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

**Washington, D.C. 20549**

 

**FORM10-QSB**

 

**(Mark One)**

** **

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

 

**For the quarterly period ended March 31, 2005**

** **

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

 

**For the transition periodfrom         to         **

 

**Commission file number 001-15757**

 

**IMAGEWARESYSTEMS, INC.**

(ExactName of Small Business Issuer as Specified in Its Charter)

 

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

 

**10883 Thornmint RoadSan Diego, CA 92127**

(Addressof Principal Executive Offices)

 

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

 

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

 

State the number of sharesoutstanding of each of the issuer’s classes of common equity, as of the latestpracticable date: As of May 12, 2005, the number of outstanding shares of theRegistrant’s common stock, par value $.01, was 12,110,018.

 

Transitional Small BusinessDisclosure Format (check one) Yes o  No ý

 

 

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**IMAGEWARE SYSTEMS, INC. INDEX**

** **
| PART I.    | FINANCIAL INFORMATION |                                                                                                                  |
|------------|-----------------------|-----------------------------------------------------------------------------------------------------------------------|
|       | ITEM 1.               | FINANCIAL  STATEMENTS (UNAUDITED)                                                                                     |   |
|       |                  | Condensed  Consolidated Balance Sheet as of March 31, 2005                                                            |   |
|       |                  | Condensed  Consolidated Statements of Operations for the three months ended  March 31, 2005 and 2004                  |   |
|       |                  | Condensed  Consolidated Statements of Cash Flows for the three months ended  March 31, 2005 and 2004                  |   |
|       |                  | Condensed  Consolidated Statements of Comprehensive Income (Loss) for the  three months ended March 31, 2005 and 2004 |   |
|       |                  | Notes  to Condensed Consolidated Financial Statements                                                                 |   |
|       | ITEM  2.              | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                           |   |
|       | ITEM 3.               | Controls and  Procedures                                                                                              |   |
|       |                  |                                                                                                                  |   |
| PART II.   | OTHER INFORMATION     |                                                                                                                  |
|       | ITEM 2.               | CHANGES IN SECURITIES                                                                                                 |   |
|       | ITEM 6.               | EXHIBITS AND  REPORTS ON FORM 8-K                                                                                     |   |
|       |                  |                                                                                                                  |   |
| SIGNATURES |                  |

 

2

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**PART I**

### **FINANCIAL INFORMATION**

 

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

 

**IMAGEWARE SYSTEMS, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEET**

**ASSETS**

**(IN THOUSANDS)**

**(UNAUDITED)**

 
| ** **                                                                                                                                                                                                                                                             | ** ** | **March 31,  2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|
| ** **                                                                                                                                                                                                                                                             | ** ** | ** **          | ** ** |
| Current Assets:                                                                                                                                                                                                                                                        |       |                |       |
| Cash                                                                                                                                                                                                                                                                   |       | $                   | 1,928      |   |
| Restricted cash and cash equivalents                                                                                                                                                                                                                                   |       | 106                 |       |
| Accounts receivable, net                                                                                                                                                                                                                                               |       | 1,890               |       |
| Inventory                                                                                                                                                                                                                                                              |       | 840                 |       |
| Other current assets                                                                                                                                                                                                                                                   |       | 272                 |       |
| Total Current Assets                                                                                                                                                                                                                                                   |       | 5,036               |       |
|                                                                                                                                                                                                                                                                   |       |                |       |
| Property and equipment, net                                                                                                                                                                                                                                            |       | 517                 |       |
| Other assets                                                                                                                                                                                                                                                           |       | 785                 |       |
| Intangible assets, net of accumulated  amortization                                                                                                                                                                                                                    |       | 689                 |       |
| Goodwill                                                                                                                                                                                                                                                               |       | 4,661               |       |
| **Total Assets**                                                                                                                                                                                                                                                       | ** ** | **$**               | **11,688** | ** ** |
| ** **                                                                                                                                                                                                                                                             | ** ** | ** **          | ** ** |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                                                                                                                                                         |       |                |       |
| ** **                                                                                                                                                                                                                                                             | ** ** | ** **          | ** ** |
| Current Liabilities:                                                                                                                                                                                                                                                   |       |                |       |
| Accounts payable                                                                                                                                                                                                                                                       |       | $                   | 997        |   |
| Deferred revenue                                                                                                                                                                                                                                                       |       | 1,066               |       |
| Accrued expenses                                                                                                                                                                                                                                                       |       | 1,099               |       |
| Billings in excess of costs and estimated  earnings on uncompleted contracts                                                                                                                                                                                           |       | 8                   |       |
| Notes & advances payable to third  parties                                                                                                                                                                                                                         |       | 10                  |       |
| Total Current Liabilities                                                                                                                                                                                                                                              |       | 3,180               |       |
|                                                                                                                                                                                                                                                                   |       |                |       |
| Pension obligation                                                                                                                                                                                                                                                     |       | 800                 |       |
| Total Liabilities                                                                                                                                                                                                                                                      |       | 3,980               |       |
|                                                                                                                                                                                                                                                                   |       |                |       |
| 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, 2005, liquidation preference $623,500 at March 31, 2005 |       | 2                   |       |
| Common stock, $.01 par value, 50,000,000  shares authorized, 12,108,599 shares issued and 12,101,895 shares outstanding  at March 31, 2005                                                                                                                             |       | 120                 |       |
| Additional paid in capital                                                                                                                                                                                                                                             |       | 64,265              |       |
| Treasury stock, at cost - 6,704 shares                                                                                                                                                                                                                                 |       | (64                 | )          |
| Accumulated other comprehensive income                                                                                                                                                                                                                                 |       | 202                 |       |
| Accumulated deficit                                                                                                                                                                                                                                                    |       | (56,817             | )          |
| Total shareholders’ equity                                                                                                                                                                                                                                        |       | 7,708               |       |
|                                                                                                                                                                                                                                                                   |       |                |       |
| **Total Liabilities and Shareholders’ Equity**                                                                                                                                                                                                                    | ** ** | **$**               | **11,688** | ** ** |

 

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

 

3

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**IMAGEWARE SYSTEMS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS**

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

**(UNAUDITED)**

 
| ** **                                                                                                                        | ** ** | **THREE MONTHS ENDED  March 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                                                        | ** ** | **2005**                          | ** ** | **2004** | ** ** |
|                                                                                                                              |       |                              |       |   |   |
| **Revenues:**                                                                                                                     |       |                              |       |   |   |
| Product                                                                                                                           |       | $                                 | 2,315      |   | $ | 1,814 |   |
| Maintenance                                                                                                                       |       | 495                               |       | 444 |   |
|                                                                                                                              |       | 2,810                             |       | 2,258 |   |
| **Cost of revenues:**                                                                                                             |       |                              |       |   |   |
| Product                                                                                                                           |       | 845                               |       | 460 |   |
| Maintenance                                                                                                                       |       | 268                               |       | 221 |   |
| Gross profit                                                                                                                      |       | 1,697                             |       | 1,577 |   |
|                                                                                                                              |       |                              |       |   |   |
| **Operating expenses:**                                                                                                           |       |                              |       |   |   |
| General & administrative                                                                                                      |       | 1,083                             |       | 1,126 |   |
| Sales and marketing                                                                                                               |       | 941                               |       | 656 |   |
| Research & development                                                                                                        |       | 691                               |       | 633 |   |
| Depreciation and amortization                                                                                                     |       | 159                               |       | 186 |   |
|                                                                                                                              |       | 2,874                             |       | 2,601 |   |
|                                                                                                                              |       |                              |       |   |   |
| Loss from operations                                                                                                              |       | (1,177                            | )          | (1,024 | ) |
|                                                                                                                              |       |                              |       |   |   |
| Interest (income) expense, net                                                                                                    |       | (6                                | )          | 1,291 |   |
|                                                                                                                              |       |                              |       |   |   |
| Other income, net                                                                                                                 |       | (44                               | )          | (20 | ) |
|                                                                                                                              |       |                              |       |   |   |
| Loss from continuing operations before  income taxes                                                                              |       | (1,127                            | )          | (2,295 | ) |
|                                                                                                                              |       |                              |       |   |   |
| Income tax expense (benefit)                                                                                                      |       | —                            |       | — |   |
|                                                                                                                              |       |                              |       |   |   |
| Loss from  continuing operations                                                                                                  |       | (1,127                            | )          | (2,295 | ) |
|                                                                                                                              |       |                              |       |   |   |
| Discontinued  operations:                                                                                                         |       |                              |       |   |   |
| Gain (loss) from  operations of discontinued Digital Imaging Asia Pacific Component (including  gain on disposal of $233 in 2005) |       | 223                               |       | (10 | ) |
| Income tax  benefit (expense)                                                                                                     |       | —                            |       | — |   |
| Gain (loss) on  discontinued operations                                                                                           |       | 223                               |       | (10 | ) |
|                                                                                                                              |       |                              |       |   |   |
| Net loss                                                                                                                          |       | $                                 | (904       | ) | $ | (2,305 | ) |
| Basic and diluted (loss) per common share -  see note 2                                                                           |       |                              |       |   |   |
| Loss from continuing operations                                                                                                   |       | $                                 | (0.10      | ) | $ | (0.21 | ) |
| Discontinued operations                                                                                                           |       | $                                 | 0.02       |   | — |   |
| Net loss per common share                                                                                                         |       | $                                 | (0.08      | ) | $ | (0.21 | ) |
| Weighted-average shares (basic and diluted)                                                                                       |       | 12,036,104                        |       | 11,210,019 |   |

