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

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

**(Mark One)**

 

| **ý** | ** ** | **QUARTERLY  REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934**       |
|------------|------------|---------------------------------------------------------------------------------------------------------|
|       |       |                                                                                                    |
|       |       | **For the quarterly period ended March 31, 2006**                                                  |
|       |       |                                                                                                    |
| **o**      | ** ** | **TRANSITION  REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT**                          |
|       |       |                                                                                                    |
|       |       | **For the transition period  from         to  ** |

 

**Commission file number 001-15757**

 

**IMAGEWARESYSTEMS, INC.**

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

 

| **Delaware**                                                    | ** ** | **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 suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days. Yes ý  No o

 

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

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

 

Indicate by check mark whether the registrant is a shell company (asdefined  in Rule 12b-2 of theExchange Act).Yes  o No ý

 

Thenumber of shares of Common Stock, with $0.01 par value, outstanding on May 12,2006 was 13,547,662.

 

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 March 31, 2006 and December 31, 2005                                |   |
|          |                  | Condensed Consolidated  Statements of Operations for the three months ended March 31, 2006 and  2005                  |   |
|          |                  | Condensed Consolidated  Statements of Cash Flows for the three months ended March 31, 2006 and  2005                  |   |
|          |                  | Condensed Consolidated  Statements of Comprehensive Income (Loss) for the three months ended March 31,  2006 and 2005 |   |
|          |                  | Notes to Condensed  Consolidated Financial Statements                                                                      |   |
|          | ITEM 2.               | Management’s Discussion and Analysis or Plan of  Operation                                                            |   |
|          | ITEM 3.               | Quantitive and Qualitive  Disclosures About Market Risk                                                                    |   |
|          | ITEM 4.               | Controls and Procedures                                                                                                    |   |
|          |                  |                                                                                                                       |   |
| PART II. | OTHER  INFORMATION    |                                                                                                                       |
|          | ITEM  1A.             | Risk  Factors                                                                                                              |   |
|          | ITEM 6.               | Exhibits and Reports on Form 8-K                                                                                      |   |
|          |                  |                                                                                                                       |   |
| SIGNATURES    |                  |
|               |                       |                                                                                                                            |  |  |

 

2

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**PART I**

**FINANCIAL INFORMATION**

 

**ITEM 1. FINANCIAL STATEMENTS**

 

**IMAGEWARE SYSTEMS, INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(In Thousands, except share data)**

 
| ** **                                                                                                                                                                                                                                                                                                                                   | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                                                                                                                                                                   | ** ** | **(Unaudited)**          | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                                                                                                   | ** ** | ** **               | ** ** | ** **                  | ** ** |
| Current Assets:                                                                                                                                                                                                                                                                                                                              |       |                     |       |                        |       |
| Cash                                                                                                                                                                                                                                                                                                                                         |       | $                        | 1,298      |                        | $          | 741 |   |
| Accounts receivable, net                                                                                                                                                                                                                                                                                                                     |       | 1,765                    |       | 1,340                       |       |
| Inventory                                                                                                                                                                                                                                                                                                                                    |       | 192                      |       | 208                         |       |
| Other current assets                                                                                                                                                                                                                                                                                                                         |       | 332                      |       | 219                         |       |
| Total Current Assets                                                                                                                                                                                                                                                                                                                         |       | 3,587                    |       | 2,508                       |       |
|                                                                                                                                                                                                                                                                                                                                         |       |                     |       |                        |       |
| Property and equipment, net                                                                                                                                                                                                                                                                                                                  |       | 428                      |       | 424                         |       |
| Other assets                                                                                                                                                                                                                                                                                                                                 |       | 762                      |       | 738                         |       |
| Intangible assets, net of accumulated amortization                                                                                                                                                                                                                                                                                           |       | 153                      |       | 218                         |       |
| Goodwill                                                                                                                                                                                                                                                                                                                                     |       | 3,416                    |       | 3,416                       |       |
| **Total  Assets**                                                                                                                                                                                                                                                                                                                            | ** ** | **$**                    | **8,346**  | ** **                  | **$**      | **7,304** | ** ** |
|                                                                                                                                                                                                                                                                                                                                         |       |                     |       |                        |       |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                                                                                                                                                                                                                                | ** ** | ** **               | ** ** | ** **                  | ** ** |
|                                                                                                                                                                                                                                                                                                                                         |       |                     |       |                        |       |
| Current Liabilities:                                                                                                                                                                                                                                                                                                                         |       |                     |       |                        |       |
| Accounts payable                                                                                                                                                                                                                                                                                                                             |       | $                        | 994        |                        | $          | 690 |   |
| Deferred revenue                                                                                                                                                                                                                                                                                                                             |       | 1,372                    |       | 1,084                       |       |
| Accrued expenses                                                                                                                                                                                                                                                                                                                             |       | 1,053                    |       | 1,035                       |       |
| Notes payable to third parties, net of  discount                                                                                                                                                                                                                                                                                             |       | 1,149                    |       | —                      |       |
| Total Current Liabilities                                                                                                                                                                                                                                                                                                                    |       | 4,568                    |       | 2,809                       |       |
|                                                                                                                                                                                                                                                                                                                                         |       |                     |       |                        |       |
| Pension obligation                                                                                                                                                                                                                                                                                                                           |       | 1,152                    |       | 1,130                       |       |
| Total Liabilities                                                                                                                                                                                                                                                                                                                            |       | 5,720                    |       | 3,939                       |       |
|                                                                                                                                                                                                                                                                                                                                         |       |                     |       |                        |       |
| 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 March 31, 2006 and December 31, 2005, liquidation  preference $623,500 at March 31, 2006 and December 31, 2005 |       | 2                        |       | 2                           |       |
| Common stock, $.01 par value, 50,000,000  shares authorized, 13,554,366 shares issued and 13,547,662 shares outstanding  at March 31, 2006 and December 31, 2005, respectively                                                                                                                                                     |       | 134                      |       | 134                         |       |
| Additional paid in capital                                                                                                                                                                                                                                                                                                                   |       | 68,305                   |       | 67,650                      |       |
| Treasury stock, at cost - 6,704 shares                                                                                                                                                                                                                                                                                                       |       | (64                      | )          | (64                         | )          |
| Accumulated other comprehensive income                                                                                                                                                                                                                                                                                                       |       | (82                      | )          | (35                         | )          |
| Accumulated deficit                                                                                                                                                                                                                                                                                                                          |       | (65,669                  | )          | (64,322                     | )          |
| Total shareholders’ equity                                                                                                                                                                                                                                                                                                              |       | 2,626                    |       | 3,365                       |       |
|                                                                                                                                                                                                                                                                                                                                         |       |                     |       |                        |       |
| **Total  Liabilities and Shareholders’ Equity**                                                                                                                                                                                                                                                                                         | ** ** | **$**                    | **8,346**  | ** **                  | **$**      | **7,304** | ** ** |

 

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

 

3

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**IMAGEWARE SYSTEMS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

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

**(UNAUDITED)**

 
| ** **                                                                                                                       | ** ** | **THREE MONTHS ENDED  March 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                                                       | ** ** | **2006**                               | ** ** | **2005** | ** ** |
|                                                                                                                             |       |                                   |       |   |   |
| **Revenues:**                                                                                                                    | ** ** | ** **                             | ** ** | ** ** | ** ** |
| Product                                                                                                                          |       | $                                      | 2,298      |   | $ | 2,315 |   |
| Maintenance                                                                                                                      |       | 511                                    |       | 495 |   |
|                                                                                                                             |       | 2,809                                  |       | 2,810 |   |
| **Cost of revenues:**                                                                                                            | ** ** | ** **                             | ** ** | ** ** | ** ** |
| Product                                                                                                                          |       | 527                                    |       | 845 |   |
| Maintenance                                                                                                                      |       | 281                                    |       | 268 |   |
| Gross profit                                                                                                                     |       | 2,001                                  |       | 1,697 |   |
|                                                                                                                             |       |                                   |       |   |   |
| **Operating expenses:**                                                                                                          | ** ** | ** **                             | ** ** | ** ** | ** ** |
| General & administrative                                                                                                |       | 1,238                                  |       | 1,083 |   |
| Sales and marketing                                                                                                              |       | 1,093                                  |       | 941 |   |
| Research & development                                                                                                  |       | 934                                    |       | 691 |   |
| Depreciation and amortization                                                                                                    |       | 125                                    |       | 159 |   |
|                                                                                                                             |       | 3,390                                  |       | 2,874 |   |
|                                                                                                                             |       |                                   |       |   |   |
| Loss from operations                                                                                                             |       | (1,389                                 | )          | (1,177 | ) |
|                                                                                                                             |       |                                   |       |   |   |
| Interest (income) expense, net                                                                                                   |       | 26                                     |       | (6 | ) |
|                                                                                                                             |       |                                   |       |   |   |
| Other income, net                                                                                                                |       | (69                                    | )          | (44 | ) |
|                                                                                                                             |       |                                   |       |   |   |
| Loss from continuing operations before income taxes                                                                              |       | (1,346                                 | )          | (1,127 | ) |
|                                                                                                                             |       |                                   |       |   |   |
| Income tax expense (benefit)                                                                                                     |       | —                                 |       | — |   |
|                                                                                                                             |       |                                   |       |   |   |
| Loss from  continuing operations                                                                                                 |       | (1,346                                 | )          | (1,127 | ) |
|                                                                                                                             |       |                                   |       |   |   |
| Discontinued  operations:                                                                                                        |       |                                   |       |   |   |
| Gain (loss) from operations of discontinued Digital Imaging Asia  Pacific Component (including gain on disposal of $233 in 2005) |       | —                                 |       | 223 |   |
| Income tax benefit (expense)                                                                                                     |       | —                                 |       | — |   |
| Gain (loss) on discontinued operations                                                                                           |       | —                                 |       | 223 |   |
|                                                                                                                             |       |                                   |       |   |   |
| Net loss                                                                                                                         |       | $                                      | (1,346     | ) | $ | (904 | ) |
| Basic and diluted (loss) per common share - see note 2                                                                           |       |                                   |       |   |   |
| Loss from continuing operations                                                                                                  |       | $                                      | (0.10      | ) | $ | (0.10 | ) |
| Discontinued operations                                                                                                          |       | $                                      | —     |   | 0.02 |   |
| Net loss per common share                                                                                                        |       | $                                      | (0.10      | ) | $ | (0.08 | ) |
| Weighted-average shares (basic and diluted)                                                                                      |       | 13,547,662                             |       | 12,036,104 |   |

