thousands)**           | ** ** |
| Total Assets by Segment:             |       |                         |       |
|                                 |       |                         |       |
| Law Enforcement                      |       | $                            | 877        |   |
| Identification                       |       | 7,998                        |       |
| Digital Photography                  |       | 1,386                        |       |
| Total assets for reportable segments |       | 10,261                       |       |
| Corporate                            |       | 2,804                        |       |
| Total consolidated assets            |       | $                            | 13,065     |   |

 

10

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**NOTE 4. WARRANT LIABILITY**

 

In conjunction with the Company’s issuance of secured convertible promissorynotes in June 2003 (the “Notes”), the Company agreed to register with theSecurities and Exchange Commission the shares of common stock underlying thewarrants issued in connection with the Notes. In conjunction with the Company’s issuance of common stock in separateprivate placement transactions in November 2003 and January 2004, theCompany agreed to register with the Securities and Exchange Commission theshares of common stock underlying the warrants issued as part of the privateplacement transactions.  In accordancewith the Financial Accounting Standards Board Emerging Issue Task Force 00-19 (“EITF00-19”), the Company has recorded a long-term liability for the allocated valueof the warrants.  Accordingly, theCompany is accounting for the liability under fair value accounting.  During the three months ended June 30,2004, the Company registered with the Securities and Exchange Commission theshares of common stock underlying the warrants issued in connection with boththe notes and private placement transactions. In accordance with EITF 00-19, the Company has reclassified the fairvalue of the warrant liability as determined on effective date of theregistration statements to additional paid in capital.  The following table sets forth the changes infair value, resulting interest income or expense of this liability asdetermined under fair value accounting and amount reclassified to additionalpaid in capital during 2004:

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

# ** **

# **NOTE5. COMMON STOCK**

# ** **

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

 

11

----

 

private placement.  During thenine months ended September 30, 2004, the Company issued 108,597 shares ofcommon stock pursuant to stock option exercises and issued 91,817 shares ofcommon stock pursuant to warrant exercises.

 

# **NOTE6. ACCRUED LIABILITIES**

# ** **

During the nine months ended September 30, 2004, the Company hasrecorded approximately $713,000 in interest expense related to liquidateddamages of which $299,000 remains as an accrued liability at September 30,2004.  The liquidated damages wereincurred as the Company did not meet certain time requirements for theregistration of shares of the Company’s common stock under the registrationrights agreements for the November 2003 and January 2004 privateplacements.  The Company has offered theparticipants in the private placements the option of either receiving anyamounts due in a cash payment or accepting a reduction to the exercise price ofthe warrants issued to the participants ranging from 15% to 17%.  The current valuation of $299,000 is based onthe cash payout amount.  For thoseparticipants electing the warrant exercise price reduction, the Company willrecord the value of the warrant strike price reduction using the Black-Sholesoption pricing model.

 

12

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

 

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

 

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

 

**OVERVIEW**

 

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

 

**RESULTS OF OPERATIONS**

 

***THREE MONTHS ENDED SEPTEMBER 30, 2004AND 2003.***

 
| ** **                              | ** ** | **THREE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **            | ** ** |
|-----------------------------------------|------------|---------------------------------------------|------------|------------|------------|-----------------------|------------|
| **Net  Product Revenues**               | ** ** | **2004**                                    | ** ** | **2003**   | ** ** | **$ ****Change** | ** ** | **%****Change** | ** ** |
| **(dollars in thousands)**              | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** **            | ** ** | ** ** | ** ** |
|                                    |       |                                        |       |       |       |                  |       |   |   |
| **Product  revenues:**                  |       |                                        |       |       |       |                  |       |   |   |
| Law Enforcement                         |       | $                                           | 334        |       | $          | 204                   |       | $ | 130 |   | 64 | % |
| Percentage of total net product revenue |       | 23                                          | %          | 5          | %          |                  |       |   |   |
| Identification                          |       | $                                           | 941        |       | $          | 3,481                 |       | $ | (2,540 | ) | -73 | % |
| Percentage of total net product revenue |       | 66                                          | %          | 84         | %          |                  |       |   |   |
| Digital Photography                     |       | $                                           | 162        |       | $          | 482                   |       | $ | (320 | ) | -66 | % |
| Percentage of total net product revenue |       | 11                                          | %          | 11         | %          |                  |       |   |   |
| Total net product revenues              |       | $                                           | 1,437      |       | $          | 4,167                 |       | $ | (2,730 | ) | -66 | % |

 

Overallproduct revenues decreased 66% from $4,167,000 for the three months ended September 30,2003 to $1,437,000 for the corresponding period in 2004.  Revenues related to law enforcement productsincreased $130,000 for the three months ended September 30, 2004 ascompared to the corresponding period in 2003. This increase is due primarily to increased revenues fromimplementations of our Crime Capture System (CCS) products.  We believe that the increase in terrorism hascreated heightened interest in the ability of law enforcement and othergovernment agencies to be able to efficiently retrieve, analyze and shareinformation from their respective criminal databases.  We anticipate that these factors willcontinue to increase the overall demand for the Company’s law enforcementproducts and software; however, we cannot predict the timing of the shift indemand.

 

Identification product revenues decreased 73% from $3,481,000 for thethree months ended September 30, 2003 to $941,000 for the correspondingperiod in 2004.  Domestically,Identification revenues decreased approximately $1,059,000 or 63% for the threemonths ended September 30, 2004 as compared to the corresponding period in2003.  This decrease in domestic revenueis reflective of a decrease in project-oriented work and a decrease in boxedsoftware sold through distribution channels. In mid 2003, we established a master distributor to handle our domesticsales of our EPI line of boxed software. The master distributor model has not produced the results weanticipated, and we have terminated that arrangement effective June ofthis year and have re-established direct sales to our distributionchannel.  Internationally, ourIdentification revenues decreased approximately $1,481,000.  This decrease is a result of actions taken inthe fourth quarter of 2003 to reposition our foreign sales offices in Germanyand Singapore to lower fixed costs and pursue significant Identificationprojects utilizing the Company’s software technologies as our primarydifferentiator.  These offices hadhistorically emphasized the resale of third party merchandise (hardware andconsumables) which generated lower gross margins than software (as a percentageof revenue) and required significant fixed costs for sales, service andsupport.  Revenues from these two officeswere $1,481,000 below their levels in the same quarter of 2003, however, fixedcosts during the quarter were approximately $433,000 lower than the previousyear.  The Company feels that foreignmarkets served by these offices will embrace 

 

13

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

 

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

 

DigitalPhotography product revenues decreased 66% from $482,000 for the three monthsended September 30, 2003 to $162,000 for the corresponding period in2004.  This decrease is due to areduction in custom contract programming during the three months ended September 30,2004.