 

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

 

4

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**IMAGEWARE SYSTEMS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASHFLOWS**

**(IN THOUSANDS)**

**(UNAUDITED)**

 
| ** **                                                                      | ** ** | **Three Months Ended  March 31,** | ** **  |
|---------------------------------------------------------------------------------|------------|-----------------------------------|-------------|
| ** **                                                                      | ** ** | **2005**                          | ** **  | **2004** | ** ** |
| ** **                                                                      | ** ** | ** **                        | ** **  | ** ** | ** ** |
| **Cash flows from operating activities**                                        |       |                              |        |   |   |
| Net loss                                                                        |       | $                                 | (904        | ) | $ | (2,305 | ) |
| Adjustments to reconcile net loss to net  cash used by operating activities     |       |                              |        |   |   |
| Depreciation and amortization                                                   |       | 161                               |        | 191 |   |
| Gain on sale of subsidiary                                                      |       | (233                              | )           | — |   |
| Non cash interest and amortization of debt  discount and debt issuance costs    |       | —                            |        | 865 |   |
| Stock-based compensation                                                        |       | 70                                |        | — |   |
| Change in assets and liabilities                                                |       |                              |        |   |   |
| Accounts receivable, net                                                        |       | (173                              | )           | (64 | ) |
| Inventory                                                                       |       | 14                                |        | 243 |   |
| Other current assets                                                            |       | (43                               | )           | (459 | ) |
| Intangible and other assets                                                     |       | 21                                |        | 7 |   |
| Accounts payable                                                                |       | (223                              | )           | (341 | ) |
| Accrued expenses                                                                |       | (317                              | )           | 130 |   |
| Accrued interest                                                                |       | —                            |        | (56 | ) |
| Deferred revenue                                                                |       | 22                                |        | 22 |   |
| Contract costs                                                                  |       | (416                              | )           | — |   |
| Pension obligation                                                              |       | (12                               | )           | 18 |   |
| Total adjustments                                                               |       | (1,129                            | )           | 556 |   |
| Net cash used by operating activities                                           |       | (2,033                            | )           | (1,749 | ) |
|                                                                            |       |                              |        |   |   |
| **Cash flows from investing activities**                                        |       |                              |        |   |   |
| Purchase of property and equipment                                              |       | (109                              | )           | (30 | ) |
| Proceeds from sale of subsidiary net of  cash sold and direct transaction costs |       | 1,209                             |        | — |   |
| Payment on advances from related  stockholders                                  |       | —                            |        | (45 | ) |
| Net cash provided (used) by investing  activities                               |       | 1,100                             |        | (75 | ) |
|                                                                            |       |                              |        |   |   |
| **Cash flows from financing activities**                                        |       |                              |        |   |   |
| Repayment of notes payable                                                      |       | (9                                | )           | (16 | ) |
| Proceeds from issuance of common stock, net  of issuance costs                  |       | —                            |        | 6,083 |   |
| Proceeds from exercised stock options                                           |       | 37                                |        | 174 |   |
| Dividends paid                                                                  |       | —                            |        | (159 | ) |
|                                                                            |       |                              |        |   |   |
| Net cash provided by financing activities                                       |       | 28                                |        | 6,082 |   |
| Effect of exchange rate changes on cash                                         |       | (79                               | )           | (88 | ) |
| Net increase (decrease) in cash                                                 |       | (984                              | )           | 4,170 |   |
|                                                                            |       |                              |        |   |   |
| Cash at beginning of period                                                     |       | 2,912                             |        | 578 |   |
|                                                                            |       |                              |        |   |   |
| Cash at end of period                                                           |       | $                                 |  1,928 |   | $ |  4,748 |   |
| Supplemental disclosure of cash flow  information:                              |       |                              |        |   |   |
| Summary of non-cash investing and financing  activities:                        |       |                              |        |   |   |
| Exchange of common shares for marketable  equity securities                     |       | $                                 | 231         |   | $ | — |   |

 

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

 

5

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**IMAGEWARE SYSTEMS, INC.**

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

**(IN THOUSANDS)**

**(UNAUDITED)**

 
| ** **                                           | ** ** | **THREE MONTHS ENDED  MARCH 31,** | ** ** |
|------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                           | ** ** | **2005**                          | ** ** | **2004** | ** ** |
| ** **                                           | ** ** | ** **                        | ** ** | ** ** | ** ** |
| Net loss                                             |       | $                                 | (904       | ) | $ | (2,305 | ) |
| Other comprehensive income (loss), net of  tax:      |       |                              |       |   |   |
| Unrealized loss on securities:                       |       |                              |       |   |   |
| Unrealized holding losses arising during  the period |       | (52                               | )          | — |   |
|                                                 |       |                              |       |   |   |
| Foreign currency translation adjustment              |       | (79                               | )          | (88 | ) |
|                                                 |       |                              |       |   |   |
| Comprehensive loss                                   |       | $                                 | (1,035     | ) | $ | (2,393 | ) |

 

Theaccompanying notes are an integral part of these condensed consolidatedfinancial statements.

 

6

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**IMAGEWARE SYSTEMS, INC.**

 

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE1.  DESCRIPTION OF BUSINESS ANDOPERATIONS**

 

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

 

ImageWare’s biometric productis a core software component of an organizations’ security infrastructure andincludes a multi-biometric identity management solution for enrolling, managingand identifying people by the physical characteristics of the human body. Wedevelop, sell and support various identity management capabilities withingovernment, law enforcement, corporate organizations and even entertainment foridentification and verification purposes. Our IWS Biometric Engine is abiometric identity management platform for multi-biometric enrollment,management and authentication, managing population databases of unlimitedsizes. It’s also offered as an Software Development Kit based search engine,enabling developers and system integrators to implement a biometric solution orintegrate biometric capabilities into existing applications without having toderive biometric functionality from pre-existing applications. IWS BiometricEngine combined with our secure credential platform, IWS EPI Builder, providesa comprehensive, integrated biometric and secure credential solution that canbe leveraged for high-end applications such as passports, driver licenses,national IDs, and other secure documents. It can also be utilized within ourlaw enforcement systems to incorporate any number of various multiplebiometrics into one system, as well as within our digital imaging products toenable the entertainment industry such as cruise lines to help increase photosales.

 

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

 

ImageWare’s ID solutionsempower customers to create secure and smart digital identification documentswith complete ID systems. We develop, sell and support software and designsystems which utilize digital imaging in the production of photo identificationcards and credentials and identification systems. Our sales in the digitalidentification market were initially developed through our acquisitions of ITC,Goddard and G & A (discussed below). Our products in this market consistof IWS EPI Suite, IWS EPI Builder (SDK), Identifier for Windows, ID Card Maker,and IWS Aviation. These products allow for the production of digitalidentification cards and related databases and records and can be used by,among others, schools, airports, hospitals, corporations or governments.  We have recently added the ability toincorporate multiple biometrics into the ID systems we offer with the additionof our new IWS Biometric Engine to our product line.

 

ImageWare’s Digital Imagingproduct line consists of a suite of software for the professional photographymarket. The software provides professional photographers with a completeworkflow solution which enables them to digitally capture and manipulateimages, create a custom package or layout and store the images with anassociated database. They can then print the digital images themselves or sendthem via the Internet or CD to a professional lab for processing. Our productsinclude IWS PC Pro, IWS PC Event, IWS School Days+, IWS Studio and IWSGreenScreen. Our customers use the software products in a wide variety of waysincluding retail studio environments, on-location event photography and “pictureday” at schools and day care centers. Our software products are sold through adealer network and directly to major accounts. We also operate an e-commerceservice, IWS Picturemore.com, used by professional photographers, labs andmini-labs to allow their customers to order re-prints and various specialtyitems. Our sales in the digital photography market were initially developed asa result of our acquisition of Castleworks and E-Focus West in August, 2001.

 

7

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*Liquidity and Capital Resources*

 

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

 

New financingwill be required to fund working capital and operations should the Company beunable to generate positive cash flow from operations in the near future. TheCompany is exploring the possible sale of equity securities and/or debtfinancing, and believes that additional financing will be available under termsand conditions that are acceptable to the Company. However, there can be noassurance that additional financing will be available. In the event financingis not available in the time frame required, the Company will be forced toreduce its rate of growth, if any, reduce operating expenses, curtail sales andmarketing activities and reschedule research and development projects. Inaddition, the Company might be required to sell certain of its assets orlicense its technologies to others. These actions, while necessary for thecontinuance of operations during a time of cash constraints and a shortage ofworking capital, could adversely affect the Company’s business.

