**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

**FORM 10-Q**

**(Mark One)**

**x**                              QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF1934

**For thequarterly period ended March 31, 2007**

**o**                                 TRANSITION REPORTPURSUANT TO SECTION 13 OR 15(d) OF THE EXCHANGE ACT

**For the transition periodfrom         to**

**Commission file number 001-15757**

**IMAGEWARE SYSTEMS, INC.**

(Exact Name of Registrant as Specified in Its Charter)

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

 

**10883Thornmint Road**

**SanDiego, CA 92127**

(Address of Principal Executive Offices)

**(858)673-8600**

(Registrant’s Telephone Number, Including Area Code)

Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe preceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes x  No o

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

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-12 of the Exchange Act).  Yes o  No x

The number of shares ofCommon Stock, with $0.01 par value, outstanding on May 10, 2007 was 14,680,473.

 

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**IMAGEWARE SYSTEMS,INC. INDEX**
| PART I.    |   | FINANCIAL INFORMATION |   |                                                                                                             |   |
|------------|--------|-----------------------|--------|------------------------------------------------------------------------------------------------------------------|--------|
|       |   | ITEM 1.               |   | FINANCIAL STATEMENTS  (UNAUDITED)                                                                                |   |   |   |
|       |   |                  |   | Condensed Consolidated Balance Sheets as of  March 31, 2007 and December 31, 2006                      |   |   |   |
|       |   |                  |   | Condensed Consolidated Statements of Operations for  the three months ended March 31, 2007 and 2006         |   |   |   |
|       |   |                  |   | Condensed Consolidated Statements of Cash Flows for  the three months ended March 31, 2007 and 2006         |   |   |   |
|       |   |                  |   | Condensed Consolidated Statements of Comprehensive  Loss for the three months ended March 31, 2007 and 2006 |   |   |   |
|       |   |                  |   | Notes to Condensed Consolidated Financial Statements                                                             |   |   |   |
|       |   | ITEM 2.               |   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                      |   |   |   |
|       |   | ITEM 3.               |   | Quantitative  and Qualitative Disclosures About Market Risk                                                      |   |   |   |
|       |   | ITEM 4.               |   | Controls and  Procedures                                                                                         |   |   |   |
|       |   |                  |   |                                                                                                             |   |   |   |
| PART II.   |   | OTHER INFORMATION     |   |                                                                                                             |   |
|       |   | ITEM 1A.              |   | Risk Factors                                                                                                     |   |   |   |
|       |   | ITEM 6.               |   | Exhibits                                                                                                         |   |   |   |
|       |   |                  |   |                                                                                                             |   |   |   |
| SIGNATURES |   |                  |   |

 

2

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**PART I**

**FINANCIAL INFORMATION**

**ITEM 1.FINANCIAL STATEMENTS**

**IMAGEWARE SYSTEMS, INC.**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(In Thousands, except share data)**
| ** **                                                                                                                                                                                                                                                                                                         | ** ** | **March 31,  2007** | ** ** | **December 31,  2006** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                                                                                                                                                                         | ** ** | **(Unaudited)**          | ** ** | ** **                  | ** ** |
| **ASSETS**                                                                                                                                                                                                                                                                                                         | ** ** | ** **               | ** ** | ** **                  | ** ** |
| Current Assets:                                                                                                                                                                                                                                                                                                    |       |                     |       |                        |       |
| Cash                                                                                                                                                                                                                                                                                                               |       | $                        | 1,443      |                        | $          | 939 |   |
| Accounts  receivable, net of allowance for doubtful accounts of $498 (unaudited) and  $483 at  March 31, 2007 and December 31, 2006, respectively                                                                                                                                                        |       | 998                      |       | 1,722                       |       |
| Inventory                                                                                                                                                                                                                                                                                                          |       | 78                       |       | 58                          |       |
| Other current  assets                                                                                                                                                                                                                                                                                              |       | 167                      |       | 138                         |       |
| Total Current  Assets                                                                                                                                                                                                                                                                                              |       | 2,686                    |       | 2,857                       |       |
|                                                                                                                                                                                                                                                                                                               |       |                     |       |                        |       |
| Property and equipment,  net                                                                                                                                                                                                                                                                                       |       | 310                      |       | 352                         |       |
| Other assets                                                                                                                                                                                                                                                                                                       |       | 176                      |       | 174                         |       |
| Pension assets                                                                                                                                                                                                                                                                                                     |       | 621                      |       | 609                         |       |
| Intangible assets, net  of accumulated amortization                                                                                                                                                                                                                                                                |       | 137                      |       | 141                         |       |
| Goodwill                                                                                                                                                                                                                                                                                                           |       | 3,416                    |       | 3,416                       |       |
| **Total  Assets**                                                                                                                                                                                                                                                                                                  | ** ** | **$**                    | **7,346**  | ** **                  | **$**      | **7,549** | ** ** |
|                                                                                                                                                                                                                                                                                                               |       |                     |       |                        |       |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                                                                                                                                                                                                     | ** ** | ** **               | ** ** | ** **                  | ** ** |
|                                                                                                                                                                                                                                                                                                               |       |                     |       |                        |       |
| Current Liabilities:                                                                                                                                                                                                                                                                                               |       |                     |       |                        |       |
| Accounts payable                                                                                                                                                                                                                                                                                                   |       | $                        | 1,873      |                        | $          | 1,719 |   |
| Deferred revenue                                                                                                                                                                                                                                                                                                   |       | 1,396                    |       | 1,258                       |       |
| Accrued expenses                                                                                                                                                                                                                                                                                                   |       | 1,526                    |       | 1,139                       |       |
| Notes payable to  third parties, net of discount                                                                                                                                                                                                                                                                   |       | —                   |       | 1,097                       |       |
| Total Current  Liabilities                                                                                                                                                                                                                                                                                         |       | 4,795                    |       | 5,213                       |       |
|                                                                                                                                                                                                                                                                                                               |       |                     |       |                        |       |
| Pension obligation                                                                                                                                                                                                                                                                                                 |       | 1,036                    |       | 1,016                       |       |
| Total Liabilities                                                                                                                                                                                                                                                                                                  |       | 5,831                    |       | 6,229                       |       |
|                                                                                                                                                                                                                                                                                                               |       |                     |       |                        |       |
| Shareholders’ equity:                                                                                                                                                                                                                                                                                         |       |                     |       |                        |       |
| Preferred stock,  authorized 4,000,000 shares:                                                                                                                                                                                                                                                                     |       |                     |       |                        |       |
| Series B  convertible redeemable preferred stock, $0.01 par value; designated 750,000  shares, 389,400 shares issued, and 239,400 shares outstanding at  March 31, 2007 and December 31, 2006; liquidation preference $599 at  March 31, 2007 and December 31, 2006                                           |       | 2                        |       | 2                           |       |
| Series C  convertible non-redeemable preferred stock, $0.01 par value; designated 3,500  shares, 2,500 shares issued, and 2,500 shares outstanding at March 31,  2007 and December 31, 2006; liquidation preference $2,500 at March 31, 2007  and December 31, 2006                                           |       | —                   |       | —                      |       |
| Series D  convertible non-redeemable preferred stock, $0.01 par value; designated 2,000  shares, 1,500 shares issued, and 1,500 and 0 shares outstanding at  March 31, 2007 and December 31, 2006, respectively; liquidation  preference $1,500 and $0 at March 31, 2007 and December 31, 2006,  respectively |       | —                   |       | —                      |       |
| Common stock,  $.01 par value, 50,000,000 shares authorized; 14,518,425 (unaudited) and  13,700,849 shares issued at March 31, 2007 and December 31, 2006,  respectively, and 14,511,721 (unaudited) and 13,694,145 shares outstanding at  March 31, 2007 and December 31, 2006, respectively  |       | 144                      |       | 136                         |       |
| Additional paid  in capital                                                                                                                                                                                                                                                                                        |       | 74,527                   |       | 71,554                      |       |
| Treasury stock,  at cost - 6,704 shares                                                                                                                                                                                                                                                                            |       | (64                      | )          | (64                         | )          |
| Accumulated  other comprehensive income                                                                                                                                                                                                                                                                            |       | 15                       |       | 25                          |       |
| Accumulated  deficit                                                                                                                                                                                                                                                                                               |       | (73,109                  | )          | (70,333                     | )          |
| Total  Shareholders’ equity                                                                                                                                                                                                                                                                                   |       | 1,515                    |       | 1,320                       |       |
|                                                                                                                                                                                                                                                                                                               |       |                     |       |                        |       |
| **Total Liabilities and  Shareholders’ Equity**                                                                                                                                                                                                                                                               | ** ** | **$**                    | **7,346**  | ** **                  | **$**      | **7,549** | ** ** |

 

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

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**IMAGEWARESYSTEMS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS**