 

Ourbacklog of product orders as of September 30, 2004 was approximately$583,000.  At September 30, 2004, wealso had maintenance and support backlog of approximately $872,000 underexisting maintenance agreements.  Productrevenue is typically recognized within a three to six month time perioddepending upon the required degree of customization, if any.  Historically, we have experienced a veryminimal risk of order cancellation.  Ourrevenue from maintenance agreements is generally recognized ratably over therespective maintenance periods provided no significant obligations remain andcollectibility of the related receivable is probable.

 
| ** **                                  | ** ** | **THREE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **      | ** ** |
|---------------------------------------------|------------|---------------------------------------------|------------|------------|------------|-----------------|------------|
| **Maintenance  Revenues**                   | ** ** | **2004**                                    | ** ** | **2003**   | ** ** | **$****Change** | ** ** | **%****Change** | ** ** |
| **(dollars  in thousands)**                 | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** **      | ** ** | ** ** | ** ** |
|                                        |       |                                        |       |       |       |            |       |   |   |
| **Maintenance  revenues:**                  |       |                                        |       |       |       |            |       |   |   |
| Law Enforcement                             |       | $                                           | 482        |       | $          | 488             |       | $ | (6 | ) | -1 | % |
| Percentage of total net maintenance revenue |       | 85                                          | %          | 83         | %          |            |       |   |   |
| Identification                              |       | $                                           | 81         |       | $          | 102             |       | $ | (21 | ) | -21 | % |
| Percentage of total net maintenance revenue |       | 14                                          | %          | 17         | %          |            |       |   |   |
| Digital Photography                         |       | $                                           | 8          |       | $          | 0               |       | $ | 8 |   | 100 | % |
| Percentage of total net maintenance revenue |       | 1                                           | %          | 0          | %          |            |       |   |   |
| Total net maintenance revenues              |       | $                                           | 571        |       | $          | 590             |       | $ | (19 | ) | -3 | % |

 

Maintenancerevenues decreased 3% from $590,000 for the three months ended September 30,2003 to $571,000 for the corresponding period in 2004. Law enforcementmaintenance revenues decreased 1% or $6,000 for the three months ended September 30,2004 from $488,000 for the three months ended September 30, 2003 to$482,000 for the corresponding period in 2004. 

 

Identificationmaintenance revenues decreased 21% or $21,000 for the three months ended September 30,2004 from $102,000 for the three months ended September 30, 2003 to$81,000 for the corresponding period in 2004. This decrease is due primarily tothe shift in our strategy in late 2003 to outsource international service andmaintenance for hardware.  This shift hasenabled us to reduce costs and focus our resources on expanding ourinternational sales effort of Digital Identification, Biometric, LawEnforcement and Digital Photography solutions.

 

14

----

 
| ** **                                        | ** ** | **THREE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **            | ** ** |
|---------------------------------------------------|------------|---------------------------------------------|------------|------------|------------|-----------------------|------------|
| **Cost  of Product Revenues:**                    | ** ** | **2004**                                    | ** ** | **2003**   | ** ** | **$ ****Change** | ** ** | **%****Change** | ** ** |
| **(dollars  in thousands)**                       | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** **            | ** ** | ** ** | ** ** |
|                                              |       |                                        |       |       |       |                  |       |   |   |
| **Cost of  Product Revenues:**                    |       |                                        |       |       |       |                  |       |   |   |
| Law Enforcement                                   |       | $                                           | 175        |       | $          | 128                   |       | $ | 47 |   | 37 | % |
| Percentage of Law Enforcement product  revenue    |       | 52                                          | %          | 63         | %          |                  |       |   |   |
| Identification                                    |       | $                                           | 123        |       | $          | 1,260                 |       | $ | (1,137 | ) | -90 | % |
| Percentage of Identification product  revenue     |       | 13                                          | %          | 36         | %          |                  |       |   |   |
| Digital Photography                               |       | $                                           | 6          |       | $          | 17                    |       | $ | (11 | ) | -65 | % |
| Percentage of Digital Photography product revenue |       | 4                                           | %          | 4          | %          |                  |       |   |   |
| Total net product revenues                        |       | $                                           | 304        |       | $          | 1,405                 |       | $ | (1,101 | ) | -78 | % |
| Percentage of total product revenues              |       | 21                                          | %          | 34         | %          |                  |       |   |   |

 

Overallcost of product revenues as a percentage of product revenues decreased from 34%for the three month period ended September 30, 2003 to 21% of productrevenues for the corresponding period in 2004. This decrease is due primarilyto a change in our product mix with a greater percentage of product revenuesbeing from software.

 

Costof product revenues for our Law Enforcement segment increased 37%, or $47,000from $128,000 or 63% of Law Enforcement product revenues for the three monthsended September 30, 2003 to $175,000, or 52% of Law Enforcement productrevenues for the corresponding period in 2004. This decrease, as a percentage of product revenues is due primarily tothe larger revenue base to absorb fixed product costs and product mix with ahigher percentage of hardware and consumables sales during the three monthsended September 30, 2004 as compared to the corresponding period in2003.  Costs of products can vary as apercentage of product revenue from period to period depending upon product mixand the hardware content, print media consumable content and software contentincluded in systems installed during a given period.

 

Costof product revenues related to our Identification segment decreased 90% or$1,137,000 from $1,260,000 or 36% of Identification product revenues for thethree months ended September 30, 2003 to $123,000 or 13% of Identificationproduct revenues for the corresponding period in 2004.  The dollar decrease is reflective of lowerIdentification revenues both domestically and internationally.  The percentage decrease in Identificationcost of revenues as a percentage of Identification revenues from 36% for thethree months ended September 30, 2003 to 13% for the corresponding periodin 2004 is reflective of higher sales of software only solutions during thethree months ended September 30, 2004.

 

Costof product revenues related to our Digital Photography segment decreased 65% or$11,000 from 17,000 or 4% of Digital Photography product revenues for the threemonths ended September 30, 2004 to $6,000 or 4% of Digital Photographyproduct revenues for the corresponding period in 2004.  The dollar decrease is reflective of lowerDigital Photography revenues during the three months ended September 30,2004 as compared to the corresponding period in 2003.  

 
| ** **                                              | ** ** | **THREE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **      | ** ** |
|---------------------------------------------------------|------------|---------------------------------------------|------------|------------|------------|-----------------|------------|
| **Maintenance  cost of revenues**                       | ** ** | **2004**                                    | ** ** | **2003**   | ** ** | **$****Change** | ** ** | **%****Change** | ** ** |
| ** **                                              | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** **      | ** ** | ** ** | ** ** |
| **Maintenance  cost of revenues:**                      |       |                                        |       |       |       |            |       |   |   |
| Law Enforcement                                         |       | $                                           | 214        |       | $          | 185             |       | $ | 29 |   | 16 | % |
| Percentage of Law Enforcement  maintenance revenue |       | 44                                          | %          | 38         | %          |            |       |   |   |
| Identification                                          |       | $                                           | 50         |       | $          | 85              |       | $ | (35 | ) | -41 | % |
| Percentage of Identification maintenance  revenue       |       | 62                                          | %          | 83         | %          |            |       |   |   |
| Digital Photography                                     |       | $                                           | —     |       | $          | —          |       | $ | — |   | N/A |   |
| Percentage of Digital Photography  maintenance revenue  |       | —                                      | %          | —     | %          | —          |       | N/A |   |
| Total net maintenance revenues                          |       | $                                           | 264        |       | $          | 270             |       | $ | (6 | ) | -2 | % |
| Percentage of total maintenance revenues                |       | 46                                          | %          | 46         | %          |            |       |   |   |

 

Costsof maintenance revenues decreased 2% from $270,000, or 46% of maintenancerevenues, for the three months ended September 30, 2003 to $264,000, or46% of maintenance revenues, for the corresponding period in 2004. Cost of maintenancerevenues in Law Enforcement increased 16%, or $29,000 from $185,000 or 38% ofmaintenance revenues for the three months ended September 30, 2003 to$214,000 or 44% of maintenance revenues for the corresponding period in 2003.This dollar increase in costs of maintenance revenues is reflective of slightlyhigher costs paid to third party maintenance service providers and slightlyhigher costs paid for replacement equipment during the three months ended September 30,2004 as compared to the comparable period in 2003.  Identification maintenance cost of revenuesdecreased $35,000 largely due to the shift in strategy to outsource hardwareservice and maintenance in late 2003.