 

In view of thematters described in the preceding paragraph, recoverability of a major portionof the recorded asset amounts shown in the accompanying condensed consolidatedbalance sheet is dependent upon continued operations of the Company, which, inturn, is dependent upon the Company’s ability to continue to raise capital andgenerate positive cash flows from operations. The condensed consolidated financial statements do not include anyadjustments relating to the recoverability and classification of recorded assetamounts or amounts and classifications of liabilities that might be necessaryshould the Company be unable to continue its existence.

 

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

 

*Basis of Presentation*

 

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

 

The accompanying condensedconsolidated unaudited financial statements of ImageWare have been preparedpursuant to the rules and regulations of the Securities and Exchange Commission(“SEC”) regarding interim financial reporting. Accordingly, they do not includeall of the information and footnotes required by generally accepted accountingprinciples for annual financial statements and should be read in conjunctionwith the consolidated financial statements for the year ended December 31, 2004and notes thereto included in the Company’s Annual Report on Form 10-KSB, filedwith the SEC on March 31, 2005. In the opinion of management, the accompanyingcondensed consolidated financial statements contain all adjustments, consistingonly of adjustments of a normal recurring nature, necessary for a fairpresentation of the Company’s financial position as of March 31, 2005, and itsresults of operations for the periods presented. These condensed consolidatedunaudited financial statements are not necessarily indicative of the results tobe expected for the entire year.

 

As more fullyexplained in Note 5 to these condensed consolidated financial statements, priorperiod financial statements for the three months ended March 31, 2004 have beenrestated to present the operations of the Company’s wholly-owned subsidiary,Digital Imaging Asia Pacific as a discontinued operation due to this subsidiary’ssale in March 2005.

 

*Stock-Based Compensation*

 

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

 

Hadcompensation cost for the Company’s stock option plan been determined based onthe fair value at the grant date for awards consistent with the provisions ofStatement of Financial Accounting Standards. (“SFAS”) No. 123, Accounting forStock-

 

8

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Based Compensation, the Company’snet losses would have been increased to the pro forma amount indicated belowfor the three months ended March 31, 2005 and 2004:

 
| ** **                                                       | ** ** | **THREE  MONTHS ENDED  MARCH 31,** | ** ** |
|------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                       | ** ** | **2005**                           | ** ** | **2004** |   |
| Net Loss:                                                        |       |                               |       |   |   |
| As reported                                                      |       | $                                  | (904       | ) | $ | (2,305 | ) |
| Stock-based compensation included in net  loss                   |       | 70                                 |       | — |   |
| Stock-based employee compensation under  fair value based method |       | (131                               | )          | (224 | ) |
| Pro forma net loss                                               |       | $                                  | (965       | ) | $ | (2,529 | ) |
|                                                             |       |                               |       |   |   |
| Basic loss per common share:                                     |       |                               |       |   |   |
| As reported                                                      |       | $                                  | (0.08      | ) | $ | (0.21 | ) |
| Pro forma                                                        |       | $                                  | (0.09      | ) | $ | (0.23 | ) |

 

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

 

Inaccordance with Financial Accounting Standards Board Interpretation No. 44 —Accounting for Certain Transactions Involving Stock Compensation (“FIN 44”),the Company will recognize stock-based compensation expense ratably over thevesting period of the restricted stock. Such compensation expense was $70,000 and $0 for the three months endedMarch 31, 2005 and 2004, respectively, due to the commencement of the vestingperiod on March 30, 2004.

 

Certain reclassificationshave been made to the prior period balances in order to conform to the currentperiod presentation.

 

**NOTE2.  NET LOSS PER COMMON SHARE**

 

Basic loss percommon share is calculated by dividing net loss available to commonshareholders for the period by the weighted-average number of common sharesoutstanding during the period. Diluted earnings per common share is calculatedby dividing net loss available to common shareholders for the period by theweighted-average number of common shares outstanding during the period,adjusted to include, if dilutive, potential dilutive shares consisting ofconvertible preferred stock, stock options, convertible notes payable andwarrants, calculated using the treasury stock method. During the periods endedMarch 31, 2005 and 2004, the Company has excluded the following securities fromthe calculation of diluted loss per share, as their effect would have beenantidilutive due to the Company’s net loss:

 
| **Potential Dilutive Securities:** | ** ** | **Number of  Common Shares  Convertible into at  March 31, 2005** | ** ** | **Number of  Common Shares  Convertible into at  March 31, 2004** | ** ** |
|------------------------------------|------------|------------------------------------------------------------------------|------------|------------------------------------------------------------------------|------------|
|                               |       |                                                                   |       |                                                                   |       |
| Convertible preferred stock        |       | 47,280                                                                 |       | 61,033                                                                 |       |
| Stock options                      |       | 914,483                                                                |       | 870,424                                                                |       |
| Warrants                           |       | 5,824,863                                                              |       | 6,334,997                                                              |       |

 

The following table setsforth the computation of basic and diluted loss per share for the three monthperiods ended March 31, 2005 and 2004 (amounts in thousands except share andper share amounts):

 
| ** **                                                              | ** ** | **THREE MONTHS ENDED  MARCH 31,** | ** ** |
|-------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                              | ** ** | **2005**                          | ** ** | **2004** | ** ** |
| Numerator – loss from continuing  operations:                      | ** ** | ** **                        | ** ** | ** ** | ** ** |
| Net loss from continuing operations                                     |       | $                                 | (1,127     | ) | $ | (2,295 | ) |
| Less Series B preferred dividends                                       |       | (13                               | )          | (15 | ) |
| Net loss from continuing operations available  to common shareholders   |       | $                                 | (1,140     | ) | $ | (2,310 | ) |
|                                                                    |       |                              |       |   |   |
| Numerator – loss from discontinued  operations                     |       |                              |       |   |   |
| Net gain (loss) from discontinued  operations                           |       | 223                               |       | (10 | ) |
| Less Series B preferred dividends                                       |       | (13                               | )          | (15 | ) |
| Net loss from discontinued operations  available to common shareholders |       | 210                               |       | (25 | ) |
|                                                                    |       |                              |       |   |   |
| Denominator                                                             |       |                              |       |   |   |
| Weighted-average shares outstanding                                     |       | 12,036,104                        |       | 11,210,019 |   |
|                                                                    |       |                              |       |   |   |
| Basic and diluted loss per share:                                       |       |                              |       |   |   |
| Continuing operations                                                   |       | $                                 | (0.09      | ) | $ | (0.21 | ) |
| Discontinued operations                                                 |       | 0.02                              |       | — |   |
| Net loss per share                                                      |       | (0.07                             | )          | (0.21 | ) |

 

9

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**NOTE3.  SEGMENT INFORMATION**

 

The Company is comprised of three reportable segments: Law Enforcement,Identification and Digital Photography. The Law Enforcement segment includessales of products and services to law enforcement and public safety agencies tomanage criminal history records and investigate crime.  The Identification segment includes sales ofproducts and services to government agencies and commercial customers for theproduction of photo identification cards, documents and identification badgingsystems.  The Digital Photography segmentincludes sales of products and services to commercial customers engaged invarious aspects of the professional photography business.

 

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

 

The tablebelow summarizes information about reportable segments for the three monthsended March 31, 2005 and 2004:

 

 
| ** **                                             | ** ** | **THREE MONTHS ENDED  March 31,** | ** ** |
|--------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                             | ** ** | **2005**                          | ** ** | **2004** | ** ** |
| ** **                                             | ** ** | **(in  thousands)**               | ** ** |
| Net Revenue:                                           | * *   | * *                          | * *   | * * | * * |
| Law Enforcement                                        |       | $                                 | 919        |   | $ | 1,213 |   |
| Identification                                         |       | 1,799                             |       | 890 |   |
| Digital Photography                                    |       | 92                                |       | 155 |   |
| Total consolidated net sales                           |       | $                                 | 2,810      |   | $ | 2,258 |   |
|                                                   |       |                              |       |   |   |
| Operating profit (loss):                               |       |                              |       |   |   |
| Law Enforcement                                        |       | $                                 | (744       | ) | $ | 162 |   |
| Identification                                         |       | (240                              | )          | (959 | ) |
| Digital Photography                                    |       | (193                              | )          | (227 | ) |
|                                                   |       |                              |       |   |   |
| Other unallocated amounts:                             |       |                              |       |   |   |
| Interest expense (income)                              |       | (6                                | )          | 1,291 |   |
| Other expense (income)                                 |       | (44                               | )          | (20 | ) |
|                                                   |       |                              |       |   |   |
| Income (loss) from continuing operations  before taxes |       | $                                 | (1,127     | ) | $ | (2,295 | ) |

 
| ** **                           | ** ** | **March 31,  2005** | ** ** |
|--------------------------------------|------------|---------------------|------------|
| ** **                           | ** ** | **(in thousands)**  | ** ** |
| Total Assets by Segment:             | * *   | * *            | * *   |
|                                 | * *   | * *            | * *   |
| Law Enforcement                      |       | $                   | 1,061      |   |
| Identification                       |       | 7,073               |       |
| Digital Photography                  |       | 1,338               |       |
| Total assets for reportable segments |       | 9,472               |       |
| Corporate                            |       | 2,216               |       |
| Total consolidated assets            |       | $                   | 11,688     |   |
|                                      |            |                     |            |  |  |

 

10

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**NOTE4.  INVESTMENTS**

 

In conjunctionwith the sale of the Company’s wholly-owned subsidiary, as more fully describedin Note 5 to these condensed consolidated financial statements, the Company andArgus Solutions Ltd, each agreed to purchase $250,000 of each others commonstock at a per share price equal to 108% of the closing price of each others’stock as determined by the American Stock Exchange and Australian StockExchange, respectively.  As legalconsideration, each Company paid the other cash of $250,000.  The Company and Argus consummated thetransaction through the exchange of common shares.  The Company exchanged 71,225 shares of itscommon stock for 1,929,914 shares of common stock of Argus Solutions Ltd.,which represents approximately one percent of the voting equity of Argus.    In accordance with Statement of FinancialAccounting Standards No. 153, “Exchange of Nonmonetary Assets, an amendment ofAPB Opinion No. 29” (“SFAS 153), the Company has recorded this transaction as anonmonetay exchange based on the fair value of the shares exchanged asdetermined by the closing price of the Company’s shares on the American StockExchange on the transaction date of $3.25 or $231,000.