 

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

 

4

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**IMAGEWARE SYSTEMS, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(In Thousands)**

**(UNAUDITED)**

 
| ** **                                                                      | ** ** | **Three Months Ended  March 31,** | ** ** |
|---------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                      | ** ** | **2006**                               | ** ** | **2005** | ** ** |
| ** **                                                                      | ** ** | ** **                             | ** ** | ** ** | ** ** |
| **Cash flows from operating activities**                                        |       |                                   |       |   |   |
| Net loss                                                                        |       | $                                      | (1,346     | ) | $ | (904 | ) |
| Adjustments to reconcile net loss to net  cash used by operating activities     |       |                                   |       |   |   |
| Depreciation and amortization                                                   |       | 125                                    |       | 161 |   |
| Gain on sale of subsidiary                                                      |       | —                                 |       | (233 | ) |
| Non cash interest and amortization of debt  discount and debt issuance costs    |       | 25                                     |       | — |   |
| Stock-based compensation                                                        |       | 338                                    |       | 70 |   |
| Change in assets and liabilities                                                |       |                                   |       |   |   |
| Accounts receivable, net                                                        |       | (425                                   | )          | (173 | ) |
| Inventory                                                                       |       | 16                                     |       | 14 |   |
| Other current assets                                                            |       | (24                                    | )          | (43 | ) |
| Intangible and other assets                                                     |       | (24                                    | )          | 21 |   |
| Accounts payable                                                                |       | 304                                    |       | (223 | ) |
| Accrued expenses                                                                |       | (83                                    | )          | (317 | ) |
| Deferred revenue                                                                |       | 289                                    |       | 22 |   |
| Contract costs                                                                  |       | —                                 |       | (416 | ) |
| Pension obligation                                                              |       | 21                                     |       | (12 | ) |
| Total adjustments                                                               |       | 562                                    |       | (1,129 | ) |
| Net cash used by operating activities                                           |       | (784                                   | )          | (2,033 | ) |
|                                                                            |       |                                   |       |   |   |
| **Cash flows from investing activities**                                        |       |                                   |       |   |   |
| Purchase of property and equipment                                              |       | (64                                    | )          | (109 | ) |
| Proceeds from sale of subsidiary net of  cash sold and direct transaction costs |       | —                                 |       | 1,209 |   |
| Net cash provided (used) by investing  activities                               |       | (64                                    | )          | 1,100 |   |
|                                                                            |       |                                   |       |   |   |
| **Cash flows from financing activities**                                        |       |                                   |       |   |   |
| Repayment of notes payable                                                      |       | —                                 |       | (9 | ) |
| Proceeds from issuance of notes payable  with warrants                          |       | 1,550                                  |       | — |   |
| Proceeds from exercised stock options                                           |       | —                                 |       | 37 |   |
| Debt issuance costs                                                             |       | (98                                    | )          | — |   |
|                                                                            |       |                                   |       |   |   |
| Net cash provided by financing activities                                       |       | 1,452                                  |       | 28 |   |
| Effect of exchange rate changes on cash                                         |       | (47                                    | )          | (79 | ) |
| Net increase (decrease) in cash                                                 |       | 557                                    |       | (984 | ) |
|                                                                            |       |                                   |       |   |   |
| Cash at beginning of period                                                     |       | 741                                    |       | 2,912 |   |
|                                                                            |       |                                   |       |   |   |
| Cash at end of period                                                           |       | $                                      | 1,298      |   | $ | 1,928 |   |
| Supplemental disclosure of cash flow information:                               |       |                                   |       |   |   |
| Summary of non-cash investing and financing  activities:                        |       |                                   |       |   |   |
| Exchange of common shares for marketable  equity securities                     |       | $                                      | —     |   | $ | 231 |   |

 

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

 

5

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**IMAGEWARE SYSTEMS, INC.**

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

**(In thousands)**

**(UNAUDITED)**

 
| ** **                                     | ** ** | **THREE MONTHS ENDED  MARCH 31,** | ** ** |
|------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                     | ** ** | **2006**                               | ** ** | **2005** | ** ** |
| ** **                                     | ** ** | ** **                             | ** ** | ** ** | ** ** |
| Net loss                                       |       | $                                      | (1,346     | ) | $ | (904 | ) |
| Other comprehensive income (loss), net of tax: |       |                                   |       |   |   |
|                                           |       |                                   |       |   |   |
| Foreign currency translation adjustment        |       | (47                                    | )          | (79 | ) |
|                                           |       |                                   |       |   |   |
| Comprehensive loss                             |       | $                                      | (1,393     | ) | $ | (1,035 | ) |

 

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

 

6

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**IMAGEWARE SYSTEMS, INC.**

 

**NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**Three Months Ended March 31, 2006**

**(Unaudited**)

 

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

 

ImageWareSystems, Inc. (the “Company”), formerly known as ImageWare Software, Inc.,utilizes identity management technology to provide stand alone, networked andweb-based software solutions for secure credentials, biometrics, lawenforcement and professional photography.

 

*Basis of Presentation*

 

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

 

Theaccompanying condensed consolidated unaudited financial statements of ImageWarehave been prepared pursuant to the rules and regulations of the Securitiesand Exchange Commission (“SEC”) regarding interim financial reporting.Accordingly, they do not include all of the information and footnotes requiredby generally accepted accounting principles for annual financial statements andshould be read in conjunction with the consolidated financial statements forthe year ended December 31, 2005, and notes thereto included in theCompany’s Annual Report on Form 10-KSB, filed with the SEC on April 17,2006. In the opinion of management, the accompanying condensed consolidatedfinancial statements contain all adjustments, consisting only of adjustments ofa normal recurring nature, necessary for a fair presentation of the Company’sfinancial position as of March 31, 2006, and its results of operations forthe periods presented. These condensed consolidated unaudited financial statementsare not necessarily indicative of the results to be expected for the entireyear.

 

*Going Concern*

 

As reflected in the accompanying consolidated financial statements, theCompany has continuing losses and negative cash flows from operations. Thesematters raise doubt about the Company’s ability to continue as a going concern.

 

New financing will be required to fund working capital and operationsshould the Company be unable to generate positive cash flow from operations inthe near future. The Company is exploring the possible sale of equitysecurities and/or debt financing, and believes that additional financing willbe available under terms and conditions that are acceptable to the Company.However, there can be no assurance that additional financing will be available.In the event financing is not available in the time frame required, the Companywill be forced to reduce its rate of growth, if any, reduce operating expenses,curtail sales and marketing activities and reschedule research anddevelopment projects. In addition, the Company might be required to sellcertain of its assets or license its technologies to others. These actions,while necessary for the continuance of operations during a time of cashconstraints and a shortage of working capital, could adversely affect theCompany’s business.

 

In view of the matters described in the preceding paragraph,recoverability of a major portion of the recorded asset amounts shown in theaccompanying consolidated balance sheet is dependent upon continued operationsof the Company, which, in turn, is dependent upon the Company’s ability tocontinue to raise capital and generate positive cash flows from operations. Theconsolidated financial statements do not include any adjustments relating tothe recoverability and classification of recorded asset amounts or amounts andclassifications of liabilities that might be necessary should the Company beunable to continue its existence.

 

The Company operates in markets that are emerging and highlycompetitive. There is no assurance that the Company will operate at a profit inthe future.