 

15

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| ** **                                         | ** ** | **THREE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **      | ** ** |
|----------------------------------------------------|------------|---------------------------------------------|------------|------------|------------|-----------------|------------|
| **Product  gross profit (dollars in thousands)**   | ** ** | **2004**                                    | ** ** | **2003**   | ** ** | **$****Change** | ** ** | **%****Change** | ** ** |
| ** **                                         | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** **      | ** ** | ** ** | ** ** |
| **Product  gross profit**                          |       |                                        |       |       |       |            |       |   |   |
| Law Enforcement                                    |       | $                                           | 159        |       | $          | 76              |       | $ | 83 |   | 109 | % |
| Percentage of Law Enforcement product  revenue     |       | 48                                          | %          | 37         | %          |            |       |   |   |
| Identification                                     |       | $                                           | 818        |       | $          | 2,221           |       | $ | (1,403 | ) | -63 | % |
| Percentage of Identification product  revenue      |       | 87                                          | %          | 64         | %          |            |       |   |   |
| Digital Photography                                |       | $                                           | 156        |       | $          | 465             |       | $ | (309 | ) | -66 | % |
| Percentage of Digital Photography product  revenue |       | 96                                          | %          | 96         | %          |            |       |   |   |
| Total net product revenues                         |       | $                                           | 1,133      |       | $          | 2,762           |       | $ | (1,629 | ) | -59 | % |
| Percentage of total product revenues               |       | 79                                          | %          | 66         | %          |            |       |   |   |

 

Totalproduct gross margin as a percentage of product revenues increased from 66% forthe three month period ended September 30, 2003 to 79% of product revenuesfor the corresponding period in 2004. The overall increase is primarily due toa higher percentage of total revenues coming from the sales of software.

 

LawEnforcement gross profit as a percentage of Law Enforcement product revenueincreased from 37% for the three months ended September 30, 2003 to 48%for the corresponding period of 2004. This increase is due primarily to ourproduct mix containing a high percentage of software during the three monthsended September 30, 2004 as compared to the comparable period in 2003, aswell as a higher revenue base to absorb fixed product costs.  Costs of products can vary as a percentage ofproduct revenue from quarter to quarter depending upon product mix and hardwarecontent and print media consumable content included in systems installed duringa given period.

 

Identification gross profit as a percentage of Identification productrevenue increased from 64% for the three months ended September 30, 2003to 87% of Identification product revenues for the corresponding period in2004.  This increase is due primarily toour product mix containing higher percentages of software than the comparableperiod in 2003.  The shift in product mixis a result of lower sales in the period of hardware and consumables due toprocurement problems experienced during the third quarter of 2004.

 

Grossmargins for the Digital Photography product segment decreased 66% or $309,000,from $465,000 or 96% of Digital Photography product revenues for the threemonths ended September 30, 2003 to $156,000, or 96% of Digital Photographyproduct revenues for the corresponding period in 2004. The dollar decrease of$309,000 is reflective of our lower custom contract programming in the threemonths ended September 30, 2004 as compared to the corresponding period in2003.  

 
| ** **                                             | ** ** | **THREE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **            | ** ** |
|--------------------------------------------------------|------------|---------------------------------------------|------------|------------|------------|-----------------------|------------|
| **Maintenance  gross profit**                          | ** ** | **2004**                                    | ** ** | **2003**   | ** ** | **$ ****Change** | ** ** | **%****Change** | ** ** |
| **(dollars  in thousands)**                            | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** **            | ** ** | ** ** | ** ** |
|                                                   |       |                                        |       |       |       |                  |       |   |   |
| **Maintenance  gross profit**                          |       |                                        |       |       |       |                  |       |   |   |
| Law Enforcement                                        |       | $                                           | 268        |       | $          | 303                   |       | $ | (35 | ) | -12 | % |
| Percentage of Law Enforcement maintenance  revenue     |       | 56                                          | %          | 62         | %          |                  |       |   |   |
| Identification                                         |       | $                                           | 31         |       | $          | 17                    |       | $ | 14 |   | 82 | % |
| Percentage of Identification maintenance  revenue      |       | 38                                          | %          | 17         | %          |                  |       |   |   |
| Digital Photography                                    |       | $                                           | 8          |       | $          | —                |       | $ | 8 |   | -100 | % |
| Percentage of Digital Photography  maintenance revenue |       | N/A                                         |       | N/A        |       |                  |       |   |   |
| Total net maintenance revenues                         |       | $                                           | 307        |       | $          | 320                   |       | $ | (13 | ) | -4 | % |
| Percentage of total maintenance revenues               |       | 54                                          | %          | 54         | %          |                  |       |   |   |

 

Grossmargins related to maintenance revenues decreased $13,000 from $320,000, or 54%of maintenance revenues for the three months ended September 30, 2003 to$307,000, or 54% of maintenance revenues for the corresponding period in 2004.The dollar decrease is due primarily to slightly higher costs of third partymaintenance service providers and slightly higher costs paid for replacementequipment.

 

16

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| ** **                      | ** ** | **THREE MONTHS ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **            | ** ** |
|---------------------------------|------------|--------------------------------------------|------------|------------|------------|-----------------------|------------|
| **Operating  expenses**         | ** ** | **2004**                                   | ** ** | **2003**   | ** ** | **$ ****Change** | ** ** | **%****Change** | ** ** |
| **(dollars  in thousands)**     | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** **            | ** ** | ** ** | ** ** |
|                            |       |                                       |       |       |       |                  |       |   |   |
| General & administrative    |       | $                                          | 1,145      |       | $          | 1,461                 |       | $ | (316 | ) | -22 | % |
| Percentage of total net revenue |       | 57                                         | %          | 31         | %          |                  |       |   |   |
| Sales and marketing             |       | $                                          | 1,021      |       | $          | 883                   |       | $ | 138 |   | 16 | % |
| Percentage of total net revenue |       | 51                                         | %          | 19         | %          |                  |       |   |   |
| Research & development      |       | $                                          | 615        |       | $          | 509                   |       | $ | 106 |   | 21 | % |
| Percentage of total net revenue |       | 31                                         | %          | 11         | %          |                  |       |   |   |
| Depreciation and amortization   |       | $                                          | 176        |       | $          | 219                   |       | $ | (43 | ) | -21 | % |
| Percentage of total net revenue |       | 9                                          | %          | 5          | %          |                  |       |   |   |

 

*GENERAL AND ADMINISTRATIVE EXPENSES.* General and administrative expenses are comprised of salaries and otheremployee-related costs for executive, financial and other infrastructurepersonnel. General legal, accounting and consulting services, insurance,occupancy and communication costs are also included with general andadministrative expenses.  Such expensesdecreased 22%, or $316,000 from $1,461,000 for the three months ended September 30,2003 to $1,145,000 for the corresponding period in 2004.  Such expenses, as a percentage of total netrevenues, increased from 31% for the three months ended September 30, 2003to 57% for the corresponding period in 2004. This percentage increase is reflective of lower total net revenuesduring the three months ended September 30, 2004 as compared to thecorresponding period in 2003.  The dollardecrease of $316,000 is reflective of headcounts reductions at our San Diego,California and Stuttgart, Germany offices as well as lower occupancy costs atour San Diego, California office.  We arecontinuing to focus our efforts on achieving additional future operatingefficiencies by reviewing and improving upon existing business processes andevaluating our cost structure. We believe these efforts will allow us togradually decrease our level of general and administrative expenses expressedas a percentage of total revenues.