 

In accordancewith Statement of Financial Accounting Standards (“SFAS”) No. 115 “Accountingfor Certain Investments in Debt and Equity Securities” and based on ourintentions regarding these instruments, we classify marketable equitysecurities into trading or available-for-sale categories.  Marketable securities that are bought andheld principally for the purpose of selling them in the near term areclassified as trading securities and are reported at fair value, withunrealized gains and losses recognized in earnings.  Marketable securities not classified astrading are classified as available-for-sale and are carried at fair market value,with the unrealized gains and losses, net of tax, included in the determinationof comprehensive income and reported in shareholders’ equity.  Marketable equity securities are included inother non-current assets.  At March 31,2005, the Company had classified $179,000 as available-for-sale marketablesecurities.  These securities arereported at fair value as determined through quoted market sources.  Unrealized gain or loss on these investmentsis recorded as a component of accumulated other comprehensive income, net oftax and amounted to a loss of $52,000 and $0 at March 31, 2005 and 2004,respectively.

 

**NOTE5.  SALE OF SUBSIDIARY**

 

On March 3, 2005, the Company sold its wholly-owned Singaporesubsidiary, Digital Imaging Asia Pacific Pte. Ltd., for cash of$1,300,000.  The Company decided to sellthis subsidiary as part of its overall strategic partnership with ArgusSolutions Ltd (“Argus”),  as a means ofstrengthening its position in the Asia-Pacific region.  In conjunction with this strategy, theCompany entered into an International Distributor Agreement with Argus pursuantto which Argus will distribute the Company’s biometric engine, law enforcementand secure credential solutions in the Asia-Pacific region, excluding Japan andKorea, for a period of three years. Argus will pay the Company a minimum license fee during the first threeyears of $1,400,000; $200,000 in year one; $400,000 in year two and $800,000 inyear three.  In accordance with theprovisions of Statement of Position 97-2, Software Revenue Recognition (“SOP97-2”) regarding fee determination and collectibility criteria, we recognizedrevenues of $17,000 and recorded deferred revenues of $33,000 related to thisminimum license fee for the three months ended March 31, 2005.

 

In accordance with SFAS 144, this subsidiary,previously included in the Company’s Identification segment, is treated as adiscontinued operation.  The net loss forthis subsidiary for the three months ended March 31, 2005 and 2004 arereflected in the Company’s condensed Consolidated Statement of Operations asloss from discontinued operations. Included in the 2005 loss results is a gain on sale of subsidiary of$233,000 net of direct transaction costs of $49,000 and including theallocation of $637,000 of goodwill.

 

The assets and liabilities sold as part of the transaction included thefollowing:

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

 

Digital Imaging Asia Pacific’s sales, reported in discontinuedoperations, for the three months ended March 31, 2005 and 2004 were $42,000 and$104,000, respectively.  Digital ImagingAsia Pacific’s pretax loss, reported in discontinued operations, for the threemonths ended March 31, 2005 and 2004, were $10,000 and $10,000respectively.   Prior period financialstatements for the three months ended March 31, 2004 have been restated topresent the operations of Digital Imaging Asia Pacific as a discontinuedoperation.

 

**NOTE6.  RELATED PARTIES**

 

Subsequent tothe Company’s sale of its wholly-owned subsidiary, Digital Imaging Asia PacificPte. Ltd., to Argus Solutions Ltd (“Argus’), as more fully described in Note 5to these condensed consolidated financial statements, the Company’s ChiefExecutive Officer accepted an invitation to become a member of Argus’ Board ofDirectors.  Prior to the closing of theCompany’s sale transaction with Argus, the Company had no material relationshipwith Argus Solutions.

 

**NOTE7.  SUBSEQUENT EVENTS**

 

Subsequent to March 31, 2005, the Company issued 8,123 shares of commonstock pursuant to stock option exercises.

 

11

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**ITEM 2.  MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.**

 

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

 

The following discussion ofthe financial condition and results of operations should be read in conjunctionwith the condensed consolidated financial statements included elsewhere withinthis quarterly report. Fluctuations in annual and quarterly results may occuras a result of factors affecting demand for the Company’s products such as thetiming of new product introductions by us and by our competitors and ourcustomers’ political and budgetary constraints. Due to such fluctuations,historical results and percentage relationships are not necessarily indicativeof the operating results for any future period.

 

**OVERVIEW**

 

ImageWare Systems, Inc.utilizes its imaging technology to develop software used to create booking andinvestigative software, smart and secure identification systems and documents,and software for professional photographers. Our software systems andassociated hardware enable our customers to quickly capture, archive, search,retrieve and share digital photographs and associated text records.  The following management’s discussion andanalysis based upon our Law Enforcement, Identification and Digital Photographysegments.  Results as presented for ourIdentification segment do not contain the results of our wholly-ownedsubsidiary, Digital Imaging Asia Pacific, due to this component of our Identificationsegment being classified as discontinued operations due to the sale of thissubsidiary during the three months ended March 31, 2005.

 

**RESULTS OFOPERATIONS**

 

***THREE MONTHS ENDED MARCH 31, 2005 AND 2004.***

 
| ** **                                       | ** ** | **THREE MONTHS  ENDED  MARCH 31,** | ** ** | ** ** | ** ** | ** **            | ** ** |
|--------------------------------------------------|------------|------------------------------------|------------|------------|------------|-----------------------|------------|
| **Net Product Revenues  (dollars in thousands)** | ** ** | **2005**                           | ** ** | **2004**   | ** ** | **$ ****Change** | ** ** | **%****Change** | ** ** |
|                                             |       |                               |       |       |       |                  |       |   |   |
| **Product revenues:**                            |       |                               |       |       |       |                  |       |   |   |
| Law Enforcement                                  |       | $                                  | 328        |       | $          | 781                   |       | $ | (453 | ) | (58 | )% |
| Percentage of total net product revenue          |       | 14                                 | %          | 43         | %          |                  |       |   |   |
| Identification                                   |       | $                                  | 1,905      |       | $          | 879                   |       | $ | 1,026 |   | 117 | % |
| Percentage of total net product revenue          |       | 82                                 | %          | 49         | %          |                  |       |   |   |
| Digital Photography                              |       | $                                  | 82         |       | $          | 154                   |       | $ | (72 | ) | (47 | )% |
| Percentage of total net product revenue          |       | 4                                  | %          | 8          | %          |                  |       |   |   |
| Total net product revenues                       |       | $                                  | 2,315      |       | $          | 1,814                 |       | $ | (501 | ) | 28 | % |

 

Product revenues increased28% from $1,814,000 for the three months ended March 31, 2004, to $2,315,000for the corresponding period in 2005. Revenues related to law enforcementsystems and software decreased $453,000 for the three months ended March 31, 2005,as compared to the corresponding period in 2004.  We believe that the increase in terrorism hascreated heightened interest in the ability of law enforcement and othergovernment agencies to be able to efficiently retrieve, analyze and shareinformation from their respective criminal databases.  We anticipate that these factors willincrease the overall demand for the Company’s law enforcement products,however, we cannot predict the timing of the shift in demand.

 

Identification productrevenues increased 117% from $879,000 for the three months ended March 31,2004, to $1,905,000 for the corresponding period in 2005.  Domestically, Identification revenuesincreased approximately $1,085,000.  Thisincrease in revenue is reflective of sales of our Biometric Engine product intoproject-oriented work and an increase in boxed software and consumables soldthrough distribution channels.  In Juneof 2004 we terminated our master distributor model because it did not producethe results we anticipated, and we re-established direct sales to ourdistribution channel.  Internationally,our Identification revenues decreased approximately $59,000.  This decrease is reflective of the repositioningof our international sales office in Germany to lower fixed costs and thisoffice’s pursuit of significant Identification projects utilizing the Company’ssoftware technologies as our primary differentiator.  This office had historically emphasized theresale of third-party merchandise (hardware and 

 

12

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consumables) which generated lower grossmargins than software (as a percentage of revenue) and required significantfixed costs for sales, service and support. Management feels that foreign markets served by these offices willembrace our identification and biometric solutions for large-scale high-endsolutions.  We continue to be of theopinion that government agencies and private entities will react to heightenedsecurity concerns resulting from acts of terrorism by re-evaluating andupgrading their ability to positively identify and track their employees,consultants and visitors. We anticipate that these factors will increaseoverall demand for the Company’s identification products, however, we cannotpredict the timing of the shift in demand.