 

7

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*Recently Issued Accounting Standards*

 

In March 2006, the FASB issued SFAS No. 156*, Accounting for Servicing of Financial Assets, anamendment of FASB Statements No. 140* (SFAS 156). SFAS 156requires that servicing assets and servicing liabilities be recognized at fairvalue, if practicable, when the Company enters into a servicing agreement. Thisaccounting standard will be effective for the Company beginning January 1,2007. SFAS 156 is not expected to have a material impact on the Company’sfinancial position, results of operations or cash flows.

 

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

 

**NOTE 2. STOCK BASED COMPENSATION**

 

AtMarch 31, 2006, the Company had three stock-based compensation plans foremployees and nonemployee directors which authorize the granting of variousequity-based incentives including stock options and restricted stock.

 

Priorto January 1, 2006, the Company accounted for the measurement and recognitionof stock-based compensation under the provisions of APB Opinion No. 25,“Accounting for Stock Issued to Employees,” and related Interpretations,permitted under Statement of Financial Accounting Standard No. 123, “Accountingfor Stock-Based Compensation (SFAS 123). As a result, employee stock optionbased compensation was included as a pro forma disclosure in the Notes to theCompany’s financial statements for prior year periods.

 

Priorto the adoption of SFAS No. 123(R), the Company provided the disclosuresrequired under SFAS No. 123. The pro forma effect on net income and net incomeper share as if the fair value of stock-based compensation had been recognizedas compensation for the first fiscal quarter of 2005 was as follows:

 

 
| ** **                                                         | ** ** | **Three Months  Ended March 31,** | ** ** |
|--------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| **(In thousands, except per share data)** | ** ** | **2005**                                         | ** ** |
|                                                               |       |                                             |       |
| Net Loss:                                                          |       |                                             |       |
| As reported                                                        |       | $                                                | (904       | ) |
| Stock-based compensation included in net  loss                     |       | 70                                               |       |
| Stock based employee compensation under  fair value based method   |       | (131                                             | )          |
| Pro forma net loss                                                 |       | $                                                | (965       | ) |
|                                                               |       |                                             |       |
| Basic loss per common share:                                       |       |                                             |       |
| As reported                                                        |       | $                                                | (0.08      | ) |
| Pro forma                                                          |       | $                                                | (0.09      | ) |

 

OnJanuary 1, 2006, the Company adopted the provisions of Statement of FinancialAccounting Standards No. 123(R), “Share-Based Payment”, (SFAS 123(R)) using themodified prospective transition method. SFAS 123(R) requires companies tomeasure and recognized the cost of employee services received in exchange forawards of equity instruments based on the grant date fair value of thoseawards. For share option instruments issued subsequent to the adoption of SFAS123(R), compensation cost is recognized ratably using the straight-lineattribution method over the expected vesting period. For equity options issuedprior to the adoption of SFAS 123(R), compensation cost is recognized using agraded vesting attribution method. In addition, pursuant to SFAS 123(R), we arerequired to estimate the amount of expected forfeitures when calculatingcompensation costs, instead of accounting for forfeitures as incurred, whichwas our previous method. Prior periods are not restated under this transitionmethod. Options previously awarded and classified as equity instrumentscontinue to maintain their equity classification under SFAS 123(R).

 

Theeffect of recording stock-based compensation for the first quarter of fiscal2006 was as follows:

 

8

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| ** **                                                         | ** ** | **Three Months  Ended March 31,** | ** ** |
|--------------------------------------------------------------------|------------|---------------------------------------------|------------|
| **(In thousands, except per share data)** | ** ** | **2006**                                    | ** ** |
| Stock-based compensation expense by type of  award:                |       |                                        |       |
| Employee stock options                                             |       | $                                           | 236        |   |
| Restricted stock grants                                            |       | 102                                         |       |
| Total employee stock based compensation                            |       | 338                                         |       |
| Tax effect on stock-based compensation                             |       | —                                      |       |
| Tax effect on net income                                           |       | —                                      |       |
| Stock-based compensation include in net  loss                      |       | $                                           | 338        |   |
|                                                               |       |                                        |       |
| Effect on loss per common share:                                   |       |                                        |       |
| Basic                                                              |       | $                                           | 0.03       |   |
| Diluted                                                            |       | $                                           | 0.03       |   |

 

Priorto adopting SFAS No. 123(R), the Company presented all excess tax benefits, itany, resulting from the exercise of stock options as operating cash flows inthe Statement of Cash Flows. SFAS No. 123(R) requires cash flows resulting fromexcess tax benefits to be classified as a financing activity. Excess taxbenefits are realized from tax deductions for exercised options in excess ofthe deferred tax asset attributable to stock compensation costs for suchoptions. The Company did not record any excess tax benefits as a result ofadopting SFAS 123(R) in the three months ended March 31, 2006 because theCompany is currently providing a full valuation on future tax benefits realizedin the United States until it can sustain a level of profitability thatdemonstrates its ability to utilize the assets.

 

SFASNo. 123(R) requires the use of a valuation model to calculate the fair value ofstock-based awards. For the three months ended March 31, 2006, the Company haselected to use the Black-Sholes option-pricing model, which incorporatesvarious assumptions including volatility, expected life, and interest rates.The Company is required to make various assumptions in the application of theBlack-Sholes option pricing model. The Company has determined that the bestmeasure of expected volatility is based on the historical weekly volatility ofthe Company’s common stock. Historical volatility factors utilized in theCompany’s Black-Sholes computations range from 83.5% to 98.5%. The Company haselected to estimate the expected life of an award based upon the SEC approved“simplified method” noted under the provisions of Staff Accounting Bulletin No.107. Under this formula, the expected term is equal to: ((weighted-averagevesting term + original contractual term)/2). The expected term used by theCompany as computed by this method range from 3.5 years to 6.1 years. Theinterest rate used is the risk free interest rate and is based upon U. S.Treasury rates appropriate for the expected term. Interest rates used in theCompany’s Black-Sholes calculations range from 2.7% to 4.6%. Dividend yield iszero as we do not expect to declare any dividends in the foreseeable future.

 

Asummary of the activity under the Company’s stock option plans for the threemonths ended March 31, 2006 is as follows:

 
| ** **                   | ** ** | **Options** | ** ** | **Weighted-   Average  Exercise  Price** | ** ** | **Weighted-  Average  Remaining  Contractual  Term** | ** ** |
|------------------------------|------------|-------------|------------|-----------------------------------------------|------------|------------------------------------------------------|------------|
|                         |       |        |       |                                          |       |                                                 |       |
| Balance at December 31, 2005 |       | 1,474,093   |       | $                                             | 2.68       |                                                 | 8.31       |   |
| Granted                      |       | 314,000     |       | $                                             | 1.92       |                                                 | 9.84       |   |
| Forfeited                    |       | (138,629    | )          | $                                             | 3.28       |                                                 | 5.04       |   |
| Exercised                    |       | —      |       | $                                             | —     |                                                 | —     |   |
|                         |       |        |       |                                          |       |                                                 |       |
| Balance at March 31, 2006    |       | 1,649,464   |       | $                                             | 2.77       |                                                 | 8.49       |   |

 

Optionsexercisable at March 31, 2006 totaled 540,901 at a weighted-average price of$2.75, with a remaining weighted average contractual term of approximately 7.2years.

 

Theweighted-average grant date fair value of options granted during the threemonths ended March 31, 2006 was $1.40.

 

9

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Thefollowing table sets forth a summary of the status and changes of the Company’sunvested shares related to its stock option plans as of and during the threemonths ended March 31, 2006:

 
| ** **                   | ** ** | **Options** | ** ** | **Weighted-  Average  Grant Date  Fair Value  Per Share** | ** ** |
|------------------------------|------------|-------------|------------|--------------------------------------------------------------------------|------------|
|                         |       |        |       |                                                                     |       |
| Balance at December 31, 2005 |       | 849,930     |       | $                                                                        | 1.83       |   |
| Granted                      |       | 314,000     |       | $                                                                        | 1.40       |   |
| Vested                       |       | (30,367     | )          | $                                                                        | 1.97       |   |
| Forfeited                    |       | (25,000     | )          | $                                                                        | 1.92       |   |
|                         |       |        |       |                                                                     |       |
| Balance at March 31, 2006    |       | 1,108,563   |       | $                                                                        | 1.72       |   |

 

At March 31,2006, the total remaining unrecognized compensation cost related to unvestedstock options amounted to approximately $937,000, which will be amortized overthe weighted-average remaining requisite service period of 2.6 years.