 

*SALES AND MARKETING.*  Salesand marketing expenses consist primarily of the salaries, commissions, otherincentive compensation, employee benefits and travel expenses of our salesforce. Such expenses increased 16%, or $138,000 from $883,000 for the threemonths ended September 30, 2003 to $1,021,000 for the corresponding periodin 2004.  Such expenses, as a percentageof total net revenues, increased from 19% for the three months ended September 30,2003 to 51% for the corresponding period in 2004. This percentage increase isreflective of lower total net revenues during the three months ended September 30,2004 as compared to the corresponding period in 2003.  The dollar increase of $138,000 is dueprimarily to increased headcount and higher amounts paid to sales consultantsoffset by lower sales commissions.  Theincrease in headcount and amounts paid to sales consultants (includinglobbyists) reflects both the required resources needed to pursue large projectsolution opportunities and our commitment to increase our presence in the fastgrowing area of biometrics.  This isespecially true for our traditional Law Enforcement market as well as thefast-paced Identity Management sector. We anticipate that expenses for sales and marketing will increasethrough 2004 as we continue to add personnel and resources to meet theseopportunities.

 

*RESEARCH AND DEVELOPMENT.* Research and development costs consist primarily of salaries, employeebenefits and outside contractors for new product development, productenhancements and custom integration work. Such expenses increased 21% or $106,000from $509,000 for the three months ended September 30, 2003 to $615,000for the corresponding period in 2004 due primarily to the accelerateddevelopment of our new ImageWare Biometric Engine and the web enablement of ourCCS product line utilizing contract programming services in conjunction withinternal research and development resources.   Our level of expenditures inresearch and development reflects our belief that to maintain our competitiveposition in markets characterized by rapid rates of technological advancement,we must continue to invest significant resources in new systems and software aswell as continue to enhance existing products.

 

*DEPRECIATION AND AMORTIZATION.* Depreciation and amortization decreased $43,000 from $219,000 for thethree months ended September 30, 2003 to $176,000 for the correspondingperiod in 2004. This decrease is due primarily to lower amortization ofintangible assets due to such assets being fully amortized and lowerdepreciation expense related to fixed assets being fully depreciated. 

 

*INTEREST (INCOME) EXPENSE, NET.*  Forthe three months ended September 30, 2004, we recognized interest incomeof $4,000 and interest expense of $3,000. For the three months ended September 30,2003, we recognized interest income of $713,000 and interest expense of$782,000.  Interest income for the threemonths ended September 30, 2003 contains $711,000 of interest incomerelated to fair value accounting for our warrant liability due to theregistration rights agreement associated with the underlying shares of theCompany’s common stock to be issued upon conversion of the warrants.  Interest expense for the three months ended September 30,2003 includes approximately of $619,000 of debt discount and deferred financingfee amortization classified as interest expense.  The following table sets forth the majorcomponents of net interest expense for the three months ended September 30,2004 and 2003:

 

17

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| ** **                                                                                                                                                           | ** ** | **THREE MONTHS ENDED  SEPTEMBER 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| **Components  of net interest expense (income):**                                                                                                                    | ** ** | **2004**                                   | ** ** | **2003** | ** ** |
| **(dollars  in thousands)**                                                                                                                                          | ** ** | ** **                                 | ** ** | ** ** | ** ** |
|                                                                                                                                                                 |       |                                       |       |   |   |
| Subordinated convertible promissory notes  issued March 2003, interest rate 8.5%, due April 15, 2005;  principal amount $600,000                           |       |                                       |       |   |   |
| Coupon interest rate expense                                                                                                                                         |       | $                                          | —     |   | $ | 13 |   |
| Amortization to interest expense of note  discount related to beneficial conversion feature                                                                          |       | —                                     |       | 13 |   |
| Interest expense from amortization of  deferred financing fees                                                                                                       |       | —                                     |       | 7 |   |
|                                                                                                                                                                 |       |                                       |       |   |   |
| Senior secured convertible promissory notes  issued June 2003, interest rate 12.5% due May 22, 2005, principal amount  $4,256,000; (“the New Notes”): |       |                                       |       |   |   |
| Coupon interest rate expense                                                                                                                                         |       | —                                     |       | 136 |   |
| Amortization to interest expense of note  discount related to fair value of warrants                                                                                 |       | —                                     |       | 262 |   |
| Amortization to interest expense of note  discount relating to beneficial conversion feature                                                                         |       | —                                     |       | 264 |   |
| Interest expense from amortization of  deferred financing fees                                                                                                       |       | —                                     |       | 73 |   |
| Other note payable interest expense                                                                                                                                  |       | 3                                          |       | 14 |   |
|                                                                                                                                                                 |       |                                       |       |   |   |
| Change in warrant liability classified as  interest (income) or expense                                                                                              |       | —                                     |       | (711 | ) |
|                                                                                                                                                                 |       |                                       |       |   |   |
| Interest expense from incurrence of  liquidated damages related to non-timely registration of common stock                                                           |       | —                                     |       | — |   |
|                                                                                                                                                                 |       |                                       |       |   |   |
| Interest income                                                                                                                                                      |       | (4                                         | )          | (2 | ) |
|                                                                                                                                                                 |       |                                       |       |   |   |
| Net interest (income) expense                                                                                                                                        |       | $                                          | (1         | ) | $ | 69 |   |

 

***NINE MONTHS ENDED SEPTEMBER 30, 2004AND 2003.***

 
| ** **                              | ** ** | **NINE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **            | ** ** |
|-----------------------------------------|------------|--------------------------------------------|------------|------------|------------|-----------------------|------------|
| **Net  Product Revenues**               | ** ** | **2004**                                   | ** ** | **2003**   | ** ** | **$ ****Change** | ** ** | **% Change** | ** ** |
| **(dollars  in thousands)**             | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** **            | ** ** | ** ** | ** ** |
|                                    |       |                                       |       |       |       |                  |       |   |   |
| **Product  revenues:**                  |       |                                       |       |       |       |                  |       |   |   |
| Law Enforcement                         |       | $                                          | 2,022      |       | $          | 964                   |       | $ | 1,058 |   | 110 | % |
| Percentage of total net product revenue |       | 37                                         | %          | 8          | %          |                  |       |   |   |
| Identification                          |       | $                                          | 3,032      |       | $          | 8,716                 |       | $ | (5,684 | ) | -65 | % |
| Percentage of total net product revenue |       | 55                                         | %          | 82         | %          |                  |       |   |   |
| Digital Photography                     |       | $                                          | 462        |       | $          | 956                   |       | $ | (494 | ) | -52 | % |
| Percentage of total net product revenue |       | 8                                          | %          | 9          | %          |                  |       |   |   |
| Total net product revenues              |       | $                                          | 5,516      |       | $          | 10,636                |       | $ | (5,120 | ) | -48 | % |

 

Totalproduct revenues decreased 48% from $10,636,000 for the nine months ended September 30,2003 to $5,516,000 for the corresponding period in 2004. Revenues related tolaw enforcement products increased $1,058,000 for the nine months ended September 30,2004 as compared to the corresponding period in 2003.  This increase is due primarily to revenuesfrom our implementation of a browser-based, investigative law enforcementsystem for the New South Wales Police Department and increased sales of our CCSand Face ID products.  We believe thatthe increase in terrorism has created heightened interest in the ability of lawenforcement and other

 

18

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

 

Identificationproduct revenues decreased 65% from $8,716,000 for the nine months ended September 30,2003 to $3,032,000 for the corresponding period in 2004.  Domestically, Identification revenuesdecreased approximately $2,193,000, or 52%. This decrease in domestic revenue is reflective of a decrease inproject-oriented work and a decrease in boxed software sold through distributionchannels.  In mid 2003, we established amaster distributor to handle our domestic sales of our EPI line of boxedsoftware.  The master distributor modelhas not produced the results we anticipated and we have terminated thatarrangement effective June of this year and have re-established directsales to our distribution channel. Internationally, our Identification revenues decreased approximately$3,491,000.   This decrease is a resultof actions taken in the fourth quarter of 2003 to reposition our foreign salesoffices in Germany and Singapore to lower fixed costs and pursuesignificant Identification projects utilizing the Company’s softwaretechnologies as our primary differentiator. These offices had historically emphasized the resale of third partymerchandise (hardware and consumables) which generated lower gross margins thansoftware (as a percentage of revenue) and required significant fixed costs forsales, service and support.  Revenuesfrom these two offices were $3.491,000 below their levels in the first ninemonths of 2003, however, fixed costs during the quarter were approximately$1,273,000 lower than the previous year. The Company feels that foreign markets served by these offices willembrace the Company’s identification and biometric solutions for large-scalehigh-end installations.  We continue tobe of the opinion that government agencies and private entities will react toheightened security concerns resulting from acts of terrorism by re-evaluatingand upgrading their ability to positively identify and track their citizens, employees, consultants and visitors. Weanticipate that these factors will increase overall demand for the Company’sidentification products; however, we cannot predict the timing of the shift indemand.