 

Digital Photography productrevenues decreased 47% from $154,000 for the three months ended March 31, 2004,to $82,000 for the corresponding period in 2005.  We believe this decrease is due to ourcustomers delaying purchasing decisions until the next version of our DigitalPhotography is released.

 

Our backlog of productorders as of March 31, 2005, was approximately $763,000.  At March 31, 2005, we also had maintenance and support backlog ofapproximately $868,000 under existing maintenance agreements.  Product revenue is typically recognizedwithin a three to six month period depending upon the required degree ofcustomization, if any.  Historically, wehave experienced a very minimal risk of order cancellation.  Our revenue from maintenance agreements isgenerally recognized ratably over the respective maintenance periods providedno significant obligations remain and collectibility of the related receivableis probable.

 
| ** **                                       | ** ** | **THREE MONTHS  ENDED  MARCH 31,** | ** ** | ** ** | ** ** | ** **      | ** ** |
|--------------------------------------------------|------------|------------------------------------|------------|------------|------------|-----------------|------------|
| **Maintenance Revenues  (dollars in thousands)** | ** ** | **2005**                           | ** ** | **2004**   | ** ** | **$****Change** | ** ** | **%****Change** | ** ** |
|                                             |       |                               |       |       |       |            |       |   |   |
| **Maintenance revenues:**                        |       |                               |       |       |       |            |       |   |   |
| Law Enforcement                                  |       | $                                  | 478        |       | $          | 432             |       | $ | 46 |   | 11 | % |
| Percentage of total net maintenance revenue      |       | 96                                 | %          | 97         | %          |            |       |   |   |
| Identification                                   |       | $                                  | 5          |       | $          | 12              |       | $ | (7 | ) | (58 | )% |
| Percentage of total net maintenance revenue      |       | 1                                  | %          | 3          | %          |            |       |   |   |
| Digital Photography                              |       | $                                  | 12         |       | $          | —          |       | $ | 12 |   | N/A |   |
| Percentage of total net maintenance revenue      |       | 3                                  | %          | 0          | %          |            |       |   |   |
| Total net maintenance revenues                   |       | $                                  | 495        |       | $          | 444             |       | $ | 51 |   | 12 | % |

 

Maintenance revenues increased12% from $444,000 for the three months ended March 31, 2004, to $495,000 forthe corresponding period in 2005. Law enforcement maintenance revenuesincreased 11% or $46,000 for the three months ended March 31, 2005, from$432,000 for the three months ended March 31, 2004, to $478,000 for thecorresponding period in 2005. This increase is due to the expansion of ourinstalled base in the Law Enforcement market.

 

Identification maintenancerevenues decreased 58% or $7,000 for the three months ended March 31, 2005,from $12,000 for the three months ended March 31, 2005, to $5,000 for thecorresponding period in 2005. This decrease and the related levels ofidentification maintenance is due primarily to the shift in our strategy tooutsource international service and maintenance for hardware. This shift hasenabled Company to reducecosts and focus its resources on expanding our international sales effort ofDigital Identification, Biometric, Law Enforcement and Digital Photographysolutions.

 

Our increase in DigitalPhotography maintenance revenues of $12,000 for the three months endedMarch 31, 2005, as compared to the corresponding period in 2004 isreflective of software maintenance services on custom contract programmingprojects completed in subsequent to the first quarter of 2004.

 
| ** **                                            | ** ** | **THREE MONTHS  ENDED  MARCH 31,** | ** ** | ** ** | ** ** | ** **      | ** ** |
|-------------------------------------------------------|------------|------------------------------------|------------|------------|------------|-----------------|------------|
| **Cost of Product Revenues:  (dollars in thousands)** | ** ** | **2005**                           | ** ** | **2004**   | ** ** | **$****Change** | ** ** | **%****Change** | ** ** |
|                                                  |       |                               |       |       |       |            |       |   |   |
| **Cost of Product Revenues:**                         |       |                               |       |       |       |            |       |   |   |
| Law Enforcement                                       |       | $                                  | 193        |       | $          | 183             |       | $ | 10 |   | 5 | % |
| Percentage of Law Enforcement product  revenue        |       | 59                                 | %          | 23         | %          |            |       |   |   |
| Identification                                        |       | $                                  | 650        |       | $          | 261             |       | $ | 389 |   | 149 | % |
| Percentage of Identification product  revenue         |       | 34                                 | %          | 30         | %          |            |       |   |   |
| Digital Photography                                   |       | $                                  | 2          |       | $          | 16              |       | $ | (14 | ) | (85 | )% |
| Percentage of Digital Photography product  revenue    |       | 3                                  | %          | 10         | %          |            |       |   |   |
| Total product cost of revenues                        |       | $                                  | 845        |       | $          | 460             |       | $ | 385 |   | 84 | % |
| Percentage of total product revenues                  |       | 37                                 | %          | 25         | %          |            |       |   |   |

 

13

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Cost of total productrevenues increased from 84%, or $385,000 from $460,000 or 25% of productrevenues for the three month period ended March 31, 2004, to $845,000 or 37% ofproduct revenues for the corresponding period in 2005. This increase is dueprimarily to higher sales of hardware and consumables (which have higher coststhan software only solutions) resulting in higher cost of sales as a percentageof product revenues.

 

Cost of product revenues forour Law Enforcement segment increased 5%, or $10,000 from $183,000 or 23% ofLaw Enforcement product revenues for the three months ended March 31, 2004, to$193,000, or 59% of product revenues for the corresponding period in 2005.  This increase is due primarily to the smallerrevenue base available to absorb fixed product costs and higher sales of hardware.  Costs of products also can vary as apercentage of product revenue from period to period depending upon product mixand the hardware content, print media consumable content and software contentincluded in systems installed during a given period.

 

Cost of product revenues forour Identification segment increased 149% or $389,000 from $261,000 or 30% ofIdentification product revenues for the three months ended March 31, 2004, to$650,000 or 34% of Identification product revenues for the corresponding periodin 2005.  This increase is reflectiveprimarily of higher domestic identification revenues from project-oriented workwhich included cost for equipment, third-party software licenses and contractprogramming fees for software customization. Costs of products can vary as a percentage of product revenue fromperiod to period depending upon product mix and the hardware content, printmedia consumable content and software content included in systems installedduring a given period.

 

Cost ofproduct revenue related to our Digital Photography segment decreased 85% or$14,000 from $16,000 or 10% of Digital Photography product revenues for thethree months ended March 31, 2004 to $2,000 or 3% of Digital Photographyrevenues for the corresponding period in 2005. This decrease is due primarily to lower Digital Photography sales duringthe three months ended March 31, 2005, as compared to the corresponding periodin 2004.

 
| ** **                                             | ** ** | **THREE MONTHS  ENDED  MARCH 31,** | ** ** | ** ** | ** ** | ** **            | ** ** |
|--------------------------------------------------------|------------|------------------------------------|------------|------------|------------|-----------------------|------------|
| **Maintenance cost of revenues**                       | ** ** | **2005**                           | ** ** | **2004**   | ** ** | **$ ****Change** | ** ** | **%****Change** | ** ** |
|                                                   |       |                               |       |       |       |                  |       |   |   |
| **Maintenance cost of revenues:**                      |       |                               |       |       |       |                  |       |   |   |
| Law Enforcement                                        |       | $                                  | 252        |       | $          | 196                   |       | $ | 56 |   | 29 | % |
| Percentage of Law Enforcement maintenance  revenue     |       | 53                                 | %          | 45         | %          |                  |       |   |   |
| Identification                                         |       | $                                  | 16         |       | $          | 25                    |       | $ | (9 | ) | (35 | )% |
| Percentage of Identification maintenance  revenue      |       | 339                                | %          | 208        | %          |                  |       |   |   |
| Digital Photography                                    |       | $                                  | —     |       | $          | —                |       | $ | — |   | N/A |   |
| Percentage of Digital Photography  maintenance revenue |       |                               | %          |       | %          |                  |       |   |   |
| Total maintenance cost of revenues                     |       | $                                  | 268        |       | $          | 221                   |       | $ | 47 |   | 21 | % |
| Percentage of total maintenance revenues               |       | 54                                 | %          | 50         | %          |                  |       |   |   |

 