**(INTHOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)**

**(UNAUDITED)**
| ** **                                                          | ** ** | **THREE MONTHS ENDED  MARCH 31,** | ** ** |
|---------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                          | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| **Revenues:**                                                       | ** ** | ** **                                       | ** ** | ** ** | ** ** |
| Product                                                             |       | $                                                | 709        |   | $ | 2,254 |   |
| Maintenance                                                         |       | 627                                              |       | 511 |   |
|                                                                |       | 1,336                                            |       | 2,765 |   |
| **Cost of revenues:**                                               | ** ** | ** **                                       | ** ** | ** ** | ** ** |
| Product                                                             |       | 185                                              |       | 526 |   |
| Maintenance                                                         |       | 294                                              |       | 281 |   |
| Gross profit                                                        |       | 857                                              |       | 1,958 |   |
|                                                                |       |                                             |       |   |   |
| **Operating expenses:**                                             | ** ** | ** **                                       | ** ** | ** ** | ** ** |
| General &  administrative                                       |       | 1,143                                            |       | 1,221 |   |
| Sales and  marketing                                                |       | 694                                              |       | 998 |   |
| Research &  development                                         |       | 1,186                                            |       | 930 |   |
| Depreciation and  amortization                                      |       | 61                                               |       | 125 |   |
|                                                                |       | 3,084                                            |       | 3,274 |   |
| Loss from operations                                                |       | (2,227                                           | )          | (1,316 | ) |
|                                                                |       |                                             |       |   |   |
| Interest expense  (income), net                                     |       | 243                                              |       | 26 |   |
|                                                                |       |                                             |       |   |   |
| Other income, net                                                   |       | (38                                              | )          | (69 | ) |
| Loss from  continuing operations before income taxes                |       | (2,432                                           | )          | (1,273 | ) |
|                                                                |       |                                             |       |   |   |
| Income tax  expense (benefit)                                       |       | —                                           |       | — |   |
|                                                                |       |                                             |       |   |   |
| Loss from  continuing operations                                    |       | (2,432                                           | )          | (1,273 | ) |
|                                                                |       |                                             |       |   |   |
| Discontinued  operations:                                           |       |                                             |       |   |   |
| Loss from  operations of discontinued Digital Photography Component |       | —                                           |       | (73 | ) |
| Income tax  benefit (expense)                                       |       | —                                           |       | — |   |
| Loss on  discontinued operations                                    |       | —                                           |       | (73 | ) |
|                                                                |       |                                             |       |   |   |
| Net loss                                                            |       | $                                                | (2,432     | ) | $ | (1,346 | ) |
| Preferred dividends                                                 |       | (433                                             | )          | (13 | ) |
| Net loss available to  common shareholders                          |       | $                                                | (2,865     | ) | $ | (1,359 | ) |
|                                                                |       |                                             |       |   |   |
| Basic and diluted loss  per common share — see note 2:         |       |                                             |       |   |   |
| Loss from continuing  operations                                    |       | $                                                | (0.21      | ) | $ | (0.10 | ) |
| Discontinued operations                                             |       | —                                           |       | $ | — |   |
| Basic and diluted loss  per common share - see note 2               |       | $                                                | (0.21      | ) | $ | (0.10 | ) |
|                                                                |       |                                             |       |   |   |
| Weighted-average shares (basic and diluted)                         |       | 13,763,224                                       |       | 13,547,662 |   |

 

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

4

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**IMAGEWARESYSTEMS, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(INTHOUSANDS)**

**(UNAUDITED)**
| ** **                                                                   | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| **Cash flows from operating  activities**                                    |       |                                             |       |   |   |
| Net loss                                                                     |       | $                                                | (2,432     | ) | $ | (1,346 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities  |       |                                             |       |   |   |
| Depreciation and amortization                                                |       | 61                                               |       | 125 |   |
| Reduction in  inventory obsolescence reserve                                 |       | (33                                              | )          | — |   |
| Non cash  interest and amortization of debt discount and debt issuance costs |       | 229                                              |       | 25 |   |
| Stock based  compensation                                                    |       | 202                                              |       | 338 |   |
| Provision for  losses on accounts receivable                                 |       | 25                                               |       | — |   |
| Change in assets  and liabilities                                            |       |                                             |       |   |   |
| Accounts  receivable, net                                                    |       | 699                                              |       | (425 | ) |
| Inventory                                                                    |       | 13                                               |       | 16 |   |
| Other current  assets                                                        |       | (45                                              | )          | (24 | ) |
| Pension assets                                                               |       | (12                                              | )          | (24 | ) |
| Accounts payable                                                             |       | 154                                              |       | 304 |   |
| Accrued expenses                                                             |       | 385                                              |       | (83 | ) |
| Deferred revenue                                                             |       | 137                                              |       | 289 |   |
| Pension  obligation                                                          |       | 20                                               |       | 21 |   |
| Total  adjustments                                                           |       | 1,835                                            |       | 562 |   |
| Net cash used in  operating activities                                       |       | (597                                             | )          | (784 | ) |
|                                                                         |       |                                             |       |   |   |
| **Cash flows from investing  activities**                                    |       |                                             |       |   |   |
| Purchase of  property and equipment                                          |       | (15                                              | )          | (64 | ) |
| Net cash used in  investing activities                                       |       | (15                                              | )          | (64 | ) |
|                                                                         |       |                                             |       |   |   |
| **Cash flows from financing  activities**                                    |       |                                             |       |   |   |
| Repayment of  notes payable                                                  |       | (1,310                                           | )          | — |   |
| Proceeds from  issuance of notes payable with warrants                       |       | —                                           |       | 1,550 |   |
| Debt issuance  costs                                                         |       | —                                           |       | (98 | ) |
| Proceeds from  issuance of preferred stock, net of issuance costs            |       | 1,386                                            |       | — |   |
| Other financing  issuance costs                                              |       | (55                                              | )          | — |   |
| Proceeds from  exercised stock purchase warrants                             |       | 1,105                                            |       | — |   |
|                                                                         |       |                                             |       |   |   |
| Net cash  provided by financing activities                                   |       | 1,126                                            |       | 1,452 |   |
| Effect of exchange  rate changes on cash                                     |       | (10                                              | )          | (47 | ) |
| Net increase  (decrease) in cash                                             |       | 504                                              |       | (557 | ) |
|                                                                         |       |                                             |       |   |   |
| Cash at beginning of  period                                                 |       | 939                                              |       | 741 |   |
|                                                                         |       |                                             |       |   |   |
| Cash at end of  period                                                       |       | $                                                | 1,443      |   | $ | 1,298 |   |
|                                                                         |       |                                             |       |   |   |
| Supplemental disclosure  of cash flow information:                           |       |                                             |       |   |   |
| Cash paid for  interest                                                      |       | $                                                | 46         |   | $ | — |   |
| Summary of non-cash  investing and financing activities:                     |       |                                             |       |   |   |
| Beneficial conversion  feature of series D preferred stock                   |       | $                                                | 344        |   | $ | — |   |

 

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

5

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**IMAGEWARE SYSTEMS, INC**

**CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVELOSS**

**(IN THOUSANDS)**

**(UNAUDITED)**
| ** **                               | ** ** | **THREE MONTHS ENDED  MARCH 31,** | ** ** |
|------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                               | ** ** | **2007**                                         | ** ** | **2006** | ** ** |
| Net loss                                 |       | $                                                | (2,432     | ) | $ | (1,346 | ) |
| Other comprehensive  loss:               |       |                                             |       |   |   |
| Foreign currency  translation adjustment |       | (10                                              | )          | (47 | ) |
| Comprehensive loss                       |       | $                                                | (2,442     | ) | $ | (1,393 | ) |

 

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

 

6

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**IMAGEWARESYSTEMS, INC.**

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS**

**NOTE1.  DESCRIPTION OF BUSINESS ANDOPERATIONS**

ImageWare Systems, Inc. (the “Company” or“Imageware”), formerly known as ImageWare Software, Inc., utilizesidentity management technology to provide stand alone, networked and web-basedsoftware solutions for biometrics, law enforcement and secure credentials.

Our “flagship” product is the IWS BiometricEngineTM.  Scalable for small citybusiness or worldwide deployment, our biometric engine is a multi-biometricplatform that is hardware and algorithm independent, enabling the enrollmentand management of unlimited population sizes. Our identification products are used to manage and issue securecredentials including national IDs, passports, driver licenses, smart cards andaccess control credentials. Our law enforcement products provide lawenforcement with integrated mug shot, fingerprint Livescan and investigativecapabilities.  The biometric technologyis now an integral part of all markets we address, and all of our products areintegrated into the Biometric Engine Platform.  Elements of the biometricengine can be used as investigative tools to law enforcement potentiallyutilizing multiple biometrics and forensic data elements, and to enhancesecurity and authenticity of public and private sector credentials.

Our biometric technology is a core software componentof an organization’s security infrastructure and includes a multi-biometricidentity management solution for enrolling, managing, identifying and verifyingthe identities of people by the physical characteristics of the human body. Wedevelop, sell and support various identity management capabilities withingovernment (federal, state and local), law enforcement, commercial enterprises,and transportation and aviation markets for identification and verificationpurposes. Our IWS Biometric Engine is a biometric identity management platformfor multi-biometric enrollment, management and authentication, managingpopulation databases of virtually unlimited sizes. It is also offered as aSoftware Development Kit (SDK) based search engine, enabling developers andsystem integrators to implement a biometric solution or integrate biometriccapabilities into existing applications without having to derive biometricfunctionality from pre-existing applications. The IWS Biometric Engine combined with our secure credential platform,IWS EPI Builder, provides a comprehensive, integrated biometric and securecredential solution that can be leveraged for high-end applications such aspassports, driver licenses, national IDs, and other secure documents. It canalso be utilized within our law enforcement systems to incorporate any numberof various multiple biometrics into one system.

Our law enforcement solutions enable agencies toquickly capture, archive, search, retrieve, and share digital images,fingerprints and criminal history records on a stand-alone, networked, wirelessor Web-based platform. We develop, sell and support a suite of modular softwareproducts used by law enforcement and public safety agencies to create andmanage criminal history records and to investigate crime. Our IWS LawEnforcement solution consists of seven software modules: A Capture andInvestigative module, which provides 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.  In 2005 we addeda new Livescan module which incorporates Livescan capabilities into IWS LawEnforcement, providing integrated fingerprint and palm print biometricmanagement for civil and law enforcement use.

Our Secure Credential ID solutions empower customersto create secure and smart digital identification documents with complete IDsystems. We develop, sell and support software and design systems which utilizedigital imaging in the production of photo identification cards and credentialsand identification systems. Our products in this market consist of IWS EPISuite, IWS EPI Builder (SDK), Identifier for Windows and ID Card Maker.  These products allow for the production ofdigital identification cards and related databases and records and can be usedby, among others, schools, airports, hospitals, corporations orgovernments.  We have recently added theability to incorporate multiple biometrics into the ID systems we offer withthe addition of our new IWS Biometric Engine to our product line.