 

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

 

DigitalPhotography product revenues decreased 52% from $956,000 for the nine monthsended September 30, 2003 to $462,000 for the corresponding period in2004.  This decrease is due to a decreasein custom contract programming during the first nine months of 2004.

 
| ** **                                  | ** ** | **NINE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **            | ** ** |
|---------------------------------------------|------------|--------------------------------------------|------------|------------|------------|-----------------------|------------|
| **Maintenance  Revenues**                   | ** ** | **2004**                                   | ** ** | **2003**   | ** ** | **$ ****Change** | ** ** | **%****Change** | ** ** |
| **(dollars  in thousands)**                 | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** **            | ** ** | ** ** | ** ** |
|                                        |       |                                       |       |       |       |                  |       |   |   |
| **Maintenance  revenues:**                  |       |                                       |       |       |       |                  |       |   |   |
| Law Enforcement                             |       | $                                          | 1,364      |       | $          | 1,668                 |       | $ | (304 | ) | -18 | % |
| Percentage of total net maintenance revenue |       | 89                                         | %          | 77         | %          |                  |       |   |   |
| Identification                              |       | $                                          | 160        |       | $          | 511                   |       | $ | (351 | ) | -69 | % |
| Percentage of total net maintenance revenue |       | 10                                         | %          | 23         | %          |                  |       |   |   |
| Digital Photography                         |       | $                                          | 9          |       | $          | 1                     |       | $ | 8 |   | 794 | % |
| Percentage of total net maintenance revenue |       | 1                                          | %          | 0          | %          |                  |       |   |   |
| Total net maintenance revenues              |       | $                                          | 1,533      |       | $          | 2,180                 |       | $ | (647 | ) | -30 | % |

 

Maintenancerevenues decreased 30% from $2,180,000 for the nine months ended September 30,2003 to $1,533,000 for the corresponding period in 2004.  Law enforcement maintenance revenuesdecreased 18% or $304,000 for the nine months ended September 30, 2004from $1,668,000 for the nine months ended September 30, 2003 to $1,364,000for the corresponding period in 2004. This decrease is due primarily to theexpiration of the New York City Police Department service and maintenancecontract during the third quarter of 2003.

 

Identificationmaintenance revenues decreased 69% or $351,000 for the nine months ended September 30,2004 from $511,000 for the nine months ended September 30, 2003 to$160,000 for the corresponding period in 2004. This decrease is due primarilyto the shift in our strategy in late 2003 to outsource international serviceand maintenance for hardware.  This shifthas enabled the Company to reduce costs and focus its resources on expandingour international sales effort of Digital Identification, Biometric, LawEnforcement and Digital Photography solutions.

 

19

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| ** **                                         | ** ** | **NINE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **            | ** ** |
|----------------------------------------------------|------------|--------------------------------------------|------------|------------|------------|-----------------------|------------|
| **Cost  of Product Revenues:**                     | ** ** | **2004**                                   | ** ** | **2003**   | ** ** | **$ ****Change** | ** ** | **% Change** | ** ** |
| **(dollars  in thousands)**                        | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** **            | ** ** | ** ** | ** ** |
|                                               |       |                                       |       |       |       |                  |       |   |   |
| **Cost of  Product Revenues:**                     |       |                                       |       |       |       |                  |       |   |   |
| Law Enforcement                                    |       | $                                          | 515        |       | $          | 544                   |       | $ | (29 | ) | -5 | % |
| Percentage of Law Enforcement product  revenue     |       | 25                                         | %          | 56         | %          |                  |       |   |   |
| Identification                                     |       | $                                          | 819        |       | $          | 3,892                 |       | $ | (3,073 | ) | -79 | % |
| Percentage of Identification product  revenue      |       | 27                                         | %          | 45         | %          |                  |       |   |   |
| Digital Photography                                |       | $                                          | 39         |       | $          | 46                    |       | $ | (7 | ) | -15 | % |
| Percentage of Digital Photography product  revenue |       | 8                                          | %          | 5          | %          |                  |       |   |   |
| Total net product revenues                         |       | $                                          | 1,373      |       | $          | 4,482                 |       | $ | (3,109 | ) | -69 | % |
| Percentage of total product revenues               |       | 25                                         | %          | 42         | %          |                  |       |   |   |

 

Totalcost of product revenues as a percentage of product revenues decreased from 42%for the nine month period ended September 30, 2003 to 25% of productrevenues for the corresponding period in 2004. This decrease is due primarilyto product mix with a greater percentage of product revenues being fromsoftware.

 

Costof product revenues for our Law Enforcement segment decreased 5%, or $29,000from $544,000 or 56% of Law Enforcement product revenues for the nine monthsended September 30, 2003 to $515,000, or 25% of Law Enforcement productrevenues for the corresponding period in 2004. This decrease, as a percentage of product revenues is due primarily tothe larger revenue base to absorb fixed product costs and product mix with ahigher percentage of software sales.  Thedollar decrease of $29,000 for the nine month period ended September 30,2004 as compared with the corresponding period of 2003 despite higher lawenforcement product revenues is reflective of an uncharacteristically highpercentage of software only solutions.  Costs of products also can vary as a percentage of product revenue fromperiod to period depending upon product mix and the hardware content, printmedia consumable content and software content included in systems installedduring a given period.

 

Costof product revenues related to our Identification segment decreased 79% or$3,073,000 from $3,892,000 or 45% of Identification product revenues for thenine months ended September 30, 2003 to $819,000 or 27% of Identificationproduct revenues for the corresponding period in 2004.  The dollar decrease of $3,073,000 isreflective of lower identification revenues both domestically andinternationally in the nine month period ended September 30, 2004 ascompared to the corresponding period in 2003. The decrease in Identification cost of product revenues as a percentageof Identification revenues from 45% for the nine month period ended September 30,2003 to 27% for the corresponding period in 2004 is reflective of higher salesof software only solutions and procurement problems relating to our primaryidentification card printer and related print media consumables, which causedsignificant delays in our ability to ship identification printers and relatedmedia.  Costs of products also can varyas a percentage of product revenue from period to period depending upon productmix and the hardware content, print media consumable content and softwarecontent included in systems installed during a given period.

 
| ** **                                             | ** ** | **NINE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **            | ** ** |
|--------------------------------------------------------|------------|--------------------------------------------|------------|------------|------------|-----------------------|------------|
| **Maintenance  cost of revenues**                      | ** ** | **2004**                                   | ** ** | **2003**   | ** ** | **$ ****Change** | ** ** | **%****Change** | ** ** |
|                                                   |       |                                       |       |       |       |                  |       |   |   |
| **Maintenance  cost of revenues:**                     |       |                                       |       |       |       |                  |       |   |   |
| Law Enforcement                                        |       | $                                          | 599        |       | $          | 622                   |       | $ | (23 | ) | -4 | % |
| Percentage of Law Enforcement maintenance revenue      |       | 44                                         | %          | 37         | %          |                  |       |   |   |
| Identification                                         |       | $                                          | 134        |       | $          | 317                   |       | $ | (183 | ) | -58 | % |
| Percentage of Identification maintenance  revenue      |       | 84                                         | %          | 62         | %          |                  |       |   |   |
| Digital Photography                                    |       | $                                          | —     |       | $          | —                |       | $ | — |   | N/A |   |
| Percentage of Digital Photography  maintenance revenue |       |                                       | %          |       |  %    |                  |       |   |   |
| Total net maintenance revenues                         |       | $                                          | 733        |       | $          | 939                   |       | $ | (206 | ) | -22 | % |
| Percentage of total maintenance revenues               |       | 48                                         | %          | 43         | %          |                  |       |   |   |