Costs of maintenancerevenues increased 21% from $221,000, or 50% of maintenance revenues, for thethree months ended March 31, 2004, to $268,000, or 54% of maintenance revenues,for the corresponding period in 2005. Cost of maintenance revenues in LawEnforcement increased 29%, from $196,000 or 45% of maintenance revenues for thethree months ended March 31, 2004, to $252,000 or 53% of maintenance revenuesfor the corresponding period in 2005. This dollar increase in costs of maintenancerevenues is reflective of higher costs necessary to service our expandinginstalled base. Identification maintenance cost of revenues decreased $9,000due to the outsourcing of international hardware service.

 
| ** **                                         | ** ** | **THREE MONTHS  ENDED  MARCH 31,** | ** ** | ** ** | ** ** | ** **      | ** ** |
|----------------------------------------------------|------------|------------------------------------|------------|------------|------------|-----------------|------------|
| **Product gross profit  (dollars in thousands)**   | ** ** | **2005**                           | ** ** | **2004**   | ** ** | **$****Change** | ** ** | **%****Change** | ** ** |
|                                               |       |                               |       |       |       |            |       |   |   |
| **Product gross profit**                           |       |                               |       |       |       |            |       |   |   |
| Law Enforcement                                    |       | $                                  | 135        |       | $          | 598             |       | $ | (463 | ) | (77 | )% |
| Percentage of Law Enforcement product  revenue     |       | 41                                 | %          | 77         | %          |            |       |   |   |
| Identification                                     |       | $                                  | 1,255      |       | $          | 618             |       | $ | 637 |   | 103 | % |
| Percentage of Identification product  revenue      |       | 66                                 | %          | 70         | %          |            |       |   |   |
| Digital Photography                                |       | $                                  | 79         |       | $          | 138             |       | $ | (59 | ) | (42 | )% |
| Percentage of Digital Photography product  revenue |       | 97                                 | %          | 90         | %          |            |       |   |   |
| Total product gross profit                         |       | $                                  | 1,470      |       | $          | 1,354           |       | $ | 116 |   | 9 | % |
| Percentage of total product revenues               |       | 63                                 | %          | 75         | %          |            |       |   |   |

 

14

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Total product gross profitas a percentage of product revenues decreased from 75% for the three monthperiod ended March 31, 2004, to 63% of product revenues for the correspondingperiod in 2005. The overall decrease is primarily due to a higher percentage oftotal revenues coming from the sales of hardware and consumables which havehigher costs than software only solutions.

 

Law Enforcement gross profitas a percentage of Law Enforcement product revenue decreased from 77% for thethree months ended March 31, 2004, to 41% for the corresponding period of 2005.This decrease is due primarily to our product mix containing higher percentagesof hardware (which have higher costs than software only solutions) than thecomparable period in 2004, as well as a smaller revenue base available toabsorb fixed product costs.  Costs ofproducts can vary as a percentage of product revenue from quarter to quarterdepending upon product mix and hardware content and print media consumablecontent included in systems installed during a given period.

 

Identification gross profitas a percentage of Identification product revenue decreased from 70% or$618,000 for the three months ended March 31, 2004, to 66% or $1,255,000 forthe corresponding period of 2005. The decrease is in gross profit percentagefrom 70% for the three months ended March 31, 2004, to 66% for thecorresponding period in 2005 is due primarily to our product mix containinghigher percentages of hardware and consumables (which have higher costs thansoftware only solutions) than the comparable period in 2004.  The dollar increase of $637,000 from $618,000for the three months ended March 31, 2004, to $1,255,000 for the comparableperiod in 2005 is reflective of increased domestic revenues fromproject-oriented work.  Costs of productscan vary as a percentage of product revenue from quarter to quarter dependingupon product mix and hardware content and print media consumable contentincluded in systems installed during a given period.

 

Gross margins for theDigital Photography product segment decreased 42% or $59,000, from $138,000 or90% of Digital Photography product revenues for the three months ended March31, 2004, to $79,000, or 97% of Digital Photography revenues for thecorresponding period in 2005. This decrease of $59,000 is reflective of ourlower digital photography software sales in the three months ended March 31,2005, as compared to the corresponding period in 2004.

 
| **Maintenance gross profit**                           | ** ** | **THREE MONTHS  ENDED  MARCH 31,** | ** ** | ** ** | ** ** | ** **            | ** ** |
|--------------------------------------------------------|------------|------------------------------------|------------|------------|------------|-----------------------|------------|
| **(dollars in thousands)**                             | ** ** | **2005**                           | ** ** | **2004**   | ** ** | **$ ****Change** | ** ** | **%****Change** | ** ** |
|                                                   |       |                               |       |       |       |                  |       |   |   |
| **Maintenance gross profit**                           |       |                               |       |       |       |                  |       |   |   |
| Law Enforcement                                        |       | $                                  | 226        |       | $          | 236                   |       | $ | (10 | ) | (4 | )% |
| Percentage of Law Enforcement maintenance  revenue     |       | 47                                 | %          | 55         | %          |                  |       |   |   |
| Identification                                         |       | $                                  | (11        | )          | $          | (13                   | )          | $ | (2 | ) | (12 | )% |
| Percentage of Identification maintenance  revenue      |       | (239                               | )%         | (108       | )%         |                  |       |   |   |
| Digital Photography                                    |       | $                                  | 12         |       | $          | —                |       | $ | 12 |   | 100 | % |
| Percentage of Digital Photography  maintenance revenue |       | 100                                | %          | N/A        |       |                  |       |   |   |
| Total maintenance gross profit                         |       | $                                  | 227        |       | $          | 223                   |       | $ | 4 |   | 2 | % |
| Percentage of total maintenance revenues               |       | 46                                 | %          | 50         | %          |                  |       |   |   |

 

Gross margins related tomaintenance revenues decreased $4,000 from $223,000, or 50% of maintenancerevenues for the three months ended March 31, 2004, to $227,000, or 46% ofmaintenance revenues for the corresponding period in 2005. This percentagedecrease is due primarily to higher maintenance costs in our Law Enforcement segmentneeded to service or expanding installed base.

 
| **Operating  expenses**         | ** ** | **THREE MONTHS  ENDED  MARCH 31,** | ** ** | ** ** | ** ** | ** **      | ** ** |
|---------------------------------|------------|------------------------------------|------------|------------|------------|-----------------|------------|
| **(dollars in thousands)**      | ** ** | **2005**                           | ** ** | **2004**   | ** ** | **$****Change** | ** ** | **%****Change** | ** ** |
| ** **                      | ** ** | ** **                         | ** ** | ** ** | ** ** | ** **      | ** ** | ** ** | ** ** |
| General & administrative    |       | $                                  | 1,083      |       | $          | 1,126           |       | $ | (43 | ) | -4 | % |
| Percentage of total net revenue |       | 39                                 | %          | 50         | %          |            |       |   |   |
| Sales and marketing             |       | $                                  | 941        |       | $          | 656             |       | $ | 284 |   | 43 | % |
| Percentage of total net revenue |       | 33                                 | %          | 29         | %          |            |       |   |   |
| Research & development      |       | $                                  | 691        |       | $          | 633             |       | $ | 58 |   | 9 | % |
| Percentage of total net revenue |       | 25                                 | %          | 28         | %          |            |       |   |   |
| Depreciation and amortization   |       | $                                  | 159        |       | $          | 186             |       | $ | (27 | ) | -15 | % |
| Percentage of total net revenue |       | 6                                  | %          | 8          | %          |            |       |   |   |

 

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*GENERAL AND ADMINISTRATIVE EXPENSES.* General and administrative expenses are comprised primarily of salariesand other employee-related costs for executive, financial, and otherinfrastructure personnel. General legal, accounting and consulting services,insurance, occupancy and communication costs are also included with general andadministrative expenses. Such expenses decreased 4%, or $43,000 from $1,126,000for the three months ended March 31, 2004, to $1,083,000 for the correspondingperiod in 2005.  Such expenses, as apercentage of total net revenues, decreased from 50% for the three months endedMarch 31, 2004, to 39% for the corresponding period in 2005.  This percentage decrease is reflective ofhigher total net revenues during the three months ended March 31, 2005, ascompared to the corresponding period in 2004. We are continuing to focus our efforts on achieving additional futureoperating efficiencies by reviewing and improving upon existing businessprocesses and evaluating our cost structure. We believe these efforts willallow us to gradually decrease our level of general and administrative expensesexpressed as a percentage of total revenues.

 

*SALES AND MARKETING.*  Salesand marketing expenses consist primarily of the salaries, commissions, otherincentive compensation, employee benefits and travel expenses of our salesforce. Such expenses increased 43%, or $284,000 from $656,000 for the threemonths ended March 31, 2004, to $941,000 for the corresponding period in2005.  Such expenses, as a percentage oftotal net revenues, increased from 29% for the three months ended March 31,2004, to 33% for the corresponding period in 2005.  The dollar increase of $284,000 is dueprimarily to increases in headcount and payments to sales consultants(including lobbyists).  The increase inheadcount and amounts paid to sales consultants reflects required resourcesneeded to pursue large project solution opportunities.  We anticipate that this level of expensesincurred for sales and marketing incurred during the three months ended March31, 2005, will continue as we pursue large project solution opportunities.