Our enterprise authentication software includes theIWS Desktop Security software solution which is a comprehensive authenticationmanagement infrastructure specifically designed to provide enterprise networkswith the most advanced authentication mechanisms including biometrics, RFIDtechnology, USB flash memory modules, Trusted Platform Module (TPM), and smartcards.

7

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*Basis of Presentation*

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

Theaccompanying condensed consolidated unaudited financial statements of ImageWarehave been prepared pursuant to the rules and regulations of the Securitiesand Exchange Commission (“SEC”) regarding interim financial reporting.Accordingly, they do not include all of the information and footnotes requiredby generally accepted accounting principles for annual financial statements andshould be read in conjunction with the consolidated financial statements forthe year ended December 31, 2006, and notes thereto included in theCompany’s Annual Report on Form 10-KSB, filed with the SEC onApril 17, 2007, as amended on April 30, 2007, May 7, 2007 and May 9, 2007.In the opinion of management, the accompanying condensed consolidated financialstatements contain all adjustments, consisting only of adjustments of a normalrecurring nature, necessary for a fair presentation of the Company’s financialposition as of March 31, 2007, and its results of operations for the periodspresented. These condensed consolidated unaudited financial statements are notnecessarily indicative of the results to be expected for the entire year.

*Going Concern*

Asreflected in the accompanying condensed consolidated financial statements, theCompany has continuing losses, negative working capital and negative cash flowsfrom operations. These matters raise doubt about the Company’s ability tocontinue as a going concern.

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 is exploring the possible sale of equity securities and/ordebt financing. However, there can be no assurance that additional financingwill be available. In the event financing is not available in the time framerequired, the Company will be forced to sell certain of its assets or licenseits technologies to others. These actions, while necessary for the continuanceof operations during a time of cash constraints and a shortage of workingcapital, could adversely affect the Company’s business.

As a result of the Company’s continuing losses and negative cash flowsfrom operations, the Company currently does not meet certain listing standardsof the American Stock Exchange (AMEX) Company Guide.  As a result, the Company may be consideredfor suspension or delisting from AMEX. During May 2006, the Company received notification from AMEX that it wasnot in compliance with certain sections of the AMEX Company Guide.  To maintain an AMEX listing, the Company wasrequired to submit a plan to AMEX which demonstrates the Company’s ability toregain compliance with the continued listing standards within a maximum of 18months.  The Company submitted its planto AMEX during June 2006.  The ListingQualifications Department of AMEX evaluated the Company’s plan and in September2006 notified the Company that it had made a reasonable demonstration in theplan of an ability to regain compliance with the continued listing standards bythe end of the plan periods which AMEX determined to be November 15, 2006 forSection 1003(a)(iv) of the AMEX Company Guide and November 30, 2007 forSections 1003(a)(i), 10033(a)(ii) and 1003(a)(iii) of the AMEX Company Guide.   Accordingly, in September 2006, AMEXnotified the Company that they would continue its listing subject to theCompany making a public announcement disclosing the fact that the Company isnot in compliance with the continued listing standards of the AMEX and that theCompany’s listing is being continued pursuant to an extension and the Company’sproviding certain supporting documentation of key elements of the Company’splan.  The Company made the requiredpublic announcement and provided the requested information.  The Company is subject to periodic review todetermine if it is making progress consistent with the plan.  Failure to make progress consistent with theplan or regain compliance with the continued listing standards by the end ofthe applicable extension periods could result in the AMEX initiating delistingproceedings pursuant to Section 1009 of the AMEX Company Guide.  The Company’s ability to raise additionalcapital may be dependent upon the Company’s common stock continuing to be quotedon the AMEX. There can be no assurance that the Company will make progressconsistent with the Company’s plan or that the Company will be able to satisfythe criteria for continued listing on the AMEX. Insufficient funds will requirethe Company to sell certain of the Company’s assets or license the Company’stechnologies to others and if the Company is unable to obtain additionalfunding there is substantial doubt about the Company’s ability to continue as agoing concern.

In view of thematters described in the preceding paragraphs, recoverability of a majorportion of the recorded asset amounts shown in the accompanying condensedconsolidated balance sheets is dependent upon continued operations of theCompany, which, in turn, is dependent upon the Company’s ability to continue toraise capital and generate positive cash flows from operations. The condensedconsolidated financial statements do not include any adjustments relating tothe recoverability and classification of recorded asset amounts or amounts andclassifications of liabilities that might be necessary should the Company beunable to continue its existence.

8

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

*Recently Issued Accounting Standards*

InSeptember 2006, the Financial Accounting Standards Board (FASB) issuedStatement of Financial Accounting Standards (SFAS) No. 157, “Fair ValueMeasurements” (SFAS No. 157), to increase consistency and comparability in fairvalue measurements and to expand their disclosures. The new standard includes adefinition of fair value as well as a framework for measuring fair value. Thestandard is effective for fiscal periods beginning after November 15, 2007 andshould be applied prospectively, except for certain financial instruments whereit must be applied retrospectively as a cumulative-effect adjustment to thebalance of opening retained earnings in the year of adoption. The Company iscurrently evaluating the impact of SFAS No. 157 on its consolidated financialstatements.

InFebruary 2007, the FASB issued SFAS No. 159, “The Fair Value Option forFinancial Assets and Financial Liabilities, including an amendment of FASBStatement No. 115” (SFAS No. 159). This statement permits entities to choose tomeasure many financial instruments and certain other items at fair value thatare not currently required to be measured at fair value and establishespresentation and disclosure requirements designed to facilitate comparisonsbetween entities that choose different measurement attributes for similar typesof assets and liabilities. SFAS No. 159 is effective on January 1, 2008. TheCompany is currently evaluating the impact of SFAS No. 159 on its consolidatedfinancial statements.

InJune 2006, the FASB issued Interpretation No. 48, "Accounting forUncertainty in Income Taxes, an interpretation of FASB Statement No. 109"("FIN 48"), which clarifies the accounting for uncertainty in incometaxes recognized in a company's financial statements. The interpretationprescribes a recognition threshold and measurement attribute criteria for thefinancial statement recognition and measurement of an uncertain tax positiontaken or expected to be taken in a tax return. The interpretation also providesguidance on derecognition, classification, interest and penalties, accountingin interim periods, disclosure and transition.

TheCompany adopted the provisions of FIN 48 on January 1, 2007. The implementationof FIN 48 did not have a material impact on the Company’s financial statements.The Company files tax returns in the U.S. federal jurisdiction, and in variousstates and foreign jurisdictions.

At theadoption date on January 1, 2007 and as of March 31, 2007 the Company recordedno cumulative effect adjustments related to the adoption of FIN 48.

Uponadoption of FIN 48 on January 1, 2007, and as of March 31, 2007, the Companyhad no unrecognized tax benefits or accruals for the potential payment orinterest and penalties. For the three months ended March 31, 2007, no interestor penalties were recorded.

TheCompany is not aware of any jurisdictions currently under examination by taxauthorities.

*Reclassifications*

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

**NOTE2.  NET LOSS PER COMMON SHARE**

Basicloss per common share is calculated by dividing net loss available to commonshareholders for the period by the weighted-average number of common sharesoutstanding during the period. Diluted earnings per common share is calculatedby dividing net loss available to common shareholders for the period by theweighted-average number of common shares outstanding during the period,adjusted to include, if dilutive, potential dilutive shares consisting ofconvertible preferred stock, stock options and warrants, calculated using thetreasury stock method. During the periods ended March 31, 2007 and 2006,the Company has excluded the following securities from the calculation ofdiluted loss per share, as their effect would have been antidilutive due to theCompany’s net loss:
| **Potential Dilutive Securities:** | ** ** | **Number of  Common Shares  Convertible into at  March 31, 2007** | ** ** | **Number of  Common Shares  Convertible into at  March 31, 2006** | ** ** |
|----------------------------------------------|------------|-------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------|------------|
|                                         |       |                                                                                            |       |                                                                                            |       |
| Convertible  preferred stock                 |       | 2,501,523                                                                                       |       | 47,280                                                                                          |       |
| Stock options                                |       | 1,566,882                                                                                       |       | 1,352,175                                                                                       |       |
| Warrants                                     |       | 4,982,360                                                                                       |       | 4,469,578                                                                                       |       |

 

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Preferreddividends for the three months ended March 31, 2007 contains approximately$344,000 in preferred stock dividends attributable to an embedded beneficialconversion feature recognized in conjunction with the issuance of Series D PreferredStock as more fully explained in Note 6.

**NOTE3.  SALE OF BUSINESS AND DISCONTINUEDOPERATIONS**

On November 30,2006, the Company completed the sale of its entire Digital Photography (“PDI”)product line and inventory (the “PDI Products”) to an unaffiliated third partyfor a total of $400,000, including an initial cash payment of $25,000.  The purchaser is required to pay up to thefull remaining amount of $375,000 in a series of quarterly installments equalto 12.5% of all newly acquired sales and license revenues relating to the PDIproduct line (the “Percentage Payments”). Until such time when the Company has received the full purchase price of$400,000, during any 12-month period during which the aggregate PercentagePayments to the Company are less than $50,000, the purchaser will pay theCompany the difference between the Percentage Payments and $50,000.  This component of the Company’s business waspreviously classified as the Company’s Digital Photography segment.

The Companydecided to sell this component because it has incurred significant operatinglosses in each of the last five years and has lost significant market share inthe last three years.  The assets soldconsisted primarily of a suite of software and related inventory includingsource, copyrights, trademarks, documentation and client base.

At March 31, 2007and December 31, 2006, the Company has recorded the fair value of the remainingamount due of $375,000 offset by a full valuation allowance due to theuncertainty of the ultimate collectibility of such amounts. This determinationwas based upon the maximum repayment period of 7.5 years of amounts owing theCompany at the transaction date combined with the purchaser operating in ahighly competitive business environment evidenced by rapid technologicalchange.  Accordingly, the Company hasdeferred any remaining gain from the disposal of this component until such timeas the Company determines that the realization of the remaining amounts owed isreasonably assured.