 

Costsof maintenance revenues decreased 22% from $939,000, or 43% of maintenancerevenues, for the nine months ended September 30, 2003 to $733,000, or 48%of maintenance revenues, for the corresponding period in 2004. Cost ofmaintenance revenues in our Law Enforcement segment decreased 4%, from $622,000or 37% of maintenance revenues for the nine months ended September 30,2003 to $599,000 or 44% of maintenance revenues for the corresponding period in2004. This dollar decrease in costs of maintenance revenues is reflective ofreduced costs due to the expiration of the New York City Police Departmentservice and maintenance contract in the third quarter of 2003 offset by costsnecessary to service our expanding installed base. Identification maintenancecost of revenues decreased $183,000 largely due to the shift in strategy tooutsource international hardware service and maintenance in late 2003.

 

20

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| ** **                                         | ** ** | **NINE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **            | ** ** |
|----------------------------------------------------|------------|--------------------------------------------|------------|------------|------------|-----------------------|------------|
| **Product  gross profit (dollars in thousands)**   | ** ** | **2004**                                   | ** ** | **2003**   | ** ** | **$ ****Change** | ** ** | **%****Change** | ** ** |
|                                               |       |                                       |       |       |       |                  |       |   |   |
| **Product  gross profit**                          |       |                                       |       |       |       |                  |       |   |   |
| Law Enforcement                                    |       | $                                          | 1,507      |       | $          | 420                   |       | $ | 1,087 |   | 259 | % |
| Percentage of Law Enforcement product  revenue     |       | 75                                         | %          | 44         | %          |                  |       |   |   |
| Identification                                     |       | $                                          | 2,213      |       | $          | 4,824                 |       | $ | (2,611 | ) | -54 | % |
| Percentage of Identification product  revenue      |       | 73                                         | %          | 55         | %          |                  |       |   |   |
| Digital Photography                                |       | $                                          | 423        |       | $          | 910                   |       | $ | (487 | ) | -54 | % |
| Percentage of Digital Photography product  revenue |       | 92                                         | %          | 95         | %          |                  |       |   |   |
| Total net product revenues                         |       | $                                          | 4,143      |       | $          | 6,154                 |       | $ | (2,011 | ) | -33 | % |
| Percentage of total product revenues               |       | 75                                         | %          | 58         | %          |                  |       |   |   |

 

Totalproduct gross margin as a percentage of product revenues increased from 58% forthe nine month period ended September 30, 2003 to 75% of product revenuesfor the corresponding period in 2004. The overall increase is primarily due toa higher percentage of total revenues coming from the sales of software.

 

LawEnforcement gross profit as a percentage of Law Enforcement product revenueincreased from 44% for the nine months ended September 30, 2003 to 75% forthe corresponding period of 2004. This increase is due primarily to our productmix containing uncharacteristically high percentages of software than thecomparable period in 2003, as well as a higher revenue base to absorb fixedproduct costs.  Costs of products canvary as a percentage of product revenue from quarter to quarter depending uponproduct mix and hardware content and print media consumable content included insystems installed during a given period.

 

Identification gross profit as a percentage of Identification productrevenue increased from 55% for the nine months ended September 30, 2003 to73% of Identification product revenues for the corresponding period in2004.  This increase is due primarily toour product mix containing higher percentages of software than the comparableperiod in 2003.  The shift in product mixis a result of lower sales in the period of hardware and consumables due toprocurement problems experienced during the nine months ended September 30,2004.

 

Grossmargins for the Digital Photography product segment decreased 54% or $487,000,from $910,000 or 95% of Digital Photography product revenues for the ninemonths ended September 30, 2003 to $423,000, or 92% of Digital Photographyrevenues for the corresponding period in 2004. This decrease of $487,000results primarily from lower custom contract programming in the nine monthsende

 
| ** **                                             | ** ** | **NINE MONTHS  ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **            | ** ** |
|--------------------------------------------------------|------------|--------------------------------------------|------------|------------|------------|-----------------------|------------|
| **Maintenance  gross profit**                          | ** ** | **2004**                                   | ** ** | **2003**   | ** ** | **$ ****Change** | ** ** | **%****Change** | ** ** |
| **(dollars  in thousands)**                            | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** **            | ** ** | ** ** | ** ** |
|                                                   |       |                                       |       |       |       |                  |       |   |   |
| **Maintenance  gross profit**                          |       |                                       |       |       |       |                  |       |   |   |
| Law Enforcement                                        |       | $                                          | 766        |       | $          | 1,046                 |       | $ | (280 | ) | -27 | % |
| Percentage of Law Enforcement maintenance  revenue     |       | 56                                         | %          | 63         | %          |                  |       |   |   |
| Identification                                         |       | $                                          | 25         |       | $          | 194                   |       | $ | (169 | ) | -87 | % |
| Percentage of Identification maintenance  revenue      |       | 16                                         | %          | 38         | %          |                  |       |   |   |
| Digital Photography                                    |       | $                                          | 9          |       | $          | 1                     |       | $ | 8 |   | 794 | % |
| Percentage of Digital Photography  maintenance revenue |       | 100                                        | %          | 100        | %          |                  |       |   |   |
| Total net maintenance revenues                         |       | $                                          | 800        |       | $          | 1,241                 |       | $ | (441 | ) | -36 | % |
| Percentage of total maintenance revenues               |       | 52                                         | %          | 57         | %          |                  |       |   |   |

 

Grossmargins related to maintenance revenues decreased $441,000 from $1,241,000, or57% of maintenance revenues for the nine months ended September 30, 2003to $800,000, or 52% of maintenance revenues for the corresponding period in2004. This percentage decrease is due primarily to lower maintenance revenuesto absorb fixed maintenance costs.

 

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| ** **                      | ** ** | **NINE MONTHS ENDED  SEPTEMBER 30,** | ** ** | ** ** | ** ** | ** **            | ** ** |
|---------------------------------|------------|-------------------------------------------|------------|------------|------------|-----------------------|------------|
| **Operating  expenses**         | ** ** | **2004**                                  | ** ** | **2003**   | ** ** | **$ ****Change** | ** ** | **%****Change** | ** ** |
| **(dollars  in thousands)**     | ** ** | ** **                                | ** ** | ** ** | ** ** | ** **            | ** ** | ** ** | ** ** |
|                            |       |                                      |       |       |       |                  |       |   |   |
| General & administrative    |       | $                                         | 3,422      |       | $          | 4,343                 |       | $ | (921 | ) | -21 | % |
| Percentage of total net revenue |       | 49                                        | %          | 34         | %          |                  |       |   |   |
| Sales and marketing             |       | $                                         | 2,593      |       | $          | 3,020                 |       | $ | (427 | ) | -14 | % |
| Percentage of total net revenue |       | 37                                        | %          | 24         | %          |                  |       |   |   |
| Research & development      |       | $                                         | 1,969      |       | $          | 1,439                 |       | $ | 530 |   | 37 | % |
| Percentage of total net revenue |       | 28                                        | %          | 11         | %          |                  |       |   |   |
| Depreciation and amortization   |       | $                                         | 547        |       | $          | 692                   |       | $ | (145 | ) | -21 | % |
| Percentage of total net revenue |       | 8                                         | %          | 5          | %          |                  |       |   |   |