 

*RESEARCH AND DEVELOPMENT.* Research and development costs consist primarily of salaries, employeebenefits and outside contractors for new product development, productenhancements and custom integration work. Such expenses increased 9% or $58,000from $633,000 for the three months ended March 31, 2004, to $691,000 for thecorresponding period in 2005 due primarily to increased utilization of contractprogramming services.   Our level ofexpenditures in research and development reflects our belief that to maintainour competitive position in markets characterized by rapid rates oftechnological advancement, we must continue to invest significant resources innew systems and software as well as continue to enhance existing products.

 

*DEPRECIATION AND AMORTIZATION.* Depreciation and amortization decreased $27,000 from $186,000 for thethree months ended March 31, 2004, to $159,000 for the corresponding period in2005. This decrease is due primarily to lower amortization of intangible assetsdue to such assets being fully amortized.

 

*INTEREST EXPENSE, NET.*  Forthe three months ended March 31, 2005, we recognized interest income of $7,000and interest expense of $1,000. For the three months ended March 31, 2004, werecognized interest income of $2,000 and interest expense of $1,293,000.  Interest expense for the three months endedMarch 31, 2004. contains approximately $865,000 of interest expense related tofair value accounting for our warrant liability due to the registration rightsagreement associated with the underlying shares of the Company’s common stockto be issued upon conversion of the warrants. Interest expense for the three months ended March 31, 2004, alsocontains $424,000 in penalties classified as interest expense incurred as aresult of the Company failure to register certain shares of the Company’scommon stock in conjunction with the private placement of securities inNovember 2003 and January 2004 within specified time periods.

 

 

*LIQUIDITY AND CAPITAL RESOURCES*

 

As of March 31, 2005, we had total current assets of $5,036,000 andtotal current liabilities of $3,180,000, or working capital of $1,856,000. AtMarch 31, 2005, we had available cash of $1,928,000 and $106,000 in restrictedcash securing our performance on certain software implementation contracts.

 

Net cash used in operating activities was $2,033,000 for the threemonth period ended March 31, 2005, as compared to $1,749,000 for thecorresponding period in 2004. We used cash to fund net losses of $906,000,excluding non-cash expenses 

 

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(depreciation, amortization, and stock-based compensation) of $231,000,offset by non-operating income (gain on sale of subsidiary) of $233,000 for thethree months ended March 31, 2005.  Weused cash to fund net losses of $1,249,000, excluding non-cash expenses(depreciation, amortization, non-cash interest and debt discount amortization)of $1,056,000 for the corresponding period in 2004. For the three months endedMarch 31, 2005, we used cash of $180,000 to fund increases in current assetsand used cash of $947,000 for reductions in current liabilities and deferredrevenues.  For the three months endedMarch 31, 2004, we used cash of $273,000 to fund increases in current assetsand used cash of $227,000 for reductions in current liabilities and deferredrevenues.

 

Net cash provided by investing activities was $1,100,000 for the threemonths ended March 31, 2005.  Net cashused by investing activities was $75,000 for the corresponding period in 2004.For the three months ended March 31, 2005, we used cash to fund capitalexpenditures of computer equipment and software, furniture and fixtures andleasehold improvements of approximately $109,000. The level of equipmentpurchases resulted primarily from continued growth of the business andreplacement of older equipment. For the three months ended March 31, 2005, wegenerated cash of $1,300,000 from the sale of our wholly-owned Singaporesubsidiary, Digital Imaging Asia Pacific, offset by cash sold and directtransaction costs of $91,000.  For thethree months ended March 31, 2004, we used cash of $30,000 to fund capitalexpenditures of computer equipment, software, furniture and fixtures. We usedcash of $45,000 to repay advances from related stockholders.

 

Net cash provided by financing activities was $278,000 for the threemonth period ended March 31, 2005, as compared to $6,082,000 for thecorresponding period in 2004.  For thethree months ended March 31, 2005, we generated cash of $37,000 from the exerciseof stock options.   For the three monthsperiod ended March 31, 2005, we used cash of $9,000 for the repayment of notespayable.  For the three months endedMarch 31, 2004, we generated cash of $6,083,000 from our issuance of commonstock in a private placement.  We alsogenerated cash of $174,000 from the exercise of stock options.  For the three months ended March 31, 2004, weused cash of $159,000 for the payment of dividends on our Series B PreferredStock and used cash of $16,000 for the repayment of notes payable.

 

We conduct operations in leased facilitiesunder operating leases expiring at various dates through 2006. In conjunctionwith our performance on various software installation and implementationcontracts, we are contingently liable under an irrevocable letter of credit inthe aggregate amount of $106,000. This letter of credit expires on December 26,2008.  We also have various short-termnotes payable due at various times during the next twelve months.

 

Newfinancing will be required to fund working capital and operations should theCompany be unable to generate positive cash flow from operations in the nearfuture.  The Company may be requiredto  seek additional financing that webelieve is necessary to fund our working capital requirements for at least thenext twelve months, assuming the successful implementation of our businessplan. Our business plan includes, among other things, significant increases inrevenues in future periods, 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 significant cost reduction plans. Wemay seek to sell equity or debt securities, secure a bank line of credit, orconsider strategic alliances. The sale of equity or equity related securitiescould result in additional dilution to our shareholders. There can be noassurance that additional financing, in any form, will be available at all or,if available, will be on terms acceptable to the Company. In addition, ourability to raise additional capital may be dependent upon the Company’s CommonStock being quoted on the American Stock Exchange. There can be no assurancethat the Company will be able to satisfy the criteria for continued listing onthe American Stock Exchange. Insufficient funds may require us to delay, scaleback or eliminate some or all of our activities, and if we are unable to obtainadditional funding, either through generation of positive cash flow fromoperations or by obtaining additional funding, there is substantial doubt about our ability to continue as a goingconcern.

 

*RECENTLYISSUED ACCOUNTING STANDARDS*

 

In November 2004, theFinancial Accounting Standards Board issued Statement of Financial AccountingStandards No. 151, “Inventory Costs, an amendment of ARB No. 43, Chapter 4” (“SFAS151”), which is effective beginning January 1, 2006.  SFAS 151 requires that abnormal amounts ofidle facility expense, freight, handling costs and wasted material berecognized as current period charges. The Statement also requires that the allocation of fixed productionoverhead be based on the normal capacity of the production facilities.  The effect of this Statement on the Company’sfinancial position or results of operations has not yet been determined.

 

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In December 2004, the FASBissued SFAS No.152, “Accounting for Real Estate Time-Sharing Transactions, anamendment of FASB Statements No. 66 and 67 (SFAS 152)”. The amendments made byStatement 152 amend FASB Statement No. 66, Accounting for Sales of Real Estate,to reference the financial accounting and reporting guidance for real estatetime-sharing transactions that is provided in AICPA Statement of Position (SOP)04-2, Accounting for Real Estate Time-Sharing Transactions. This Statement alsoamends FASB Statement No. 67, Accounting for Costs and Initial RentalOperations of Real Estate Projects, to state that the guidance for (a)incidental operations and (b) costs incurred to sell real estate projects doesnot apply to real estate time-sharing transactions. The accounting for thoseoperations and costs is subject to the guidance in SOP 04-2. This Statement iseffective for financial statements for fiscal years beginning after June 15,2005, with earlier application encouraged. The Company has evaluated the impactof the adoption of SFAS 152, and does not believe the impact will besignificant to the Company’s overall results of operations or financialposition.

 

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

 

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

 

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

 

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**RISK FACTORS**

 

**WE CURRENTLY HAVE LIMITED CASH RESOURCES ANDWE MAY REQUIRE ADDITIONAL FUNDING TO FINANCE OUR WORKING CAPITAL REQUIREMENTSDURING THE NEXT TWELVE MONTHS.**

** **

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

** **

**WE HAVE AHISTORY OF SIGNIFICANT RECURRING LOSSES TOTALLING APPROXIMATELY $56.8 MILLION,AND THESE LOSSES MAY CONTINUE IN THE FUTURE.**

 

As of March 31, 2005,we had an accumulated deficit of $56.8 million, and these losses maycontinue in the future. We may need to raise capital to cover these losses, andfinancing may not be available to us on favorable terms. We expect to continueto incur significant sales and marketing, research and development, and generaland administrative expenses. As a result, we will need to generate significantrevenues to achieve profitability and may never achieve profitability.

 

**THE HOLDERSOF OUR PREFERRED STOCK HAVE CERTAIN RIGHTS AND PRIVILEGES THAT ARE SENIOR TOTHE COMMON STOCK, AND WE MAY ISSUE ADDITIONAL SHARES OF PREFERRED STOCK WITHOUTSHAREHOLDER APPROVAL THAT COULD HAVE A MATERIAL ADVERSE EFFECT ON THE MARKETVALUE OF THE COMMON STOCK.**

 

Our Board of Directors hasthe authority to issue a total of up to 4,000,000 shares of preferred stock andto fix the rights, preferences, privileges, and restrictions, including votingrights, of the preferred stock, which typically are senior to the rights of thecommon shareholders, without any further vote or action by you and the othercommon shareholders. Your rights will be subject to, and may be adverselyaffected by, the rights of the holders of the preferred stock that have beenissued, or might be issued in the future. Preferred stock also could have theeffect of making it more difficult for a third party to acquire a majority ofthe outstanding voting stock of ImageWare. This could delay, defer, or preventa change in control. Furthermore, holders of preferred stock may have otherrights, including economic rights, senior to the common stock. As a result,their existence and issuance could have a material adverse effect on the marketvalue of the common stock. We have in the past issued, and, may from time totime in the future issue, preferred stock for financing or other purposes withrights, preferences, or privileges senior to the common stock.