DigitalPhotography sales, reported in discontinued operations, for the three monthsended March 31, 2007 and 2006 were $0 and $44,000, respectively.  Digital Photography’s pretax loss, reportedin discontinued operations for the three months ended March 31, 2007, and 2006were $0 and $73,000, respectively.

Prior period financial statements for the three monthsended March 31, 2006 have been restated to present the operations ofDigital Photography as discontinued operations.

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**NOTE 4. NOTESPAYABLE**

Notespayable consist of the following:
| ** **                                                                                                                                                            | ** ** | **March 31,  2007** | ** ** | **December 31,  2006** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| Notes payable to third parties:                                                                                                                                       |       |                     |       |                        |       |
| Senior secured  promissory notes to accrue interest at 8%. Face value of note $1,310,000.  Discount on note at December 31, 2006 is $212,622. Note due March 17, 2007 |       | $                        | —     |                        | $          | 1,097,378 |   |
|                                                                                                                                                                  |       |                     |       |                        |       |
| Total notes payable                                                                                                                                                   |       | $                        | —     |                        | $          | 1,097,378 |   |
| Less current portion                                                                                                                                                  |       | —                   |       | (1,097,378                  | )          |
| Long-term notes payable                                                                                                                                               |       | $                        | —     |                        | $          | — |   |

 

Asmore fully described in Note 6 below, the issuance of the Series D PreferredStock caused all amounts outstanding under the Senior Secured Promissory Notes,due March 17, 2007 (the “Notes”) to become immediately due and payable infull.  As of March 9, 2007 there was$1,196,259 in principal and $19,319 in accrued but unpaid interest outstandingunder the Notes.  Upon receipt of thefunds from the issuance of the Series D Preferred Stock, the Companyimmediately repaid, in full, all outstanding principal and accrued but unpaidinterest due under the Notes, and the Notes have terminated in their entirety.The remaining debt discount was amortized over the remaining term of the noteto the date the notes were repaid in full, resulting in the Company recordingapproximately $213,000 of debt discount amortization during the three monthsended March 31, 2007.  Such amortizationis included as a component of net interest expense in the Company’s CondensedConsolidated Statement of Operations.

**NOTE5. COMMON STOCK**

During the three months ended March 31, 2007, theCompany issued 785,956 shares of its common stock pursuant to the exercise ofcommon stock purchase warrants.  TheCompany received gross proceeds of approximately $1,105,000 from these warrantexercises.  During the three months endedMarch 31, 2007, the Company also issued 31,620 shares of its common stockpursuant to stock-based compensation agreements with certain employees.

**NOTE6. PREFERRED STOCK**

In March 2007, the Company’s Articles of Incorporationwere amended to authorize 2,000 shares of Series D 8% Convertible PreferredStock (“Series D Preferred Stock”). Each share of Series D Preferred Stock hasa par value of $0.01, a stated value of$1,000 and is convertible into the Company’s common stock at an initialconversion price of $1.90 per share. The Series D Preferred Stock does not havevoting rights.

Theholders of Series D Preferred Stock are entitled to receive cumulativedividends, at the option of the Company, (i) in common stock upon conversion ofthe Series D Preferred Stock, or (ii) in cash afterthe payment of cash dividends to the holders of Series B Preferred Stock andSeries C Preferred Stock at the rate per share (as a percentage of thestated value per share) of 8% per annum.

The holders of Series D Preferred Stock are entitled to initial distributions of $1,000per share of Series D Preferred Stock outstanding, upon liquidation andin preference to common shares and any other series of preferred stock with theexception of Series B Preferred Stock and Series C Preferred Stock, plus allaccrued but unpaid dividends.

AtMarch 31, 2007, the Company had issued a total of 1,500 shares of Series D PreferredStock and generated gross proceeds of $1.5 million. At March 31, 2007, theCompany had cumulative undeclared dividends relating to Series D Preferred Stockof approximately $8,000.

Inconjunction with the issuance of the Series D Preferred Stock, the Companyissued warrants to the holders of the Series D Preferred Stock to purchase59,207 shares of the Company’s common stock at $2.33 per share. These warrantshave been classified as equity instruments on the balance sheet.  The proceeds from the Series D PreferredStock financing were allocated to the 

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warrants and theSeries D Preferred Stock based on the relative fair value of each on the dateof issuance.  This allocation processresulted in the recognition of a discount attributable to an embeddedbeneficial conversion feature of approximately $344,000.  The discount was amortized over the minimumperiod from the date of issuance to the date at which the preferredshareholders are permitted to convert as a dividend to the Series D PreferredStock shareholders.

Inconjunction with the Series D Preferred Stock financing, the Company incurreddirect transaction costs consisting primarily of legal fees and placement agentfees of approximately $114,000. Suchcosts have been recorded as adjustment to additional paid in capital as areduction of net proceeds.

**NOTE7.  REGISTRATION PAYMENT ARRANGEMENTS**

Aspart of the Series D Preferred Stock financing, the Company entered into aRegistration Payment Arrangement as defined by Financial Accounting StandardsBoard Staff Position No. EITF 00-19-2, “Accounting for Registration PaymentArrangements” (“FSP No. EITF 00-19-2”). FSP No. EITF 00-19-2 specifies that thecontingent obligation to make future paymentsor otherwise transfer consideration under a registration payment arrangementshould be separately recognized and measured in accordance withFinancial Accounting Standards Board Statement No. 5 “Accounting forContingencies”. EITF 00-19-2 is effective for registration payment arrangementsentered into after December 21, 2006 or for the fiscal year beginning afterDecember 15, 2006.  The Company earlyadopted the provisions of EITF 00-19-2 in December 2006. The Company determinedthat no loss contingency related to the Series D Preferred Stock registrationpayment arrangement was required to be recorded as of March 31, 2007.

Aspart of the registration payment arrangement, the Company agreed to registerthe shares of common stock the Series D Preferred Stock is convertible into andthe shares of common stock underlying the warrants issued to the Series Dinvestors with the Securities and Exchange Commission (“the Commission”) withincertain contractually specified time periods. The Company also agreed to use its best efforts to keep the registrationstatement continuously effective until the earlier of either the fifth yearafter the date the registration statement is declared effective by the Commissionor the date when all the common stock, including the common stock underlyingthe warrants have been sold.  If theCompany is unable to register the shares of common stock with the Commission orkeep the registration statement continuously effective in accordance with theSecurities Purchase Agreement, the Company is subject to a liquidated damagespenalty equal to 1% of the aggregate purchase price paid for each month theregistration statement is not effective, provided that such liquidated damagesshall not exceed 12% of the aggregate purchase price.  The maximum exposure at March 31, 2007 isapproximately $180,000. The Company has met the requirements of theRegistration Payment Arrangement by filing the required registration statementwith the Commission within the time frame specified by the agreement.  Company management believes that it will beable to achieve and maintain current filing status with the Commission over theprescribed period.

Aspart of the Series C Preferred Stock financing consummated in November andDecember of 2006, the Company entered into a Registration Payment Arrangementas defined by Financial Accounting Standards Board Staff Position No. EITF11-19-2, “Accounting for Registration Payment Arrangements” (“FSP No. EITF00-19-2”).  FSP No. EITF 00-19-2specifies that the contingent obligation to make future payments or otherwisetransfer consideration under a registration payment arrangement should beseparately recognized and measured in accordance with Statement of FinancialAccounting Standards No. 5, “Accounting for Contingencies”.   FSP EITF 00-19-2 is effective forregistration payment arrangements entered into after December 21, 2006 or forthe fiscal year beginning after December 15, 2006, however early adoption ispermitted for interim or annual periods for which financial statements have notbeen issued.  The Company adopted theprovisions of FSP EITF 00-19-2 for the annual period ending December 31, 2006.  The Company determined that no losscontingency related to the Series C registration payment arrangement wasrequired to be recorded as of March 31, 2007.

Aspart of the registration payment arrangement, the Company agreed to registerthe shares of common stock the Series C preferred stock is convertible into andthe shares of common stock underlying the warrants issued to the Series Cinvestors with the Commission within certain contractually specified timeperiods.  The Company also agreed to use itsbest efforts to keep the registration statement continuously effective untilthe earlier of either the fifth year after the date the registration statementis declared effective by the Commission or the date when all the common stock,including the common stock underlying the warrants have been sold.  If the Company is unable 

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to register theshares of common stock with the Commission or keep the registration statementcontinuously effective in accordance with the Securities Purchase Agreement,the Company is subject to a liquidated damages penalty equal to 1% of theaggregate purchase price paid for each month the registration statement is noteffective, provided that such liquidated damages shall not exceed 12% of theaggregate purchase price.  The maximumexposure at March 31, 2007 is approximately $300,000. The Company has met therequirements of the Registration Payment Arrangement by registering the sharesof common stock with the Commission within the time frame specified by theagreement and has kept the registration continuously effective thereafter.  Company management believes that it will beable to maintain current filing status with the Commission over the prescribedperiod.

Aspart of a private placement in July 2005 (the “July 2005 private placement”),the Company entered into a registration payment arrangement, whereby theCompany agreed to register the shares of common stock with the Commissionwithin certain contractually specified time periods.  The Company also agreed to use its bestefforts to keep the registration statement continuously effective until theearlier of either the fifth year after the date the registration statement isdeclared effective by the Commission or the date when all the common stock,including the common stock underlying the warrants have been sold.  If the Company is unable to register theshares of common stock with the Commission or keep the registration statementcontinuously effective in accordance with the Securities Purchase Agreement,the Company is subject to a liquidating damage penalty equal to 1% of theaggregate purchase price paid for each month the registration statement is noteffective. The maximum exposure at March 31, 2007 is approximately $270,000.The Company determined that no loss contingency related to the July privateplacement registration payment arrangement was required to be recorded as ofMarch 31, 2007.