 

*GENERAL AND ADMINISTRATIVE EXPENSES.*  General and administrative expenses arecomprised of salaries and other employee-related costs for executive, financialand other infrastructure personnel. General legal, accounting and consultingservices, insurance, occupancy and communication costs are also included withgeneral and administrative expenses. Such expenses decreased 21%, or $921,000from $4,343,000 for the nine months ended September 30, 2003 to $3,422,000for the corresponding period in 2004. Such expenses, as a percentage of total net revenues, increased from 34%for the nine months ended September 30, 2003 to 49% for the correspondingperiod in 2004.  This percentage increaseis reflective of lower total net revenues during the nine months ended September 30,2004 as compared to the corresponding period in 2003.  The dollar reduction of $921,000 isreflective of the consolidation of our South Carolina office into our San Diegooffice combined with headcount reductions at our San Diego, California andStuttgart, Germany offices and lower occupancy costs at our San Diego,California office.   We are continuing tofocus our efforts on achieving additional future operating efficiencies byreviewing and improving upon existing business processes and evaluating our coststructure. We believe these efforts will allow us to gradually decrease ourlevel of general and administrative expenses expressed as a percentage of totalrevenues.

 

*SALES AND MARKETING.*  Salesand marketing expenses consist primarily of the salaries, commissions, otherincentive compensation, employee benefits and travel expenses of our salesforce. Such expenses decreased 14%, or $427,000 from $3,020,000 for the ninemonths ended September 30, 2003 to $2,593,000 for the corresponding periodin 2004.  Such expenses, as a percentageof total net revenues, increased from 24% for the nine months ended September 30,2003 to 37% for the corresponding period in 2004.  This percentage increase is reflectiveof lower total net revenues during the nine months ended September 30,2004 as compared to the corresponding period in 2003.  Thedollar decrease of $427,000 is due primarily to reduced headcount and lowersales commissions during the first nine months of 2004, offset slightly in thethird quarter by increases in headcount and payments to sales consultants(including lobbyists).  Theincrease in headcount and amounts paid to sales consultants reflects requiredresources needed to pursue large project solution opportunities.  The headcount reduction during the first sixmonths of 2004 reflects the consolidation in 2003 of our product lines andsales force under the direction of our San Diego office.  We anticipate that expenses for sales andmarketing will increase through 2004 as we continue to add personnel andresources for large project solution sales.

 

*RESEARCH AND DEVELOPMENT.* Research and development costs consist primarily of salaries, employeebenefits and outside contractors for new product development, productenhancements and custom integration work. Such expenses increased 37% or $530,000from $1,439,000 for the nine months ended September 30, 2003 to $1,969,000for the corresponding period in 2004 due primarily to the accelerateddevelopment of our new ImageWare Biometric Engine and the web enablement of ourCCS product line utilizing contract programming services in conjunction withinternal research and development resources.   Our level of expenditures inresearch and development reflects our belief that to maintain our competitiveposition in markets characterized by rapid rates of technological advancement,we must continue to invest significant resources in new systems and software aswell as continue to enhance existing products.

 

*DEPRECIATION AND AMORTIZATION.* Depreciation and amortization decreased $145,000 from $692,000 for thenine months ended September 30, 2003 to $547,000 for the correspondingperiod in 2004. This decrease is due primarily to lower amortization ofintangible assets due to such assets being fully amortized and lowerdepreciation expense related to fixed assets previously utilized in our SouthCarolina office, which was closed in June 2003.

 

*INTEREST (INCOME) EXPENSE, NET.*  Forthe nine months ended September 30, 2004, we recognized interest income of$7,000 and interest expense of $5,195,000. For the nine months ended September 30,2003, we recognized interest income of $2,000 and interest expense of$2,325,000.  Interest expense for thenine months ended September 30, 2004 contains approximately $4,472,000 ofinterest expense related to fair value accounting for our warrant liability dueto the registration rights agreement associated with the underlying shares ofthe Company’s common stock to be issued upon conversion of the warrants.  During June 2004, the Company registeredthe underlying shares of common stock with the Securities and ExchangeCommission.  In accordance with EITF00-19, there will be no further interest expense or income

 

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incurredin conjunction with these warrants. Interest expense for the nine months ended September 30, 2004 alsocontains $713,000 in liquidated damages, which were classified as interestexpense.  The liquidated damages wereincurred as the Company did not meet certain time requirements for theregistration of shares of the Company’s common stock under the registrationrights agreements for the November 2003 and January 2004 privateplacements.  Interest expense for thenine months ended September 30, 2003 includes approximately of $2,264,000of debt discount and deferred financing fee amortization classified as interestexpense and $390,000 classified as interest income related to fair valueaccounting for our warrant liability. The following table sets forth the major components of net interestexpense for the nine months ended September 30, 2004 and 2003:

 

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| ** **                                                                                                                                                           | ** ** | **NINE MONTHS ENDED  SEPTEMBER 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| **Components  of net interest expense (income):**                                                                                                                    | ** ** | **2004**                                  | ** ** | **2003** | ** ** |
| **(dollars  in thousands)**                                                                                                                                          | ** ** | ** **                                | ** ** | ** ** | ** ** |
|                                                                                                                                                                 |       |                                      |       |   |   |
| Senior secured convertible promissory note  issued May 22, 2002, interest rate 12.5% due May 22, 2004; Principal amount  $2,000,000                                  |       |                                      |       |   |   |
| Coupon interest rate expense                                                                                                                                         |       | $                                         | —     |   | $ | 199 |   |
| Amortization to interest expense of note  discount related to fair value of warrants                                                                                 |       |                                      |       | 374 |   |
| Amortization to interest expense of note  discount related to beneficial conversion feature                                                                          |       |                                      |       | 878 |   |
| Interest expense from amortization of  deferred financing fees                                                                                                       |       |                                      |       | 267 |   |
|                                                                                                                                                                 |       |                                      |       |   |   |
| Secured demand promissory note issued  September, 2002, interest rate 12.5%, due upon demand                                                                         |       | —                                    |       | 27 |   |
|                                                                                                                                                                 |       |                                      |       |   |   |
| Subordinated convertible promissory notes  issued March 2003, interest rate 8.5%, due April 15, 2005;  principal amount $600,000                           |       |                                      |       |   |   |
| Coupon interest rate expense                                                                                                                                         |       |                                      |       | 26 |   |
| Amortization to interest expense of note  discount related to beneficial conversion feature                                                                          |       |                                      |       | 28 |   |
| Interest expense from amortization of  deferred financing fees                                                                                                       |       |                                      |       | 15 |   |
|                                                                                                                                                                 |       |                                      |       |   |   |
| Senior secured convertible promissory notes  issued June 2003, interest rate 12.5% due May 22, 2005, principal amount  $4,256,000; (“the New Notes”): |       |                                      |       |   |   |
| Coupon interest rate expense                                                                                                                                         |       |                                      |       | 158 |   |
| Amortization to interest expense of note  discount related to fair value of warrants                                                                                 |       |                                      |       | 306 |   |
| Amortization to interest expense of note  discount relating to beneficial conversion feature                                                                         |       |                                      |       | 308 |   |
| Interest expense from amortization of  deferred financing fees                                                                                                       |       |                                      |       | 88 |   |
|                                                                                                                                                                 |       |                                      |       |   |   |
| Other note payable interest expense                                                                                                                                  |       | 10                                        |       | 41 |   |
|                                                                                                                                                                 |       |                                      |       |   |   |
| Change in warrant liability classified as  interest (income) or expense                                                                                              |       | 4,472                                     |       | (390 | ) |
|                                                                                                                                                                 |       |                                      |       |   |   |
| Interest expense from incurrence of  liquidated damages related to non-timely registration of common stock                                                           |       | 713                                       |       | — |   |
|                                                                                                                                                                 |       |                                      |       |   |   |
| Interest income                                                                                                                                                      |       | (7                                        | )          | (2 | ) |
|                                                                                                                                                                 |       |                                      |       |   |   |
| Net interest (income) expense                                                                                                                                        |       | $                                         | 5,188      |   | $ | 2,323 |   |

 

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*LIQUIDITY AND CAPITAL RESOURCES*

 

Asof September 30, 2004, we had total current assets of $5,846,000 and totalcurrent liabilities of $3,185,000, or working capital of $2,661,000. At September 30,2004, we had available cash of $2,932,000 and $107,000 in restricted cashsecuring our performance on certain software implementation contracts.