 

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

 

Pursuant to the terms of ourSeries B Preferred Stock we are obligated to pay cumulative cash dividends onshares of Series B Preferred Stock from legally available funds at the annualrate of $0.2125 per share, payable in two semi-annual installments of $0.10625each, which cumulative dividends must be paid prior to payment of any dividendon our Common Stock.  As of March 31,2005, the Company had cumulative undeclared dividends of approximately $22,000.

 

**WE DEPENDUPON A SMALL NUMBER OF LARGE SYSTEM SALES RANGING FROM $500,000 TO IN EXCESS OF$2,000,000, AND WE MAY FAIL TO ACHIEVE ONE OR MORE LARGE SYSTEM SALES IN THEFUTURE.**

 

In the past three years wehave derived a substantial portion of our revenues from a small number of salesof large, relatively expensive systems, typically ranging in price from$500,000 to $2,000,000. As a result, if we fail to receive orders for theselarge systems in a given sales cycle on a consistent basis, our business couldbe significantly harmed. Further, our quarterly results are difficult topredict because we cannot predict in which quarter, if any, large system saleswill occur in a given year. As a result, we believe that quarter-to-quartercomparisons of our results of operations are not a good indication of ourfuture performance. In some future quarters our operating results may be belowthe expectations of securities analysts and investors, in which case the marketprice of our common stock may decrease significantly.

 

**OUR LENGTHYSALES CYCLE MAY CAUSE US TO EXPEND SIGNIFICANT RESOURCES FOR AS LONG AS ONEYEAR IN ANTICIPATION OF A SALE, YET WE STILL MAY FAIL TO COMPLETE THE SALE.**

 

When considering thepurchase of a large computerized booking or identification system, a governmentagency may take as long as a year to evaluate different systems and obtainapproval for the purchase. If we fail to complete a sale, we will have expendedsignificant resources and received no revenue in return. Generally, agenciesconsider a wide range of issues before committing to purchase our

 

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products, including product benefits, abilityto operate with their current systems, product reliability and their ownbudgetary constraints. While potential customers are evaluating our productsand before they place an order with us, we may incur substantial selling costsand expend significant management effort to accomplish a sale.

 

**ASIGNIFICANT NUMBER OF OUR CUSTOMERS ARE GOVERNMENT AGENCIES THAT ARE SUBJECT TOUNIQUE POLITICAL AND BUDGETARY CONSTRAINTS AND HAVE SPECIAL CONTRACTINGREQUIREMENTS WHICH MAY AFFECT OUR ABILITY TO OBTAIN NEW GOVERNMENT CUSTOMERS.**

 

A significant number of ourcustomers are government agencies. These agencies often do not set their ownbudgets and therefore have little control over the amount of money they canspend. In addition, these agencies experience political pressure that maydictate the manner in which they spend money. Due to political and budgetaryprocesses and other scheduling delays that may frequently occur relating to thecontract or bidding process, some government agency orders may be canceled orsubstantially delayed, and the receipt of revenues or payments may besubstantially delayed. In addition, future sales to government agencies willdepend on our ability to meet government contracting requirements, certain ofwhich may be onerous or impossible to meet, resulting in our inability toobtain a particular contract. Common requirements in government contractsinclude bonding requirements, provisions permitting the purchasing agency tomodify or terminate at will the contract without penalty, and provisionspermitting the agency to perform investigations or audits of our businesspractices.

 

**WE MAY FAILTO CREATE NEW APPLICATIONS FOR OUR PRODUCTS AND ENTER NEW MARKETS, WHICH MAYAFFECT OUR FUTURE SUCCESS.**

 

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

 

**WEOCCASIONALLY RELY ON SYSTEMS INTEGRATORS TO MANAGE OUR LARGE PROJECTS, AND IFTHESE COMPANIES DO NOT PERFORM ADEQUATELY, WE MAY LOSE BUSINESS.**

 

We are occasionally asubcontractor to systems integrators who manage large projects that incorporateour systems, particularly in foreign countries. We cannot control thesecompanies, and they may decide not to promote our products or may price theirservices in such a way as to make it unprofitable for us to continue ourrelationship with them. Further, they may fail to perform under agreements withtheir customers, in which case we might lose sales to these customers. If we loseour relationships with these companies, our business may suffer.

 

**WE HAVE U.S. AND FOREIGN PATENTPROTECTION FOR ELEMENTS OF CERTAIN OF OUR PRODUCTS, AND HAVE PATENTAPPLICATIONS IN PROCESS, HOWEVER, A COMPETITOR MAY STILL BE ABLE TO REPLICATEOUR TECHNOLOGY.**

 

Our business is based inlarge part on our technology, and our success depends in part on our abilityand efforts to protect our intellectual property rights. If we do notadequately protect our intellectual property through copyrights, patents andvarious trade secret protections afforded to us by law, our business will beseriously harmed. We have patent protection for elements of certain of ourproducts and patent applications on file.

 

We license certain elementsof our trademarks, trade dress, copyrights, patents and other intellectualproperty to third parties. We attempt to ensure that our rights in our tradenames and the quality of third party uses of our names are maintained by thesethird parties. However, these third parties may take actions that couldsignificantly impair the value of our intellectual property and our reputationand goodwill.

 

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

 

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**WE HAVEACQUIRED SEVERAL BUSINESSES AND FACE RISKS ASSOCIATED WITH INTEGRATING THESEBUSINESSES AND POTENTIAL FUTURE BUSINESSES THAT WE MAY ACQUIRE.**

 

We completed theacquisitions of several companies, and we plan to continue to review potentialacquisition candidates.  Our business andour strategy includes building our business through acquisitions. However,acceptable acquisition candidates may not be available in the future or may notbe available on terms and conditions acceptable to us.

 

Acquisitions involvenumerous risks, including among others, difficulties and expenses incurred inthe consummation of acquisitions and assimilation of the operations, personneland services and products of the acquired companies. Additional risksassociated with acquisitions include the difficulties of operating newbusinesses, the diversion of management’s attention from other businessconcerns and the potential loss of key employees of the acquired company. If wedo not successfully integrate the businesses we may acquire in the future, ourbusiness will suffer.

 

**WE OPERATEIN FOREIGN COUNTRIES AND ARE EXPOSED TO RISKS ASSOCIATED WITH FOREIGNPOLITICAL, ECONOMIC AND LEGAL ENVIRONMENTS AND WITH FOREIGN CURRENCY EXCHANGERATES.**

 

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

 

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**Item3.  Controls and Procedures**

 

*Evaluation of disclosure controls and procedures .*Our chief executive officer and ourchief financial officer, after evaluating the effectiveness of our disclosurecontrols and procedures (as defined in Exchange Act Rule 13a-15(e) as of March31, 2005, have concluded that as of such date, our disclosure controls andprocedures were adequate and sufficient to ensure that information required tobe disclosed in our reports required to be filed under the Securities ExchangeAct of 1934 is recorded, processed, summarized and reported within the timeperiod specified in the Commission’s rules and forms.

 

*Changes in internal controls. *Therehas been no change in our internal control over financial reporting during thefiscal quarter ended March 31, 2005 that has materially affected, or isreasonably likely to materially affect, our internal control over financialreporting.

 

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**PART II**

 

**ITEM2. CHANGES IN SECURITIES**

 

**Issuanceof Common Stock**

 

On February 28, 2005, the Company completed a private placement of71,225 shares of common stock at a price at $3.51 per share to one foreignaccredited investor.  Forthis sale and issuance of common stock, we relied on the exemption fromregistration under Section 4(2) and Regulation S of the Securities Act.  Thesale did not involve a public offering or general solicitation.  No commissions were paid on the offer andsale of the shares.  The stockcertificates contained a restrictive legend in accordance with Rule 144 and RegulationS.

 

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

 
| 2.1  | Stock  Purchase Agreement dated March 1, 2005*                                               |
|------|----------------------------------------------------------------------------------------------|
| 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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*                 Incorporatedby reference to Registrant’s Current Report, Form 8-K as filed with theSecurities and Exchange Commission on March 9, 2005.

 

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**SIGNATURES**

 

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

 
|               | IMAGEWARE SYSTEMS, INC. |
|--------------------|-------------------------|
|               |                    |
|               |                    |
| Date: May 16, 2005 | By:                     | /s/  Wayne Wetherell |   |
|               |                    | Wayne  Wetherell, Chief Financial Officer  (on behalf of the Registrant and  as Registrant’s Principal Financial and  Accounting Officer) |   |

 

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