 The Company has met the requirements of theRegistration Payment Arrangement by registering the shares of common stock withthe Commission within the time frame specified by the agreement and has keptthe registration continuously effective thereafter.  Company management believes that it will beable to maintain current filing status with the Commission over the prescribedperiod.

**NOTE8. SUBSEQUENT EVENTS**

In April 2007, the Company issued 137,132 shares ofits common stock pursuant to the conversion of 200 shares of Series C PreferredStock plus accrued but undeclared dividends of $6,699 and issued 31,620 sharesof its common stock pursuant to stock-based compensation agreements withcertain employees.

**ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTSOF OPERATIONS.**

This Quarterly Report on Form 10-Q contains forward-lookingstatements within the meaning of Section 27A of the Securities Act of1933, as amended, and Section 21E of the Securities Exchange Act of 1934,as amended. All forward-looking statements included in this report are based oninformation available to us as of the date hereof and we assume no obligationto update any forward-looking statements. Forward-looking statements involveknown or unknown risks, uncertainties and other factors, which may cause ouractual results, performance or achievements, or industry results to bematerially 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 those itemsdiscussed under “Risk Factors” beginning on page 23 and elsewhere in thisQuarterly Report.

Thefollowing discussion of the financial condition and results of operationsshould be read in conjunction with the condensed consolidated financialstatements included elsewhere within this Quarterly Report. Fluctuations inannual and quarterly results may occur as a result of factors affecting demandfor our products such as the timing of new product introductions by us and byour competitors and our customers’ political and budgetary constraints. Due tosuch fluctuations, historical results and percentage relationships are notnecessarily indicative of the operating results for any future period.

**OVERVIEW**

ImageWareSystems, Inc. is a leader in the emerging market for software-basedidentity management solutions, providing biometric, secure credential and lawenforcement technologies.  Our “flagship”product is the IWS Biometric EngineTM. Scalable for small city business or worldwide deployment, our biometricengine is a multi-biometric platform that is 

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hardwareand algorithm independent, enabling the enrollment and management of unlimitedpopulation sizes.  Our identificationproducts are used to manage and issue secure credentials including nationalIDs, passports, driver licenses, smart cards and access control credentials.Our law enforcement products provide law enforcement with integrated mug shot,fingerprint Livescan and investigative capabilities.  The biometric technology is now an integralpart of all markets we address, and all of our products are integrated into theBiometric Engine Platform.  Elements of the biometric engine can beused as investigative tools to law enforcement potentially utilizing multiplebiometrics and forensic data elements, and to enhance security and authenticityof public and private sector credentials.

CRITICALACCOUNTING ESTIMATES

Thediscussion and analysis of our financial condition and results of operationsare based on our consolidated financial statements, which have been prepared inaccordance with accounting principals generally accepted in the United Statesof America, or U.S. GAAP. The preparation of these financial statements inaccordance with U.S. GAAP requires us to utilize accounting policies and makecertain estimates and assumptions that affect the reported amounts of assetsand liabilities, the disclosure of contingencies as of the date of thefinancial statements and the reported amounts of revenue and expenses during afiscal period. The SEC considers an accounting policy to be critical if it isimportant to a company’s financial condition and results of operations, and ifit requires significant judgment and estimates on the part of managementin its application. Although we believe that our judgments and estimates areappropriate and correct, actual results may differ from those estimates.

Thefollowing are our critical accounting policies because we believe they are bothimportant to the portrayal of our financial condition and results of operationsand require critical management judgments and estimates about matters that areuncertain. If actual results or events differ materially from thosecontemplated by us in making these estimates, our reported financial conditionand results of operations for future periods could be materially affected.

***Revenue Recognition***

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

·                  Long-termfixed-price contracts involving significant customization

·                  Fixed-pricecontracts involving minimal customization

·                  Softwarelicensing

·                  Salesof computer hardware and identification media

·                  Postcontractcustomer support (PCS)

TheCompany’s revenue recognition policies are consistent with U. S. GAAP includingStatements of Position 97-2 “Software Revenue Recognition” and 98-9 “Modificationof SOP 97-2, Software Revenue Recognition With Respect to Certain Transactions”,Securities and Exchange Commission Staff Accounting Bulletin 104 , EmergingIssues Task Force Issue 00-21 “Revenue Arrangements with Multiple Deliverables”,and Emerging Issues Task Force Issue 03-05 “Applicability of AICPA Statement ofPosition 97-2 to Non-Software Deliverables in an Arrangement ContainingMore-Than-Incidental Software”. Accordingly, the Company recognizes revenuewhen all of the following criteria are met: persuasive evidence of anarrangement exists, delivery has occurred or services have been rendered, thefee is fixed or determinable, and collectibility is reasonable assured.

Werecognize revenue and profit as work progresses on long-term, fixed-pricecontracts involving significant amounts of hardware and software customizationusing the percentage of completion method based on costs incurred to datecompared to total estimated costs at completion. Revenue from contracts forwhich we cannot reliably estimate total costs or which do not involve significantamounts of customization are recognized upon completion. Determining when acontract should be accounted for using the percentage of completion methodinvolves judgment. Critical items that are considered in this process are thedegree of customization and related labor hours necessary to complete therequired work as well as ongoing estimates 

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of the futurelabor hours needed to complete the contract. We also generate non-recurringrevenue from the licensing of our software. Software license revenue isrecognized upon the execution of a license agreement, upon deliverance, feesare fixed and determinable, collectibility is probable and when all othersignificant obligations have been fulfilled. We also generate revenue from thesale of computer hardware and identification media. Revenue for these items isrecognized upon delivery of these products to the customer. Our revenue fromperiodic maintenance agreements is generally recognized ratably over therespective maintenance periods provided no significant obligations remain andcollectibility of the related receivable is probable.

***Allowance for Doubtful Accounts***

Ourmanagement must make estimates of the uncollectibility of our accountsreceivable. Management specifically analyzes accounts receivable and analyzeshistorical bad debts, customer concentrations, customer creditworthiness,current economic trends, the age of the accounts receivable balances, andchanges in our customer payment terms when evaluating the adequacy of the allowancefor doubtful accounts. Our accounts receivable balance was approximately$1,496,000 and our allowance for doubtful accounts was approximately $498,000as of March 31, 2007.

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

Weassess impairment of goodwill and identifiable intangible assets wheneverevents or changes in circumstances indicate that the carrying valuemay not be recoverable. Factors we consider important which could triggeran impairment review include the following:

·              Significant underperformancerelative to historical or expected future operating results;

·                                          Significantchanges in the manner of our use of the acquired assets or the strategy of ouroverall business;

·              Significant negative industry oreconomic trends;

Whenwe determine that the carrying value of goodwill and other intangible assetsmay not be recoverable based upon the existence of one or more of theabove indicators of impairment, we measure any impairment based upon fair valuemethodologies. Goodwill and other net intangible assets amounted toapproximately $3,553,000 as of March 31, 2007.

In 2002, SFAS No. 142, “Goodwill and OtherIntangible Assets” became effective, and as a result we ceased to amortizegoodwill. In lieu of amortization, we performed an initial impairment review ofour goodwill in June, 2002 and will perform an annual impairment reviewthereafter in the fourth quarter of our fiscal year.

With the sale of our Digital Photography component in2006, we reassessed the composition of our operating segments and determinedthat we no longer operate in separate, distinct market segments but ratheroperate in one market segment, such segment being identity management.  The Company’s determination was based onfundamental changes in the Company’s business structure due to theconsolidation of operations, restructuring of the Company’s operations andmanagement team, and the integration of what where previously distinct,mutually exclusive technologies.  Thishas resulted in changes in the manner by which the Company’s chief decisionmaker assesses performance and makes decisions concerning resourceallocation.  As a result of our operationin one market segment, such segment being identity management, our 2006goodwill impairment review consisted of the comparison of the fair value of ouridentity management segment as determined by the quoted market prices of ourcommon stock to the carrying amount of the segment. As the fair value exceededthe carrying value by a substantial margin, we determined that our goodwill wasnot impaired.  Using the samemethodologies, we determined that as of March 31, 2007 there were no indicatorsof potential impairment.

There are many management assumptions and estimatesunderlying the determination of an impairment loss, and estimates usingdifferent, but reasonable, assumptions could produce significantly differentresults. Significant assumptions include estimates of future levels of revenuesand operating expenses. Therefore, the timing and recognition of impairmentlosses by us in the future, if any, may be highly dependent upon our estimatesand assumptions.  There can be noassurance that goodwill impairment will not occur in the future.

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Weaccount for long-lived assets in accordance with the provisions of SFASNo. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets.”  This statement requires that long-livedassets and certain identifiable intangible assets be reviewed for impairmentwhenever events or changes in circumstances indicate that the carrying amountof an asset may not be recoverable. Recoverability of assets to be heldand used is measured by a comparison of the carrying amount of an asset tofuture net undiscounted cash flows expected to be generated by the asset. Ifsuch assets are considered to be impaired, the impairment to be recognized ismeasured by the amount which the carrying amount of the assets exceeds the fairvalue of the assets. Fair value is determined based on discounted cash flows orappraised values, depending upon the nature of the asset. Assets to be disposedof are reported at the lower of the carrying amount of fair value less costs tosell. We determined that as of March 31, 2007 there were no indicators ofpotential impairment. There are many management assumptions and estimatesunderlying the determination of an impairment loss, and estimates usingdifferent, but reasonable, assumptions could produce significantly differentresults. Significant assumptions include estimates of future levels of revenuesand operating expenses. Therefore, the timing and recognition of impairmentlosses by us in the future, if any, may be highly dependent upon ourestimates and assumptions. There can be no assurance that intangible assetimpairment will not occur in the future.