 

**NOTE 3. NET LOSS PER COMMON SHARE**

 

Basicloss per common share is calculated by dividing net loss available to commonshareholders for the period by

 

10

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theweighted-average number of common shares outstanding during the period. Dilutedearnings per common share is calculated by dividing net loss available tocommon shareholders for the period by the weighted-average number of commonshares outstanding during the period, adjusted to include, if dilutive,potential dilutive shares consisting of convertible preferred stock, stockoptions and warrants, calculated using the treasury stock method. During theperiods ended March 31, 2006 and 2005, 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  March 31, 2006** | ** ** | **Number of  Common Shares  Convertible into at  March 31, 2005** | ** ** |
|-------------------------------------|------------|------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
|                                |       |                                                                   |       |                                                                   |       |
| Convertible preferred stock         |       | 47,280                                                                 |       | 47,280                                                                 |       |
| Stock options                       |       | 1,352,175                                                              |       | 914,483                                                                |       |
| Warrants                            |       | 4,469,578                                                              |       | 5,824,863                                                              |       |

 

Thefollowing table sets forth the computation of basic and diluted loss per sharefor the three months ended March 31, 2006 and 2005 (amounts in thousandsexcept share and per share amounts):

 
| ** **                                                            | ** ** | **THREE MONTHS ENDED  MARCH 31,** | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                            | ** ** | **2006**                               | ** ** | **2005** | ** ** |
| Numerator – loss from continuing operations:                     |       |                                   |       |   |   |
| Net loss from continuing operations                                   |       | $                                      | (1,346     | ) | $ | (1,127 | ) |
| Less Series B preferred dividends                                |       | (13                                    | )          | (13 | ) |
| Net loss from continuing operations  available to common shareholders |       | $                                      | (1,359     | ) | $ | (1,140 | ) |
|                                                                  |       |                                   |       |   |   |
| Numerator – gain from discontinued operations                    |       |                                   |       |   |   |
| Net gain from discontinued operations                                 |       | —                                 |       | 223 |   |
| .                                                                     |       |                                   |       |   |   |
| Denominator                                                           |       |                                   |       |   |   |
| Weighted-average shares outstanding                                   |       | 13,547,662                             |       | 12,036,104 |   |
|                                                                  |       |                                   |       |   |   |
| Basic and diluted loss per share:                                     |       |                                   |       |   |   |
| Continuing operations                                                 |       | $                                      | (0.10      | ) | $ | (0.09 | ) |
| Discontinued operations                                               |       | —                                 |       | 0.02 |   |
| Net loss per share                                                    |       | (0.10                                  | )          | (0.07 | ) |

 

**NOTE 4. SEGMENT INFORMATION**

 

Prior to its acquisition of G & A, Castleworks and E-Focus,the Company operated in one business segment. With its acquisition of G &A, Castleworks and E-Focus, the Company is now comprised of three reportablesegments: Law Enforcement, Identification and Digital Photography. The LawEnforcement segment develops, sells and supports a suite of modularsoftware products and designs systems used by law enforcement and public safetyagencies to manage criminal history records and investigate crime. TheIdentification segment develops, sells and supports software and designssystems which utilize digital imaging in the production of photo identificationcards, documents and identification badging systems. The Digital Photographysegment develops digital imaging software for photographic purposes.

 

Due to the Company’s integrated operations, the use of allocations inthe determination of business segment information is necessary for certainfinancial information not discretely captured.

 

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

 

There are no inter-segment transactions.

 

11

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Thetable below summarizes information about reportable segments for the threemonths ended March 31, 2006 and 2005:

 
| ** **                                            | ** ** | **THREE MONTHS ENDED  March 31,** | ** ** |
|-------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                            | ** ** | **2006**                               | ** ** | **2005** | ** ** |
| ** **                                            | ** ** | **(in thousands)**                     | ** ** |
| Net Revenue:                                          |       |                                   |       |   |   |
| Law Enforcement                                       |       | $                                      | 1,090      |   | $ | 919 |   |
| Identification                                        |       | 1,675                                  |       | 1,799 |   |
| Digital Photography                                   |       | 44                                     |       | 92 |   |
| Total consolidated net sales                          |       | $                                      | 2,809      |   | $ | 2,810 |   |
|                                                  |       |                                   |       |   |   |
| Operating profit (loss):                              |       |                                   |       |   |   |
| Law Enforcement                                       |       | $                                      | (469       | ) | $ | (744 | ) |
| Identification                                        |       | (822                                   | )          | (240 | ) |
| Digital Photography                                   |       | (98                                    | )          | (193 | ) |
|                                                  |       |                                   |       |   |   |
| Other unallocated amounts:                            |       |                                   |       |   |   |
| Interest expense (income)                             |       | 26                                     |       | (6 | ) |
| Other income                                          |       | (69                                    | )          | (44 | ) |
|                                                  |       |                                   |       |   |   |
| Income (loss) from continuing operations before taxes |       | $                                      | (1,346     | ) | $ | (1,127 | ) |

 
| ** **                           | ** ** | **March 31,  2006** | ** ** |
|--------------------------------------|------------|--------------------------|------------|
| ** **                           | ** ** | **(in thousands)**       | ** ** |
| Total Assets by Segment:             | * *   | * *                 | * *   |
|                                 |       |                     |       |
| Law Enforcement                      |       | $                        | 605        |   |
| Identification                       |       | 5,987                    |       |
| Digital Photography                  |       | 60                       |       |
| Total assets for reportable segments |       | 6,652                    |       |
| Corporate                            |       | 1,694                    |       |
| Total consolidated assets            |       | $                        | 8,346      |   |

 

**NOTE 5. NOTES PAYABLE**

 

In March 2006, the Company completed a secured debt financing in theaggregate amount of $1,550,000, with net proceeds to Company approximating$1,452,000. The Company issued a series of secured promissory notesaggregating $1,550,000 which bear interest at 8% per annum, with interestcompounded monthly and payable quarterly. The principal balance becomes due inone year or earlier upon the occurrence of the following  contractually defined events: (i) paymentsreceived by the Company in connection with contracts with Grupo Inffinix andArgus Solutions or any affiliate thereof, or any extension, renewal oramendment of such contracts; or (ii) payments made against any newcontract signed by the Company which contract amount is in excess of$1,500,000; or (iii) the receipt by the Company of proceeds from the saleof equity or equity-linked securities by the Company; or (iv) receipt ofproceeds from the issuance by  theCompany of any type of debt instruments, including lines of credit. Inaddition, the Company may prepay the notes in whole or in part uponfive days prior written notice.

 

As a condition to the loan, the Company entered into a securityagreement whereby the Company granted a security interest in all of the Company’sgoods and equipment, inventory, contract rights and general intangibles,accounts or other obligations owing to the Company, and cash deposit accountsand other investment property to secure payment of the note.

 

As a condition to the loan, the Company also issued warrants topurchase 387,500 shares of the Company’s common stock. Such warrants have a5-year terms and an exercise price $2.30 per share. Common shares underlyingthe warrants

 

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have piggyback registration rights and cashless exercise after 12months from closing date if there is no effective registration statementcovering the underlying shares.

 

The Company recorded the secured debt financing net of a discount equalto the fair value allocated to the warrants using the relative fair valuemethod of approximately $419,000. The Company estimated the fair value of thewarrants using the Black-Sholes option pricing model and the followingassumptions: term of 5 years, a risk free interest rate of 4.52%, a dividendyield of 0%, and volatility of 82%. During the three months ended March 31, 2006, the Company recordedapproximately $18,000 in debt discount amortization which is included as acomponent of net interest expense in the Company’s Condensed ConsolidatedStatement of Operations.

 

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

 

ThisQuarterly Report on Form 10-Q contains forward-looking statements withinthe meaning 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 hereof,and 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 orachievements, or industry results to be materially different from any futureresults, performance or achievements expressed or implied by suchforward-looking statements. Factors that could cause or contribute to suchdifferences include but are not limited to those items discussed under “RiskFactors” beginning on page 22 and elsewhere in this Quarterly Report.

 

Thefollowing discussion of the financial condition and results of operationsshould be read in conjunction with the condensed consolidated financialstatements included elsewhere within this quarterly report. Fluctuations inannual and quarterly results may occur as a result of factors affectingdemand for our products such as the timing of new product introductions by usand by our competitors and our customers’ political and budgetary constraints.Due to such fluctuations, historical results and percentage relationships arenot necessarily indicative of the operating results for any future period.

 

**OVERVIEW**

 

ImageWareSystems, Inc. utilizes its identity management technology to developsoftware used to create booking and investigative software, smart and secureidentification systems and documents, and software for professionalphotographers. Our software systems and associated hardware enable ourcustomers to quickly capture, archive, search, retrieve and share digitalphotographs and associated text records. The following management’s discussionand analysis is based primarily upon our Law Enforcement, Identification andDigital Photography products.

 

CRITICAL ACCOUNTING ESTIMATES

 

The discussion and analysis of our financial condition and results ofoperations are based on our consolidated financial statements, which have beenprepared in accordance with accounting principals generally accepted in theUnited States of America, or U.S. GAAP. The preparation of these financialstatements in accordance with U.S. GAAP requires us to utilize accountingpolicies and make certain estimates and assumptions that affect the reported amountsof assets and liabilities, the disclosure of contingencies as of the date ofthe financial statements and the reported amounts of revenue and expensesduring a fiscal period. The SEC considers an accounting policy to be criticalif it is important to a company’s financial condition and results ofoperations, and if it requires significant judgement and estimates on the part ofmanagement in its application. Although we believe that our judgements andestimates are appropriate and correct, actual results may differ fromthose estimates.