 

Netcash used in operating activities was $3,786,000 for the nine month periodended September 30, 2004 as compared to $1,144,000 for the correspondingperiod in 2003. We used cash to fund net losses of $3,447,000, excludingnon-cash expenses (depreciation, amortization, stock based compensation andchange in warrant liability) of $5,288,000 for the nine months ended September 30,2004.  We used cash to fund net losses of$1,831,000, excluding non-cash expenses depreciation, amortization and changein warrant liability) of $2,475,000 for the corresponding period in 2003. Forthe nine months ended September 30, 2004, we used cash of $364,000 to fundincreases in current, intangible and other assets and generated cash of $25,000through increases in current liabilities and deferred revenues, excluding debt.In the first nine months of 2003, we generated cash of $2,017,000 fromreductions in current, intangible and other assets and used cash of $1,330,000for reductions in current liabilities and deferred revenues, excluding debt.

 

Netcash used by investing activities was $137,000 for the nine months ended September 30,2004 as compared to $201,000 for the corresponding period in 2003. For the ninemonths ended September 30, 2004, we used cash to fund capital expendituresof computer equipment and software, furniture and fixtures and leaseholdimprovements of approximately $126,000. The level of equipment purchasesresulted primarily from continued growth of the business and replacement ofolder equipment. For the nine months ended September 30, 2004, we usedcash of approximately $59,000 to repay advances from related stockholders andgenerated cash of $48,000 through reductions in restricted cash.  For the nine months ended September 30,2003, we used cash of $162,000 to fund capital expenditures of computerequipment, software, furniture and fixtures. We used cash of $158,000 to repayadvances from related stockholders, generated cash of $60,000 throughreductions in restricted cash and generated cash of $59,000 from the sale ofequipment.

 

Netcash provided by financing activities was $6,305,000 for the nine month periodended September 30, 2004 as compared to $1,636,000 for the correspondingperiod in 2003.  For the nine monthsended September 30, 2004, we generated cash of $6,054,000 from ourissuance of common stock in a private placement.  We also generated cash of $483,000 from theexercise of stock options and stock purchase warrants.   For the nine month period ended September 30,2004, we used cash of $185,000 for the payment of dividends on our Series BPreferred Stock and used cash of $47,000 for the repayment of notespayable.  For the nine months ended September 30,2003, we generated cash of $4,856,000 from our issuance of subordinatedconvertible promissory notes payable offset by $554,000 in debt issuance costsand $2,500,000 for the repayment of notes payable.  We also used cash of $166,000 for therepayment of short-term borrowings under bank line of credit agreements.

 

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

 

Webelieve that our current cash balances will satisfy our projected workingcapital and capital expenditure requirements for at least the next12 months. Thereafter, we anticipate continuing to use cash, cashequivalents, and short-term investment balances to satisfy our projectedworking capital and capital expenditure requirements. However, because of ourconcern that currently weak economic conditions may continue, we have taken and continue to take stepsto limit our expenses and align our cost structure to our revenues. These stepsinclude, among other things, considering and/or taking steps, as needed, torestructure our business, consolidating our operations, negotiating volumepricing with vendors, centralizing certain services and standardizing products.We recognize that our operating expense levels, including research,development, engineering, selling, marketing, general and administrativeexpenses, depend on anticipated business activity levels. While research,development, engineering and marketing expenses are based on anticipatedinvestment levels in technology development, product development and marketdevelopment activities, the appropriate expense levels in selling, general andadministrative expenses are dependant on the level of infrastructure requiredto support our anticipated business volume. We review our business plansperiodically to determine the appropriate level of such expenses based onvarious business factors. In the past we have taken appropriate measures tocontrol our expenses based on business circumstances. In the future we willcontinue to review our business plans from time to time and make appropriatechanges to our expense levels, as we have in the past, to reduce operatingexpenses where it is advantageous to do so to improve operational efficiencies.

 

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

 

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**RISK FACTORS**

 

**WE HAVE A HISTORY OF SIGNIFICANT RECURRINGLOSSES TOTALLING APPROXIMATELY $55.0 MILLION, AND THESE LOSSES MAY CONTINUE INTHE FUTURE.**

 

As of September 30, 2004, we had an accumulated deficit ofapproximately $55.0 million, and these losses may continue in the future. Wemay need to raise capital to cover these losses, and financing may not beavailable to us on favorable terms. We expect to continue to incur significantsales and marketing, research and development, and general and administrativeexpenses. As a result, we will need to generate significant revenues to achieveprofitability and may never achieve profitability.

 

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

 

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

 

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

 

Pursuant to the terms of our Series B Preferred Stock we are obligatedto pay cumulative cash dividends on shares of Series B Preferred Stock fromlegally available funds at the annual rate of $0.2125 per share, payable in twosemi-annual installments of $0.10625 each, which cumulative dividends must bepaid prior to payment of any dividend on our Common Stock.  As of September 30, 2004, the Companyhad cumulative undeclared dividends of approximately $18,000.

 

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

 

In the past three years we have derived a substantial portion of ourrevenues from a small number of sales of large, relatively expensive systems,typically ranging in price from $300,000 to in excess of $1,000,000. As aresult, if we fail to receive orders for these large systems in a given salescycle on a consistent basis, our business could be significantly harmed.Further, our quarterly results are difficult to predict because we cannotpredict in which quarter, if any, large system sales will occur in a givenyear. 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 RELIANCE ON SINGLE SOURCE SUPPLIERS COULDDELAY PRODUCT SHIPMENTS.**

 

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

 

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

 

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

 

26

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

Our strategy includes building our business through acquisitions and wewill likely pursue future acquisitions. Integrating acquired businesses is acomplex, time consuming and expensive process. To integrate acquiredbusinesses, we must implement our technology systems in the acquired operationsand assimilate and manage the personnel of the acquired operations. Our successin completing the integration of acquired businesses may impact the marketacceptance of such acquisitions, and our willingness to acquire additionalbusinesses in the future. Further, the difficulties of integrating acquiredbusinesses could disrupt our ongoing business, distract our 

 

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

 

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

 

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

 

**ITEM3.  CONTROLS AND PROCEDURES**

 

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

 

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

 

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**PART II**

 

**ITEM 6.EXHIBITS**

 
| **(a)** | ** ** | **EXHIBITS**                                                                                                                 |
|---------|------------|------------------------------------------------------------------------------------------------------------------------------|
|    |       |                                                                                                                         |
| 31.1    |       | Certification  of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley  Act                            |
| 31.2    |       | Certification of Chief Financial Officer pursuant to Section 302  of the Sarbanes-Oxley Act                             |
| 32.1    |       | Certification by Chief Executive Officer and Chief Financial Officer  pursuant to Section 906 of the Sarbanes-Oxley Act |

 

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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:  November 15, 2004 | 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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