***Stock-Based Compensation***

Uponadoption of SFAS 123R on January 1, 2006, we began estimating the value ofemployee stock options on the date of grant using the Black-Scholes model.Prior to the adoption of SFAS 123R, the value of each employee stock option wasestimated on the date of grant using the Black-Scholes model for the purpose ofthe pro forma financial disclosure in accordance with SFAS 123. Thedetermination of fair value of stock-based payment awards on the date of grant usingan option-pricing model is affected by our stock price as well as assumptionsregarding a number of highly complex and subjective variables. These variablesinclude, but are not limited to the expected stock price volatility over theterm of the awards and the actual and projected employee stock option exercisebehaviors. The expected term of options granted is derived from historical dataon employee exercises and post-vesting employment termination behavior. Wecalculated our expected volatility assumption required in the Black-Scholesmodel based on the historical volatility of our stock. In addition to the keyassumptions used in the Black-Scholes model, the estimated forfeiture rate atthe time of valuation is a critical assumption. The Company has estimated an annualized forfeiture rate of 5.7% forcorporate officers, 2.4% for members of the Company’s Board of Directors and25% for all other employees.  The Companyreviews the expected forfeiture rate annually to determine if that percent isstill reasonable based on historical experience.

As ofJanuary 1, 2006 we have adopted the modified prospective transition methodand its effect is included in our Condensed Consolidated Statements ofOperations for the three months ended March 31, 2007 and 2006.

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**RESULTSOF OPERATIONS**

Resultsas presented do not contain the results of our Digital Photography component asthis component is classified as a discontinued operation due to the sale of theDigital Photography product line in November 2006.

***THREE MONTHS ENDED MARCH 31, 2007 AND 2006.***
| ** **                               | ** ** | **THREE MONTHS  ENDED  MARCH 31,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|------------------------------------------|------------|----------------------------------------------|------------|------------|------------|-------------------|------------|
| **Net Product Revenues**       | ** ** | **2007**                                     | ** ** | **2006**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**     | ** ** | ** **                                   | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                     |       |                                         |       |       |       |              |       |   |   |
| Software and royalties                   |       | $                                            | 614        |       | $          | 1,551             |       | $ | (937 | ) | (60 | )% |
| Percentage of total  net product revenue |       | 87                                           | %          | 69         | %          |              |       |   |   |
| Hardware and  consumables                |       | $                                            | 73         |       | $          | 617               |       | $ | (544 | ) | (88 | )% |
| Percentage of  total net product revenue |       | 10                                           | %          | 27         | %          |              |       |   |   |
| Services                                 |       | $                                            | 22         |       | $          | 86                |       | $ | (64 | ) | (74 | )% |
| Percentage of  total net product revenue |       | 3                                            | %          | 4          | %          |              |       |   |   |
| Total net product revenues               |       | $                                            | 709        |       | $          | 2,254             |       | $ | (1,545 | ) | (68 | )% |

 

Softwareand royalty revenues decreased 60% or $937,000 during the three months endedMarch 31, 2007 as compared to the corresponding period in 2006.  The decrease is due to lower project-orientedrevenues of our Biometric Engine of approximately $570,000 combined with lowerroyalties and license revenues of approximately $257,000.  Sales of boxed identity management softwarethrough our distribution channel increased approximately $35,000.

Revenuesfrom the sale of hardware and consumables decreased 88% or $544,000 during thethree months ended March 31, 2007 as compared to the corresponding period in2006.  The decrease reflects therepositioning of our international sales office in Germany in order to lowerfixed costs and pursue significant identity management projects utilizing oursoftware technologies as our primary differentiator.  This office had historically emphasized theresale of third-party hardware and consumables which generated lower grossmargins than software (as a percentage of revenue) and required significantfixed costs for sales, service and support. The resulting effect on hardware and consumables revenues from theclosure of this office was decrease of approximately $184,000 in the threemonths ended March 31, 2007 as compared to the corresponding period in2006.  Also contributing to the decrease,were lower revenues from project solutions containing hardware and consumablecomponents. 

Servicesrevenues are comprised primarily of software integration services, systeminstallation services and customer training. Such revenues decreased approximately $64,000 during the three monthsended March 31, 2007 as compared to the corresponding period in 2006 dueprimarily to lower overall revenues being generated from project work and adecrease in our installation of hardware products.  We expect service revenues to increase in theremainder of 2007 through increased implementations of large-scale high-endsolutions.

Webelieve that the lower identity management software revenue in project-orientedsolutions is largely due to the timing of government procurement with respectto the various programs we are pursuing. Based on management’s current visibility into the timing of potentialgovernment procurements, we believe that we will see a significant increase ingovernment procurement and implementations with respect to identity managementinitiatives during the remainder to 2007 and continuing into 2008 and 2009. 

Wefeel that we are well positioned for participation in one or more large-scaledomestic or international projects which will enable our company to achievesignificant product revenue growth.  Inthe past eighteen months we have continuously retooled our identity managementsuite of products to meet changing government specifications and to enablecustomization for large project applications. Additionally, we reoriented our sales organization to direct ourresources and efforts toward establishing partnerships with large systemsintegrators as we believe these integrators will be the ultimate choice forawards of large-scale secure identification solutions.

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Ourbacklog of product orders as of March 31, 2007 was approximately$1,872,000.  Approximately $1 million ofthis product backlog was in backlog at December 31, 2006 and due to customerimplementation scheduling, could not be recognized within the quarter endedMarch 31, 2007.  At March 31, 2007, wealso had maintenance and support backlog of approximately $1,271,000 underexisting maintenance agreements.  Productrevenue is typically recognized within a three to six month time perioddepending upon the required degree of customization, if any and customerimplementation schedules.  Historically,we have experienced a very minimal risk of order cancellation.  Our revenue from maintenance agreements isgenerally recognized ratably over the respective maintenance periods providedno significant obligations remain and collectibility of the related receivableis probable.
| ** **                           | ** ** | **THREE MONTHS  ENDED  MARCH 31,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|--------------------------------------|------------|----------------------------------------------|------------|------------|------------|-------------------|------------|
| **Maintenance Revenues**        | ** ** | **2007**                                     | ** ** | **2006**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)** | ** ** | ** **                                   | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| ** **                           | ** ** | ** **                                   | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| Maintenance revenues                 |       | $                                            | 627        |       | $          | 511               |       | $ | 116 |   | 23 | % |
|                                      |            |                                              |            |            |            |                   |            |  |  |  |  |  |

 

Theincrease in maintenance revenues reflects the expansion of our installed baseresulting from the completion of significant project-oriented work during theyear ended December 31, 2006.

Weanticipate continued growth of our maintenance revenues through the retentionof existing customers combined with the expansion of installed base combinedresulting from the completion of project-oriented work, however, we cannotpredict the timing of this anticipated growth.
| ** **                                              | ** ** | **THREE MONTHS  ENDED  MARCH 31,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|---------------------------------------------------------|------------|----------------------------------------------|------------|------------|------------|-------------------|------------|
| **Cost of Product Revenues:**            | ** ** | **2007**                                     | ** ** | **2006**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**                    | ** ** | ** **                                   | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                                    |       |                                         |       |       |       |              |       |   |   |
| Software and  royalties                                 |       | $                                            | 98         |       | $          | 97                |       | $ | 1 |   | 1 | % |
| Percentage of software and royalty product revenue      |       | 16                                           | %          | 6          | %          |              |       |   |   |
| Hardware and  consumables                               |       | $                                            | 85         |       | $          | 427               |       | $ | (342 | ) | (80 | )% |
| Percentage of hardware and consumables product  revenue |       | 116                                          | %          | 69         | %          |              |       |   |   |
| Services                                                |       | $                                            | 2          |       | $          | 2                 |       | $ | 0 |   | 0 | % |
| Percentage of services product revenue                  |       | 9                                            | %          | 2          | %          |              |       |   |   |
| Total net  product revenues                             |       | $                                            | 185        |       | $          | 526               |       | $ | (341 | ) | (65 | )% |
| Percentage of  total product revenues                   |       | 26                                           | %          | 23         | %          |              |       |   |   |

 

Thecost of software and royalty product revenue increased 1% during the threemonths ended March 31, 2007 as compared to the corresponding period in 2006 dueto the 2006 period containing approximately $257,000 in royalty revenues and$570,000 in Biometric Engine software revenue with minimal costs forcustomization or third-party software licenses. Costs of products can vary as a percentage of product revenue fromperiod to period depending upon level of software customization and third partysoftware license content included in product sales during a given period.

Thedecrease in the cost of product revenues for our hardware and consumable salesof $342,000 for the three months ended March 31, 2007 as compared to thecorresponding period in 2006 reflects the decrease in hardware and consumablerevenues of $544,000 for the three months ended March 31, 2007 as compared tothe comparable period in 2006.  Costs ofhardware and consumables as a percentage of hardware and consumables productrevenues increased to 116% for the three months ended March 31, 2007 from 69%for the corresponding period in 2006 due to the 2007 period containingapproximately $38,000 in expenses charged to cost of sales for restockingfees.  