 

The following are our critical accounting policies because we believethey are both important to the portrayal of our financial condition and resultsof operations and require critical management judgements and estimates aboutmatters that are uncertain. If actual results or events differ materially fromthose contemplated by us in making these estimates, our reported financialcondition and results of operations for future periods could be materiallyaffected.

 

***Revenue Recognition***

 

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

 

•                  Long-termfixed-price contracts involving significant customization

•                  Fixed-pricecontracts involving minimal customization

 

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•                  Softwarelicensing

•                  Sales ofcomputer hardware and identification media

•                  Postcontractcustomer support (PCS)

 

We recognize revenue when all of the following criteria are met:persuasive evidence of an arrangement exists, delivery has occurred or serviceshave been rendered, the fee is fixed or determinable, and collectibility isreasonable assured.

 

We recognize revenue and profit as work progresses on long-term,fixed-price contracts involving significant amount of hardware and softwarecustomization using the percentage of completion method based on costs incurredto date compared to total estimated costs at completion. Revenue from contractsfor which we cannot reliably estimate total costs or there are not significantamounts of customization are recognized upon completion. Determiningwhen a contract should be accounted for using the percentage of completionmethod involves judgment. Critical items that are considered in this processare the degree of customization and related labor hours necessary to completethe required work as well as ongoing estimates of the future labor hours neededto complete the contract. We also generate non-recurring revenue fromthe licensing of our software. Software license revenue is recognized upon theexecution of a license agreement, upon deliverance, fees are fixed anddeterminable, collectibility is probable and when all other significant obligationshave been fulfilled. We also generate revenue from the sale of computerhardware and identification media. Revenue for these items is recognized upondelivery of these products to the customer. Our revenue from periodicmaintenance agreements is generally recognized ratably over the respectivemaintenance periods provided no significant obligations remain andcollectibility of the related receivable is probable.

 

***Allowance for Doubtful Accounts***

 

Ourmanagement must make estimates of the uncollectibility of our accountsreceivables. Management specifically analyzes accounts receivable and analyzeshistorical bad debts, customer concentrations, customer creditworthiness,current economic trends, the age of the accounts receivable balances, and changesin our customer payment terms when evaluating the adequacy of the allowance fordoubtful accounts. Our accounts receivables balance was approximately $1,765,000,net of allowance for doubtful accounts of approximately $475,000 as of March 31,2006.

 

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

 

Weassess impairment of goodwill and identifiable intangible assets wheneverevents or changes in circumstances indicate that the carrying value may notbe recoverable. Factors we consider important which could trigger an impairmentreview include the following:

 

•                                          Significant underperformance relative tohistorical or expected future operating results;

 

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

 

•                                          Significant negative industry or economictrends;

 

Whenwe determine that the carrying value of goodwill and other intangible assets may notbe recoverable based upon the existence of one or more of the above indicatorsof impairment, we measure any impairment based upon fair value methodologies.Goodwill and other net intangible assets amounted to approximately $3,569,000as of March 31, 2006.

 

In2002, Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwilland Other Intangible Assets” became effective, and as a result we ceased toamortize goodwill. In lieu of amortization, we performed an initial impairmentreview of our goodwill in June, 2002 and will perform an annual impairmentreview thereafter in the fourth quarter of our fiscal year. Completion of ourinitial impairment test indicated there was no goodwill impairment. We alsoperformed our annual impairment review as of December 31, 2004 and 2005,based upon our 2005 and 2006 operating plans, respectively. This annualimpairment review indicated there was goodwill impairment in our DigitalPhotography segment as of December 31, 2005, and accordingly, we haverecorded an impairment loss in the 2005 Consolidated Statement of Operations. Bothof these tests were conducted by determining and comparing the fair value ofour reporting units, as defined in SFAS 142, to the reporting unit’s carryingvalue as of that date. Our reporting units are Law Enforcement, Identificationand Digital Photography. We determined that as of  March 31, 2006 there were no indicatorsof potential impairment. There are many management assumptions and estimatesunderlying the determination of an impairment loss, and estimates usingdifferent, but reasonable, assumptions could produce significantly differentresults. Significant assumptions include estimates of future levels of revenuesand operating expenses. Therefore, the timing and recognition of impairmentlosses by us in the future, if any, may be highly dependent upon ourestimates and assumptions. There can be no assurance that goodwill impairmentwill not occur in the future.

 

14

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Weaccount for long-lived assets in accordance with the provisions of SFAS No. 144,“Accounting for the Impairment or Disposal of Long-Lived Assets.”  This statement requires that long-livedassets and certain identifiable intangible assets be reviewed for impairmentwhenever events or changes in circumstances indicate that the carrying amountof an asset may not be recoverable. Recoverability of assets to be heldand used is measured by a comparison of the carrying amount of an asset tofuture net undiscounted cash flows expected to be generated by the asset. Ifsuch assets are considered to be impaired, the impairment to be recognized ismeasured by the amount which the carrying amount of the assets exceeds the fairvalue of the assets. Fair value is determined based on discounted cash flows orappraised values, depending upon the nature of the asset. Assets to be disposedof are reported at the lower of the carrying amount of fair value less costs tosell. In 2005, we recorded an impairment charge of approximately $253,000related to our intangible asset for certain trademark and tradenames carried inour Identification segment. This loss reflects the amount by which the carryingvalue of this asset exceeded its estimated fair value determined by the assets’future discounted cash flows. The impairment loss is recorded as a component of“Operating expenses” in the Statement of Operations for 2005. We determinedthat as of  March 31, 2006 therewere no indicators of potential impairment. There are many managementassumptions and estimates underlying the determination of an impairment loss,and estimates using different, but reasonable, assumptions could producesignificantly different results. Significant assumptions include estimates offuture levels of revenues and operating expenses. Therefore, the timing andrecognition of impairment losses by us in the future, if any, may be highlydependent upon our estimates and assumptions. There can be no assurance thatintangible asset impairment will not occur in the future.

 

***Stock-BasedCompensation***

 

Uponadoptions of SFAS 123R on January 1, 2006, we began estimating the valueof employee stock options on the date of grant using the Black-Scholes model.Prior to the adoption of SFAS 123R, the value of each employee stock option wasestimated on the date of grant using the Black-Scholes model for the purpose ofthe pro forma financial disclosure in accordance with SFAS 123. Thedetermination of fair value of stock-based payment awards on the date of grantusing an option-pricing model is affected by our stock price as well asassumptions regarding a number of highly complex and subjective variables.These variables include, but are not limited to the expected stock pricevolatility over the term of the awards and the actual and projected employeestock option exercise behaviors. The expected term of options granted isderived from historical data on employee exercises and post-vesting employmenttermination behavior. We calculated our expected volatility assumption requiredin the Black-Scholes model based on the historical volatility of our stock. Asof January 1, 2006 we have adopted the modified prospective transitionmethod and its effect is included in our first quarter 2006 financialstatements.

 

15

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**RESULTS OF OPERATIONS**

 

***THREE MONTHS ENDED MARCH 31, 2006 AND2005.***

 
| ** **                              | ** ** | **THREE MONTHS  ENDED  MARCH 31,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|-----------------------------------------|------------|-----------------------------------------|------------|------------|------------|-------------------|------------|
| **Net  Product Revenues**               | ** ** | **2006**                                | ** ** | **2005**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars  in thousands)**             | ** ** | ** **                              | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                    |       |                                    |       |       |       |              |       |   |   |
| **Product revenues:**                   | ** ** | ** **                              | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| Law Enforcement                         |       | $                                       | 612        |       | $          | 328               |       | $ | 284 |   | 87 | % |
| Percentage of total net product revenue |       | 27                                      | %          | 14         | %          |              |       |   |   |
| Identification                          |       | $                                       | 1,642      |       | $          | 1,905             |       | $ | (263 | ) | (14 | )% |
| Percentage of total net product revenue |       | 71                                      | %          | 82         | %          |              |       |   |   |
| Digital Photography                     |       | $                                       | 44         |       | $          | 82                |       | $ | (38 | ) | (46 | )% |
| Percentage of total net product revenue |       | 2                                       | %          | 4          | %          |              |       |   |   |
| Total net product revenues              |       | $                                       | 2,298      |       | $          | 2,315             |       | $ | (17 | ) | (1 | )% |

 

Theincrease in our Law Enforcement revenues is due to the deployment of our CrimeCapture System to law enforcement agencies. We believe that continued incidentsof terrorism has created heightened interest in the ability of law enforcementand other government agencies to be able to efficiently retrieve, analyze andshare information from their respective criminal databases. We anticipate thatthese factors will increase the overall demand for our law enforcement productsand software; however, we cannot predict the timing of the shift in demand.

 

Domestically,Identification revenues decreased approximately $280,000 or 16% for the threemonths ended March 31, 2006 as compared to the corresponding period in 2005.This decrease in domestic revenue is reflective of a decrease inproject-oriented work. Internationally, our Identification revenues increasedapproximately $17,000. We continue to be of the opinion that governmentagencies and private entities will react to heightened security concernsresulting from acts of terrorism by re-evaluating and upgrading their abilityto positively identify and track their citizens, employees, consultants andvisitors. We anticipate that these factors will increase overall demand for ouridentification 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 us to achieve significantproduct revenue growth in our identification segment. In the past twelve monthswe have retooled our identification products to enable customization for largeproject applications, added the biometric engine for incorporation into largescale biometric installations and reoriented our organization to direct ourresources and capabilities toward establishing a foothold in the market forlarge-scale secure identification solutions.

 

Thedecrease in Digital Photography product revenues is due to lower sales of boxedsoftware during the three months ended March 31, 2006 as compared to thecomparable period of 2005.

 

Ourbacklog of product orders as of March 31, 2006 was approximately $1,177,000.At March 31, 2006, we also had maintenance and support backlog ofapproximately $1,164,000 under existing maintenance agreements. Product revenueis typically recognized within a three to six month time period depending uponthe required degree of customization, if any. Historically, we have experienceda very minimal risk of order cancellation. Our revenue from maintenanceagreements is generally recognized ratably over the respective maintenanceperiods provided no significant obligations remain and collectibility of therelated receivable is probable.

 

16

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| ** **                                  | ** ** | **THREE MONTHS  ENDED  MARCH 31,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|---------------------------------------------|------------|-----------------------------------------|------------|------------|------------|-------------------|------------|
| **Maintenance  Revenues**                   | ** ** | **2006**                                | ** ** | **2005**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars  in thousands)**                 | ** ** | ** **                              | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                        |       |                                    |       |       |       |              |       |   |   |
| **Maintenance revenues:**                   | ** ** | ** **                              | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| Law Enforcement                             |       | $                                       | 478        |       | $          | 478               |       | $ | — |   | 0 | % |
| Percentage of total net maintenance revenue |       | 94                                      | %          | 96         | %          |              |       |   |   |
| Identification                              |       | $                                       | 33         |       | $          | 5                 |       | $ | 28 |   | 556 | % |
| Percentage of total net maintenance revenue |       | 6                                       | %          | 1          | %          |              |       |   |   |
| Digital Photography                         |       | $                                       | —     |       | $          | 12                |       | $ | (12 | ) | (100 | )% |
| Percentage of total net maintenance revenue |       | 0                                       | %          | 3          | %          |              |       |   |   |
| Total net maintenance revenues              |       | $                                       | 511        |       | $          | 495               |       | $ | 16 |   | 3 | % |

 

Theincrease in Identification maintenance revenues is due to software maintenanceon domestic identification projects.

 

Thedecrease in Digital Photography maintenance revenues as compared to the correspondingperiod in 2005 is reflective of the expiration of certain software maintenanceon custom contract programming projects.

 
| ** **                                         | ** ** | **THREE MONTHS  ENDED  MARCH 31,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|----------------------------------------------------|------------|-----------------------------------------|------------|------------|------------|-------------------|------------|
| **Cost  of Product Revenues:**                     | ** ** | **2006**                                | ** ** | **2005**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars  in thousands)**                        | ** ** | ** **                              | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                               |       |                                    |       |       |       |              |       |   |   |
| **Cost of Product Revenues:**                      | ** ** | ** **                              | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| Law Enforcement                                    |       | $                                       | 263        |       | $          | 193               |       | $ | 70 |   | 37 | % |
| Percentage of Law Enforcement product  revenue     |       | 43                                      | %          | 59         | %          |              |       |   |   |
| Identification                                     |       | $                                       | 262        |       | $          | 650               |       | $ | (388 | ) | (60 | )% |
| Percentage of Identification product  revenue      |       | 16                                      | %          | 34         | %          |              |       |   |   |
| Digital Photography                                |       | $                                       | 2          |       | $          | 2                 |       | $ | 0 |   | 0 | % |
| Percentage of Digital Photography product  revenue |       | 4                                       | %          | 3          | %          |              |       |   |   |
| Total net product revenues                         |       | $                                       | 527        |       | $          | 845               |       | $ | (318 | ) | (38 | )% |
| Percentage of total product revenues               |       | 23                                      | %          | 37         | %          |              |       |   |   |

 

Overallcost of product revenues as a percentage of product revenues decreasedprimarily due to higher sales of software only solutions in the three monthsended March 31, 2006 than the comparable period in 2005 which had highersales of hardware and consumables (which have higher costs than software onlysolutions). This change in product resulted in  lower cost of sales as a percentage of productrevenues.

 

Thecost of product revenues for our Law Enforcement segment decreased as apercentage of product revenues due primarily to product mix with a higherpercentage of software sales for the three months ended March 31, 2006 ascompared to the corresponding period in 2005. 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.

 

Thecost of product revenues for our Identification segment decreased as apercentage of product revenues due primarily to product mix with a higherpercentage of software sales for the three months ended March 31, 2006 ascompared to the corresponding period in 2005. The dollar decrease in the costof product revenues related to our Identification segment is reflective of ahigher percentage of the sale of software only solutions than the comparableperiod in 2005. The percentage decrease in Identification cost of revenues as apercentage of Identification revenues from 34% for the three months ended March  31,2005 to 16% for the corresponding period in 2006 is reflective primarily ofhigher domestic identification revenues from project-oriented work whichincluded higher percentages of software than the comparable three months ended March 31,2005. Costs of products can vary as a percentage of product revenue from periodto period depending upon product mix and the hardware content, print mediaconsumable content and

 

17

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software content included in systemsinstalled during a given period.

 
| ** **                                              | ** ** | **THREE MONTHS  ENDED  MARCH 31,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|---------------------------------------------------------|------------|-----------------------------------------|------------|------------|------------|-------------------|------------|
| **Maintenance  cost of revenues**                       | ** ** | **2006**                                | ** ** | **2005**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
|                                                    |       |                                    |       |       |       |              |       |   |   |
| **Maintenance cost of revenues:**                       | ** ** | ** **                              | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| Law Enforcement                                         |       | $                                       | 266        |       | $          | 252               |       | $ | 14 |   | 6 | % |
| Percentage of Law Enforcement  maintenance revenue |       | 56                                      | %          | 53         | %          |              |       |   |   |
| Identification                                          |       | $                                       | 15         |       | $          | 16                |       | $ | (1 | ) | (9 | )% |
| Percentage of Identification maintenance  revenue       |       | 45                                      | %          | 339        | %          |              |       |   |   |
| Digital Photography                                     |       | $                                       | —     |       | $          | —            |       | $ | — |   | N/A |   |
| Percentage of Digital Photography maintenance  revenue  |       | —                                  | %          | —     | %          | —            |       | N/A |   |
| Total net maintenance revenues                          |       | $                                       | 281        |       | $          | 268               |       | $ | 13 |   | 5 | % |
| Percentage of total maintenance revenues                |       | 55                                      | %          | 54         | %          |              |       |   |   |

 

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

 
| ** **                                         | ** ** | **THREE MONTHS  ENDED  MARCH 31,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|----------------------------------------------------|------------|-----------------------------------------|------------|------------|------------|-------------------|------------|
| **Product  gross profit (dollars in thousands)**   | ** ** | **2006**                                | ** ** | **2005**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
|                                               |       |                                    |       |       |       |              |       |   |   |
| **Product gross profit**                           |       |                                    |       |       |       |              |       |   |   |
| Law Enforcement                                    |       | $                                       | 348        |       | $          | 135               |       | $ | 213 |   | 158 | % |
| Percentage of Law Enforcement product  revenue     |       | 57                                      | %          | 41         | %          |              |       |   |   |
| Identification                                     |       | $                                       | 1,380      |       | $          | 1,255             |       | $ | 125 |   | 10 | % |
| Percentage of Identification product  revenue      |       | 84                                      | %          | 66         | %          |              |       |   |   |
| Digital Photography                                |       | $                                       | 43         |       | $          | 79                |       | $ | (37 | ) | (47 | )% |
| Percentage of Digital Photography product  revenue |       | 96                                      | %          | 97         | %          |              |       |   |   |
| Total net product revenues                         |       | $                                       | 1,771      |       | $          | 1,470             |       | $ | 301 |   | 21 | % |
| Percentage of total product revenues               |       | 77                                      | %          | 63         | %          |              |       |   |   |

 

Totalproduct gross profit as a percentage of product revenues increased despite loweroverall product sales due to a higher percentage of total revenues coming fromthe sales of software only solutions which have lower costs than sales ofhardware and consumables.

 

LawEnforcement gross profit as a percentage of Law Enforcement product revenue increaseddue primarily to our product mix containing higher percentages of software(which have lower costs than hardware and consumable sales) than the comparableperiod in 2005. Also contributing to this increase is a larger revenue baseavailable to absorb fixed product costs. Costs of products can vary as apercentage of product revenue from quarter to quarter depending upon productmix and hardware content and print media consumable content included in systemsinstalled during a given period.

 

Identificationgross profit as a percentage of Identification product revenue increased dueprimarily to our product mix containing higher percentages of software onlysolutions (which have lower costs than sales of hardware and consumables) thanthe comparable period in 2005. 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.