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| ** **                                      | ** ** | **THREE MONTHS  ENDED  MARCH 31,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|-------------------------------------------------|------------|----------------------------------------------|------------|------------|------------|-------------------|------------|
| **Maintenance cost of revenues** | ** ** | **2007**                                     | ** ** | **2006**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**            | ** ** | ** **                                   | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| ** **                                      | ** ** | ** **                                   | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| Total  maintenance cost of revenues             |       | $                                            | 294        |       | $          | 281               |       | $ | 13 |   | 5 | % |
| Percentage of  total maintenance revenues       |       | 47                                           | %          | 55         | %          |              |       |   |   |
|                                                 |            |                                              |            |            |            |                   |            |  |  |  |  |  |

 

Costof maintenance revenues as a percentage of maintenance revenues decreased to47% during the three months ended March 31, 2007 from 55% for the correspondingperiod in 2006 due primarily to higher maintenance revenues to absorb fixedmaintenance costs combined with a higher percentage of our maintenance revenuesbeing generated from software maintenance versus hardware maintenance.  The dollar increase of 5% or $14,000 duringthe three months ended March 31, 2007 as compared to the corresponding periodin 2006 reflects higher costs needed to service our expanding installed base. 
| ** **                                              | ** ** | **THREE MONTHS  ENDED  MARCH 31,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|---------------------------------------------------------|------------|----------------------------------------------|------------|------------|------------|-------------------|------------|
| **Product gross profit**                      | ** ** | **2007**                                     | ** ** | **2006**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**                    | ** ** | ** **                                   | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
| ** **                                              |       |                                         |       |       |       |              |       |   |   |
| Software and  royalties                                 |       | $                                            | 516        |       | $          | 1,454             |       | $ | (938 | ) | (65 | )% |
| Percentage of software and royalty product revenue      |       | 84                                           | %          | 94         | %          |              |       |   |   |
| Hardware and  consumables                               |       | $                                            | (12        | )          | $          | 190               |       | $ | (202 | ) | (106 | )% |
| Percentage of hardware and consumables product  revenue |       | (16                                          | )%         | 31         | %          |              |       |   |   |
| Services                                                |       | $                                            | 20         |       | $          | 84                |       | $ | (64 | ) | (76 | )% |
| Percentage of services product revenue                  |       | 91                                           | %          | 98         | %          |              |       |   |   |
| Total product  gross profit                             |       | $                                            | 524        |       | $          | 1,728             |       | $ | (1,204 | ) | (70 | )% |
| Percentage of  total product revenues                   |       | 74                                           | %          | 77         | %          |              |       |   |   |

 

Totalproduct gross profit decreased due to significantly lower product revenuesduring the three months ended March 31, 2007 as compared to the correspondingperiod in 2006.

Softwareand royalty gross profit decreased as a percentage of software and royaltyproduct revenue to 84% for the three months ended March 31, 2007 from 94% forthe corresponding period in 2006as the 2006 period contained significantroyalty and Biometric Engine software revenue with minimal corresponding costof revenues.  Costs of software productscan vary as a percentage of product revenue from quarter to quarter dependingupon product mix and third party software licenses included in softwaresolutions.

Hardwareand consumables gross profit decreased due to lower sales of hardware andconsumables during the three months ended March 31, 2007 as compared to thecorresponding period in 2006. Hardware and consumables gross profit as apercentage of hardware and consumables product revenue decrease to (16%) from31% and reflects the 2007 period containing approximately $38,000 in expensescharged to cost of sales for restocking fees. Costs of products can vary as apercentage of product revenue from quarter to quarter depending upon productmix and hardware content and print media consumable content included in systemsinstalled during a given period.

Servicesgross profit decreased due to lower project sales and lower correspondingintegration and installation services.

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| ** **                                | ** ** | **THREE MONTHS  ENDED  MARCH 31,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|-------------------------------------------|------------|----------------------------------------------|------------|------------|------------|-------------------|------------|
| **Maintenance gross profit**    | ** ** | **2007**                                     | ** ** | **2006**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)**      | ** ** | ** **                                   | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                      |       |                                         |       |       |       |              |       |   |   |
| Total  maintenance gross profit           |       | $                                            | 333        |       | $          | 230               |       | $ | 103 |   | 45 | % |
| Percentage of  total maintenance revenues |       | 53                                           | %          | 45         | %          |              |       |   |   |
|                                           |            |                                              |            |            |            |                   |            |  |  |  |  |  |

 

Grossmargins related to maintenance revenues increased due primarily to highermaintenance revenues to absorb fixed maintenance costs.
| ** **                           | ** ** | **THREE MONTHS ENDED  MARCH 31,** | ** ** | ** ** | ** ** | ** **        | ** ** |
|--------------------------------------|------------|--------------------------------------------------|------------|------------|------------|-------------------|------------|
| **Operating expenses**          | ** ** | **2007**                                         | ** ** | **2006**   | ** ** | **$ Change** | ** ** | **% Change** | ** ** |
| **(dollars in thousands)** | ** ** | ** **                                       | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** |
|                                 |       |                                             |       |       |       |              |       |   |   |
| General &  administrative        |       | $                                                | 1,143      |       | $          | 1,221             |       | $ | (78 | ) | (6 | )% |
| Percentage of total net revenue      |       | 52                                               | %          | 46         | %          |              |       |   |   |
| Sales and  marketing                 |       | $                                                | 694        |       | $          | 998               |       | $ | (304 | ) | (30 | )% |
| Percentage of total net revenue      |       | 44                                               | %          | 38         | %          |              |       |   |   |
| Research &  development          |       | $                                                | 1,186      |       | $          | 930               |       | $ | 256 |   | 27 | % |
| Percentage of total net revenue      |       | 41                                               | %          | 34         | %          |              |       |   |   |
| Depreciation and  amortization       |       | $                                                | 61         |       | $          | 125               |       | $ | (64 | ) | (51 | )% |
| Percentage of  total net revenue     |       | 3                                                | %          | 6          | %          |              |       |   |   |

 

*GENERAL AND ADMINISTRATIVE EXPENSES.*  General and administrative expenses arecomprised primarily of salaries and other employee-related costs for executive,financial, and other infrastructure personnel. General legal, accounting andconsulting services, insurance, occupancy and communication costs are alsoincluded with general and administrative expenses.  The increase in such expenses, as a percentageof total net revenues, is reflective of lower net revenues during the threemonths ended March 30, 2007 as compared to the corresponding period in2006.  The dollar decrease of $78,000 isdue to lower stock-based compensation expense of approximately $66,000 recordedin the three months ended March 31, 2007 as compared to the correspondingperiod in 2006 combined with reduced costs of approximately $73,000 due to theclosure in 2006 of our sales office in Germany, offset by approximately $61,000in higher personnel, legal, accounting, and consulting fees.  We are continuing to focus our efforts onachieving additional future operating efficiencies by reviewing and improvingupon existing business processes and evaluating our cost structure. We believethese efforts will allow us to gradually decrease our level of general andadministrative expenses expressed as a percentage of total revenues.

*SALES AND MARKETING.*  Sales and marketing expenses consistprimarily of the salaries, commissions, other incentive compensation, employeebenefits and travel expenses of our sales, marketing, business development andproduct management functions. The increase in such expenses as a percentage ofnet revenues to 44% for the three months ended March 31, 2007 from 38% for thecorresponding period in 2006 is due to the lower product revenues.  The dollar decrease of $304,000 during thethree months ended March 31, 2007 as compared to the corresponding period in2006 reflects headcount reductions due to the elimination and consolidation ofvarious sales positions.  

*RESEARCH AND DEVELOPMENT.*  Research and development expenses consistprimarily of salaries, employee benefits and outside contractors for newproduct development, product enhancements and custom integration work. Suchexpenses increased 27% or $256,000 for the three months ended March 31, 2007 ascompared to the corresponding period in 2006 due primarily to increased headcountand contract programming necessary for the continued development of ourBiometric Engine, the development of our Personal Identity Verification (PIV)solution, the web enablement of our CCS product line, and the development ofour IWS desktop security solution.  Ourlevel of expenditures in research and development reflects our belief that tomaintain our competitive position in markets characterized by rapid rates oftechnological advancement, we must continue to invest significant resources innew systems and software as well as continue to enhance existing products. 

*DEPRECIATION AND AMORTIZATION.*  During the three months ended March, 31, 2007,depreciation and amortization expense decreased 51% or $64,000 as compared tothe corresponding period in 2006. The decrease in depreciation and amortizationexpense reflects lower amortization for certain definite long-lived intangibleassets due to such assets being fully amortized as of March 31, 2006.

*INTEREST EXPENSE (INCOME), NET.*  For the three months ended March 31,2007, we recognized interest 

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income of $8,000and interest expense of $251,000. For the three months ended March 31,2006, we recognized interest income of $4,000 and interest expense of$31,000.  Interest expense for the threemonths ended March 31, 2007 contains three components approximating$248,000 related to our secured notes payable issued in March 2006: $19,000 ofcoupon interest, $213,000 in note discount amortization and $16,000 in deferredfinancing fee amortization classified as interest expense.

*LIQUIDITYAND CAPITAL RESOURCES*

As ofMarch 31, 2007, we had total current assets of $2,686,000 and totalcurrent liabilities of $4,795,000, or negative working capital of$2,109,000.  At March 31, 2007, we had availablecash of $1,443,000 and $106,000 in restricted cash securing our performance oncertain software implementation contracts.

Netcash used in operating activities was $597,000 for the three month period endedMarch 31, 2007 as compared to $784,000 for the corresponding period in 2006. Weused cash to fund net losses of $1,948,000, excluding non-cash expenses(depreciation, amortization, debt issuance costs, debt discount, stock-basedcompensation and provision for losses on accounts receivable less reductions ininventory obsolescence reserves) of $484,000 for the three months ended March31, 2007.  We used cash to fund netlosses of $858,000, excluding non-cash expenses (depreciation, amortization,debt issuance costs, debt discount and stock-based compensation) of $488,000for the three months ended March 31, 2006. For the three months ended March 31, 2007, we generated cash of $655,000through reduction in current assets and generated cash of $696,000 through increasesin current liabilities and deferred revenues, excluding debt.  For the three months ended March 31, 2006, weused cash of $457,000 to fund increases in current assets and generated cash of$531,000 through increases in current liabilities and deferred revenues,excluding debt.

Netcash used in investing activities was $15,000 for the three months endedMarch 31, 2007.  Net cash used ininvesting activities was $64,000 for the three months ended March 31,2006.  For the three months ended March31, 2007, we used cash to fund capital expenditures of computer equipment,software and furniture and fixtures of approximately $15,000.  The level of equipment purchases resultedprimarily from the replacement of older equipment. For the three months ended March 31,2006, we used cash to fund capital expenditures of computer equipment andsoftware, furniture and fixtures and leasehold improvements of approximately$64,000.