 

Thedecrease of $37,000 in gross profit from the Digital Photography productsegment is reflective of our lower sales of boxed product in the three monthsended March 31, 2006, as compared to the corresponding period in 2005.

 

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| ** **                                             | ** ** | **THREE MONTHS  ENDED  MARCH 31,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|--------------------------------------------------------|------------|-----------------------------------------|------------|------------|------------|-------------------|------------|
| **Maintenance  gross profit**                          | ** ** | **2006**                                | ** ** | **2005**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars  in thousands)**                            | ** ** | ** **                              | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                                   |       |                                    |       |       |       |              |       |   |   |
| **Maintenance gross profit**                           |       |                                    |       |       |       |              |       |   |   |
| Law Enforcement                                        |       | $                                       | 212        |       | $          | 226               |       | $ | (14 | ) | (6 | )% |
| Percentage of Law Enforcement maintenance  revenue     |       | 44                                      | %          | 47         | %          |              |       |   |   |
| Identification                                         |       | $                                       | 18         |       | $          | (11               | )          | $ | 29 |   | (265 | )% |
| Percentage of Identification maintenance  revenue      |       | 55                                      | %          | (220       | )%         |              |       |   |   |
| Digital Photography                                    |       | $                                       | 0          |       | $          | 12                |       | $ | (12 | ) | (100 | )% |
| Percentage of Digital Photography  maintenance revenue |       | N/A                                     |       | 100        | %          |              |       |   |   |
| Total net maintenance revenues                         |       | $                                       | 230        |       | $          | 227               |       | $ | 3 |   | 1 | % |
| Percentage of total maintenance revenues               |       | 45                                      | %          | 46         | %          |              |       |   |   |

 

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

 
| ** **                        | ** ** | **THREE MONTHS ENDED  MARCH 31,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|-----------------------------------|------------|----------------------------------------|------------|------------|------------|-------------------|------------|
| **Operating  expenses**           | ** ** | **2006**                               | ** ** | **2005**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars  in thousands)**       | ** ** | ** **                             | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                              |       |                                   |       |       |       |              |       |   |   |
| General & administrative |       | $                                      | 1,238      |       | $          | 1,083             |       | $ | 155 |   | 14 | % |
| Percentage of total net revenue   |       | 44                                     | %          | 39         | %          |              |       |   |   |
| Sales and marketing               |       | $                                      | 1,093      |       | $          | 941               |       | $ | 152 |   | 16 | % |
| Percentage of total net revenue   |       | 39                                     | %          | 33         | %          |              |       |   |   |
| Research & development   |       | $                                      | 934        |       | $          | 691               |       | $ | 243 |   | 35 | % |
| Percentage of total net revenue   |       | 33                                     | %          | 25         | %          |              |       |   |   |
| Depreciation and amortization     |       | $                                      | 125        |       | $          | 159               |       | $ | (34 | ) | (22 | )% |
| Percentage of total net revenue   |       | 4                                      | %          | 6          | %          |              |       |   |   |

 

*GENERAL AND ADMINISTRATIVE EXPENSES.*General and administrative expenses arecomprised primarily of salaries and other employee-related costs for executive,financial, and other infrastructure personnel. General legal, accounting andconsulting services, insurance, occupancy and communication costs are alsoincluded with general and administrative expenses. The increase in suchexpenses, as a percentage of total net revenues, is reflective of approximately$115,000 of stock –based compensation expense recorded in 2006 pursuant to theimplementation of  SFAS 123(R). 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.*Sales and marketing expenses consistprimarily of the salaries, commissions, other incentive compensation, employeebenefits and travel expenses of our sales force. The increase in such expenses,as a percentage of total net revenues, is reflective of higher headcount. Weanticipate that the level of expenses for sales and marketing will continue through2006 as we pursue large project solution opportunities.

 

*RESEARCH AND DEVELOPMENT.*Research and development costs consistprimarily of salaries, employee benefits and outside contractors for newproduct development, product enhancements and custom integration work. Suchexpenses increased due primarily to the accelerated development of our newImageWare Biometric Engine, the Web enablement of our CCS product line,development of our IWS desktop security program and product enhancements to ourDigital Photography software product suite utilizing contract programmingservices in conjunction with internal research and development resources. Ourlevel of expenditures in research and development reflects our belief that tomaintain our competitive position in markets characterized by rapid rates oftechnological advancement, we must continue to invest

 

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significantresources in new systems and software as well as continue to enhance existingproducts.

 

*DEPRECIATION AND AMORTIZATION.*Depreciation and amortization decreased forthe three months ended March 31, 2006 as compared to the comparable periodin 2005 due primarily to lower amortization of intangible assets due to suchassets being fully amortized.

 

*INTEREST (INCOME) EXPENSE, NET.*For the three months ended March  31,2006, we recognized interest income of $4,000 and interest expense of $31,000.For the three months ended March 31, 2005, we recognized interest incomeof $7,000 and interest expense of $1,000. The increase in interest expense forthe three months ended March 31, 2006 was primarily due to interestexpense incurred on our secured debt financing consummated in March 2006.

 

*LIQUIDITY AND CAPITAL RESOURCES*

 

Asof March 31, 2006, we had total current assets of $3,587,000 and totalcurrent liabilities of $4,568,000, or negative working capital of $981,000. At March 31,2006, we had available cash of $1,298,000 and $106,000 in restricted cashsecuring our performance on certain software implementation contracts.

 

Netcash used in operating activities was $784,000 for the three month period endedMarch 31, 2006 as compared to $2,033,000 for the corresponding period in2005. We used cash to fund net losses of $858,000, excluding non-cash expenses(depreciation, amortization and stock-based compensation) of $488,000, for the threemonths ended March 31, 2006. We used cash to fund net losses of $906,000,excluding non-cash expenses (depreciation, amortization, and stock-basedcompensation) of $231,000 for the corresponding period in 2005 offset bynon-operating income (gain on sale of subsidiary) of $233,000. For the threemonths ended March 31, 2006, we used cash of $458,000 to fund increases incurrent assets and generated cash of $532,000 through increases in currentliabilities and deferred revenues, excluding debt. In the first three months of2005, we used cash of $180,000 to fund increases in current assets and usedcash of $947,000 for reductions in current liabilities and deferred revenues,excluding debt.

 

Netcash used in investing activities was $64,000 for the three months ended March 31,2006. Net cash provided by investing activities for the three months ended March 31,2005 was $1,100,000. For the three months ended March 31, 2006, we usedcash to fund capital expenditures of computer equipment and software, furnitureand fixtures and leasehold improvements of approximately $64,000. The level ofequipment purchases resulted primarily from the replacement of older equipment.For the three months ended March 31, 2005, we generated cash of $1,300,000from the sale of our wholly-owned Singapore subsidiary, Digital imaging AsiaPacific, offset by cash sold and direct transaction costs of $91,000. For thethree months ended March 31, 2005, we used cash of $109,000 to fundcapital expenditures of computer equipment and software, furniture and fixturesand leasehold improvement.

 

Netcash provided by financing activities was $1,452,000 for the three month periodended March  31, 2006 as compared to $28,000 for the correspondingperiod in 2005. For the three months ended March 31, 2006, we generatedcash of $1,550,000 from the issuance of secured notes payable and incurred debtissuance costs of 98,000. For the three months ended March 31, 2005, wegenerated cash of $37,000 from the exercise of stock options. For the threemonth period ended March 31, 2005, we used cash of $9,000 for the repaymentof notes payable.

 

Weconduct operations in leased facilities under operating leases expiring atvarious dates through 2006. In conjunction with our performance on varioussoftware installation and implementation contracts, we are contingently liableunder an irrevocable letter of credit in the amount of $106,000. The letter ofcredit expires on December 26, 2008. We also have secured notes payable dueduring the next twelve months in the approximate amount of $1,550,000.

 

Thereport of the Company’s independent accountants included with our Annual Reportas filed with the Commission on April 17, 2006, contained an explanatoryparagraph regarding our ability to continue as a going concern. The Company isseeking additional financing that we believe is necessary to fund our workingcapital requirements for at least the next twelve months in conjunction withthe successful implementation of our business plan. Our business plan includes,among other things, the monitoring and controlling of operating expenses,collection of significant trade and other accounts receivables, and controllingof capital expenditures. If we are unable to secure additional financing orsuccessfully implement our business plan, we will be required to seek fundingfrom alternate sources and/or institute cost reduction measures. We may seekto sell equity or debt securities, secure a bank line of credit, or considerstrategic alliances. The sale of equity or equity-related securities couldresult in additional dilution to our shareholders. There can be no assurancethat additional financing, in any form, will be available at all or, ifavailable, will be on terms acceptable to us. In addition, our

 

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abilityto raise additional capital may be dependent upon our common stock beingquoted on the American Stock Exchange. There can be no assurance that theCompany will be able to satisfy the criteria for continued listing on theAmerican Stock Exchange. Insufficient funds may require us to delay, scaleback or eliminate some or all of our activities, and if we are unable to obtainadditional funding there is substantial doubt about our ability to continue asa going concern.

 

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**RISK FACTORS**

 

***You should carefully consider the risks and uncertaintiesdescribed below, together with all of the other information included in thisreport, in considering our business and prospects. The risks and uncertaintiesdescribed below are not the only ones facing ImageWare Systems Inc. Additionalrisks and uncertainties not presently known to us or that we currently deemimmaterial also may impair our business operations. The occurrence of anyof the following risks could harm our business, financial condition or resultsof operations*****.**

 

**WE CURRENTLY HAVE LIMITED CASH RESOURCES AND WEWILL REQUIRE ADDITIONAL FUNDING TO FINANCE OUR WORKING CAPITALREQUIREMENTS DURING THE NEXT TWELVE MONTHS.**

 

Wecurrently have limited cash resources and we will require financing to fund ouranticipated working capital requirements during the next twelve months. Weanticipate that our existing resources will not be sufficient to enable us tomaintain our current and planned operations for the next twelve months. If weare not able to generate positive cash flows from operations in the nearfuture, we will be required to seek additional funding through public orprivate equity or debt financing. There can be no assurance that additionalfinancing will be available on acceptable terms, or at all. If we are requiredto sell equity to raise additional funds, our existing shareholders may incursubstantial dilution and any shares so issued may have rights, preferencesand privileges superior to the rights, preferences and privileges of ouroutstanding Common Stock. Also, we may be required to obtain funds througharrangements with third parties that require us to relinquish rights to certainof our technologies or products that we would seek to develop or commercializeourselves. In addition, our ability to raise additional capital may bedependent upon the Company’s Common Stock being listed on the American StockExchange (“Amex”). We cannot guarantee that the Company will be able to satisfythe criteria for continued listing on AMEX.

 

**WE HAVE HAD NET LOSSES IN OUR FIVE MOSTRECENT FISCAL YEARS AND CURRENTLY HAVE STOCKHOLDER’S EQUITY OF LESS THAN$6,000,000, AND AS A RESULT, AMEX MAY CONSIDER SUSPENDING OR DELISTING OURSECURITIES FROM THE EXCHANGE.**

 

The Amex Company Guide provides that Amex will normally consider suspendingdealings in, or removing from the list, securities of a company which sustainsnet losses in its five most recent fiscal years and has  stockholders’ equity of less than $6,000,000,unless the company has total market capitalization of at least $50,000,000, ortotal assets and revenue of $50,000,000. We have sustained net losses duringour five most recent fiscal years, and as of the year ended December 31,2005, our stockholders’ equity dropped to $3,365,602, from $8,266,219 for theyear ended December 31, 2004. We do not meet the alternative minimummarket capitalization or total asset and revenue requirements. As a result, we may beconsidered for suspension or delisting from Amex. We have not received anynotice from Amex that it is considering any such action.

 

**WE HAVE A HISTORY OF SIGNIFICANT RECURRING LOSSES TOTALINGAPPROXIMATELY $65.7 MILLION, AND THESE LOSSES MAY CONTINUE IN THE FUTURE.**

 

Asof March 31, 2006, we had an accumulated deficit of $65.7 million,and these losses may continue in the future. We may need to raisecapital to cover these losses, and financing may not be available to us onfavorable terms. We expect to continue to incur significant sales andmarketing, research and development, and general and administrative expenses.As a result, we will need to generate significant revenues to achieveprofitability and we may never achieve profitability.

 

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

 

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

 

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

 

Pursuantto the terms of our Series B Preferred Stock we are obligated to paycumulative cash dividends on shares of Series B Preferred Stock fromlegally available funds at the annual rate of $0.2125 per share, payable in twosemi-annual installments of $0.10625 each, which cumulative dividends must bepaid prior to payment of any dividend on our Common Stock. As of March 31,2006, the Company had cumulative undeclared dividends of approximately $22,000.

 

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

 

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

 

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

 

Whenconsidering the purchase of a large computerized booking or identificationsystem, a government agency may take as long as a year to evaluatedifferent systems and obtain approval for the purchase. If we fail to completea sale, we will have expended significant resources and received no revenue inreturn. Generally, agencies consider a wide range of issues before committingto purchase our products, including product benefits, ability to operate withtheir current systems, product reliability and their own budgetary constraints.While potential customers are evaluating our products and before they place anorder with us, we may incur substantial selling costs and expendsignificant management effort to accomplish a sale.

 

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

 

Asignificant number of our customers are government agencies. These agenciesoften do not set their own budgets and therefore have little control over theamount of money they can spend. In addition, these agencies experiencepolitical pressure that may dictate the manner in which they spend money.Due to political and budgetary processes and other scheduling delays that may frequentlyoccur relating to the contract or bidding process, some government agencyorders may be canceled or substantially delayed, and the receipt ofrevenues or payments may be substantially delayed. In addition, futuresales to government agencies will depend on our ability to meet governmentcontracting requirements, certain of which may be onerous or impossible tomeet, resulting in our inability to obtain a particular contract. Commonrequirements in government contracts include bonding requirements, provisionspermitting the purchasing agency to modify or terminate at will the contractwithout penalty, and provisions permitting the agency to perform investigationsor audits of our business practices.

 

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

 

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

 

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

 

Weare occasionally a subcontractor to systems integrators who manage largeprojects that incorporate our systems, particularly in foreign countries. Wecannot control these companies, and they may decide not to promote ourproducts or

 

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may pricetheir services in such a way as to make it unprofitable for us to continue ourrelationship with them. Further, they may fail to perform underagreements with their customers, in which case we might lose sales to thesecustomers. If we lose our relationships with these companies, our business may suffer.

 

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

 

Ourbusiness is based in large part on our technology, and our success dependsin part on our ability and efforts to protect our intellectual propertyrights. If we do not adequately protect our intellectual property throughcopyrights, patents and various trade secret protections afforded to us by law,our business will be seriously harmed. We have patent protection for elementsof certain of our products and patent applications on file.

 

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

 

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

 

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

 

Wecompleted the acquisitions of several companies, and we plan to continue toreview potential acquisition candidates. Our business and our strategy includesbuilding our business through acquisitions. However, acceptable acquisitioncandidates may not be available in the future or may not be availableon terms and conditions acceptable to us.

 

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

 

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

 

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

 

**ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES ANDUSE OF PROCEEDS**

 

In March 2006, the Company completed a secured debt financing inthe aggregate amount of $1,550,000, with net proceeds to Company approximating$1,453,000. The Company issued a series of secured promissory notesaggregating $1,550,000 which bear interest at 8% per annum, with interestcompounded monthly and payable quarterly. As a condition to the loan, theCompany also issued warrants to purchase 387,500 shares of the Company’s commonstock. Such warrants have a 5-year terms and an exercise price $2.30 per share.Common shares underlying the warrants have piggyback registration rights andcashless exercise after 12 months from closing date if there is no effectiveregistration statement covering the underlying shares.

 

The Company recorded the secured debt financing net of a discount equalto the fair value allocated to the warrants using the relative fair valuemethod of approximately $419,000.

 

Net proceeds will be utilized for working capital purposes.

 

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**ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUTMARKET RISK**

 

*Foreign Currency Exchange Risk*

 

Our exposure to adverse movements in foreign currency exchange rates isprimarily related to our subsidiaries operating expense, primarily in Canadaand Germany, denominated in the respective local currency. We currentlydo not enter into forward exchange contracts to hedge exposures denominated inforeign currencies and do not use derivative financial instruments for tradingor speculative purposes. The effect of an immediate 10% change in foreigncurrency exchange rates should not have a material effect on our futureoperating results or cash flows; however, a long term change in foreigncurrency rates would likely result in increased technical support andengineering expenses. The vast majority of our sales are transacted inU. S. dollars.

 

**ITEM 4. CONTROLS AND PROCEDURES**

 

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

 

*Changes in internal controls.*There has been no change in our internalcontrol over financial reporting during the fiscal quarter ended March 31,2006, that has materially affected, or is reasonably likely to materiallyaffect, our internal control over financial reporting.

 

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

 
| **(a)** | ** ** | **EXHIBITS**                                                                                      |
|---------|------------|---------------------------------------------------------------------------------------------------|
|    |       |                                                                                              |
| 4.1     |       | Form  of Warrant                                                                                  |
| 10.1    |       | Form of  Secured Promissory Notes                                                            |
| 10.2    |       | Security  Agreement(1)                                                                            |
| 31.1    |       | Certification  of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley  Act |
| 31.2    |       | Certification  of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley  Act |
| 32.1    |       | Certification  by Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley  Act |
| 32.2    |       | Certification  by Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley  Act |

 

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(1) Incorporated by reference to our Form 8-K filed with theCommission on March 23, 2006.

 

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**SIGNATURES**

 

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

 

 
|                     | IMAGEWARE  SYSTEMS, INC. |
|--------------------------|-------------------------------|
|                     |                          |   |
|                     |                          |   |
| Date:  May 22, 2006 | 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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