Netcash provided by financing activities was $1,126,000 for the three month periodended March 31, 2007 as compared to $1,452,000 for the correspondingperiod in 2006.  For the three monthsended March 31, 2007, we generated cash of $1,386,000 from our issuance ofpreferred stock in a private placement net of direct transaction costs of$114,000.  We also generated cash of$1,105,000 from our issuance of common stock pursuant to warrantexercises.  For the three months endedMarch 31, 2007, we used cash of $1,310,000 for the repayment of our securednotes payable and used cash of $169,000 from the incurrence of financingrelated expenses.   For the three monthsended March 31, 2006, we generated cash of $1,550,000 from the issuance ofsecured notes payable and incurred debt issuance costs of $98,000.

Weconduct operations in leased facilities under operating leases expiring at variousdates through 2009. In conjunction with our performance on various softwareinstallation and implementation contracts, we are contingently liable under anirrevocable letter of credit in the amount of $106,000. The letter of creditexpires on December 26, 2008.

Thereport of our independent accountants included with our Annual Report on Form10-K as filed with the Commission on April 17, 2007, contained anexplanatory paragraph regarding our ability to continue as a goingconcern.  We are seeking additionalfinancing that we believe is necessary to fund our working capital requirementsfor at least the next twelve months in conjunction with the successfulimplementation of our business plan. Our business plan includes, among otherthings, the monitoring and controlling of operating expenses, collection ofsignificant trade and other accounts receivable, and controlling of capitalexpenditures. We may seek to sell equity or debt securities, secure a bankline of credit, or consider strategic alliances. The sale of equity orequity-related securities could result in additional dilution to ourshareholders. There can be no assurance that additional financing, in any form,will be available at all or, if available, will be on terms acceptable to us.In addition, our ability to raise additional capital may be dependent uponour common stock continuing to be quoted on the American Stock Exchange(“AMEX”). There can be no assurance that we will be able to satisfy thecriteria for continued listing on AMEX. Insufficient funds will require usto sell certain of our assets or license or technologies to others and if weare unable to obtain additional funding there is substantial doubt about ourability to continue as a going concern.

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**ITEM 3.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK**

*ForeignCurrency Exchange Risk*

Marketrisk is the potential loss arising from adverse changes in market rates andprices, such as interest rates and foreign currency exchange rates.  Changes in foreign currency exchange rateshave an impact on our results of operations. Our exposure to adverse movementsin foreign currency exchange rates is primarily related to our subsidiariesoperating expense, primarily in Canada, denominated in the respective localcurrency. We currently do not enter into forward exchange contracts to hedgeexposures denominated in foreign currencies and do not use derivative financialinstruments for trading or speculative purposes. The effect of an immediate 10%change in foreign currency exchange rates should not have a material effect onour future operating results or cash flows; however, a long term change inforeign currency rates would likely result in increased technical support andengineering expenses. The vast majority of our sales are transacted in U. S.dollars.

**ITEM 4. CONTROLSAND PROCEDURES**

***Conclusions Regarding the Effectivenessof Disclosure Controls and Procedures.**** *Underthe supervision and with the participation of our management, including ourprincipal executive officer and principal financial officer, we conducted anevaluation of our disclosure controls and procedures as such term is definedunder Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, asamended.  Based on this evaluation, our principal executive officer and principal financial officerhave concluded, based upon their evaluation as of the end of the period coveredby this report, that our disclosure controls and procedures are effective inensuring that information required to be disclosed in the reports that we fileor submit under the Securities Exchange Act of 1934 is recorded, processed,summarized and reported within the time periods specified in the SEC’s rules and forms.

***Changesin Internal Control Over Financial Reporting*.**  There has been no change in our internalcontrol over financial reporting during the fiscal quarter ended March 31,2007, that has materially affected, or is reasonably likely to materiallyaffect, our internal control over financial reporting.

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**PART II**

**ITEM1A.  RISK FACTORS**

Ourresults of operations and financial condition are subject to numerous risks anduncertainties described in our Annual Report on Form 10-K for our fiscal yearended December 31, 2006, filed on April 17, 2007 and as amended on April 30, 2007,May 7, 2007 and May 9, 2007 and incorporated herein by reference.  You should carefully consider these riskfactors in conjunction with the other information contained in thisreport.  Should any of these risksmaterialize, our business, financial condition and future prospects could benegatively impacted.  As of March 31,2007, there have been no material changes to the disclosures made on theabove-referenced Form 10-K, as amended, except as follows:

**WEHAVE HAD NET LOSSES IN OUR FIVE MOST RECENT FISCAL YEARS AND CURRENTLY HAVESTOCKHOLDER’S EQUITY OF LESS THAN $6,000,000, AND AS A RESULT, AMEXMAY CONSIDER SUSPENDING OR DELISTING OUR SECURITIES FROM THE EXCHANGE.**

TheAMEX Company Guide provides that AMEX will normally consider suspendingdealings in, or removing from the list, securities of a company which sustainsnet losses in its five most recent fiscal years and has stockholders’ equity ofless than $6,000,000, unless the company has total market capitalization of atleast $50,000,000, or total assets and revenue of $50,000,000. We havesustained net losses during our five most recent fiscal years, and as of theyear ended December 31, 2006, our stockholders’ equity dropped to$1,319,890, from $3,365,602 for the year ended December 31, 2005. We donot meet the alternative minimum market capitalization or total asset andrevenue requirements. As a result, we may be considered for suspension ordelisting from AMEX. During May 2006, we received notification from AMEX thatwe were not in compliance with certain sections of the AMEX Company Guide.  To maintain an AMEX listing, we were requiredto submit a plan to AMEX which demonstrates our ability to regain compliancewith the continued listing standards within a maximum of 18 months.  We submitted our plan to AMEX during June2006.  The Listing QualificationsDepartment of AMEX evaluated our plan and in September 2006 notified us that wehad made a reasonable demonstration in the plan of an ability to regaincompliance with the continued listing standards by the end of the plan periodswhich AMEX determined to be Novembeer 15, 2006 for Section 1003(a)(iv) of theAMEX Company Guide and November 30, 2007 for Sections 1003(a)(i), 10033(a)(ii)and 1003(a)(iii) of the AMEX Company Guide.  Accordingly, in September 2006, AMEX notified us that they wouldcontinue the listing of the Company subject to us making a public announcementdisclosing the fact that we are not in compliance with the continued listingstandards of the Exchange and that our listing is being continued pursuant toan extension and our providing certain supporting documentation of key elementsof our plan.  We made the required publicannouncement and provided the requested information.  We are subject to periodic review todetermine if we are making progress consistent with the plan.  Failure to make progress consistent with theplan or regain compliance with the continued listing standards by the end ofthe applicable extension periods could result in the AMEX initiating delistingproceedings pursuant to Section 1009 of the AMEX Company Guide.  There is no assurance that we will makeprogress consistent with the plan , or that we will be able to continue ourlisting on AMEX.

**WEHAVE A HISTORY OF SIGNIFICANT RECURRING LOSSES TOTALING APPROXIMATELY $73.1MILLION, AND THESE LOSSES MAY CONTINUE IN THE FUTURE.**

As ofMarch 31, 2007, we had an accumulated deficit of $73.1 million, andthese losses may continue in the future. We will need to raisecapital to cover these losses, and financing may not be available to us onfavorable terms. In the event financing is not available, in the time framerequired, we will be forced to sell certain of our assets or license ourtechnologies to others. We expect to continue to incur significant sales andmarketing, research and development, and general and administrative expenses.As a result, we will need to generate significant revenues to achieveprofitability and we may never achieve profitability.

**THEHOLDERS OF OUR PREFERRED STOCK HAVE CERTAIN RIGHTS AND PRIVILEGES THAT ARESENIOR TO THE COMMON STOCK, AND WE MAY ISSUE ADDITIONAL SHARES OFPREFERRED STOCK WITHOUT SHAREHOLDER APPROVAL THAT COULD HAVE A MATERIAL ADVERSEEFFECT ON THE MARKET VALUE OF THE COMMON STOCK.**

Our Board of Directorshas the authority to issue a total of up to 4,000,000 shares of preferred stockand to fix the rights, preferences, privileges, and restrictions, includingvoting rights, of the preferred stock, which typically are senior to the rightsof the common stockholders, without any further vote or action by the commonstockholders. The rights of our common shareholders will be subject to, and maybe adversely affected by, the rights of the holders of the preferred stock thathave been issued, or 

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might be issued in thefuture. Preferred stock also could have the effect of making it more difficultfor a third party to acquire a majority of the outstanding voting stock ofImageWare. This could delay, defer, or prevent a change in control. Furthermore,holders of preferred stock may have other rights, including economic rights,senior to the common stock. As a result, their existence and issuance couldhave a material adverse effect on the market value of the common stock. We havein the past issued and may from time to time in the future issue, preferredstock for financing or other purposes with rights, preferences, or privilegessenior to the common stock. At March 31, 2007 we had three series of preferredstock outstanding, Series B preferred stock, Series C 8% convertible preferredstock and Series D 8% convertible preferred stock.

The provisions of ourSeries B Preferred Stock prohibit the payment of dividends on the common stockunless the dividends on those preferred shares are first paid. In addition,upon a liquidation, dissolution or sale of ImageWare’s business, the holders ofthe Series B Preferred Stock will be entitled to receive, in preference to anydistribution to the holders of common stock, initial distributions of $2.50 pershare, plus all accrued but unpaid dividends.  Pursuant to the terms ofour Series B Preferred Stock we are obligated to pay cumulative cash dividendson shares of Series B Preferred Stock from legally available funds at theannual rate of $0.2125 per share, payable in two semi-annual installments of$0.10625 each, which cumulative dividends must be paid prior to payment of anydividend on our common stock. As of March 31, 2007, the Company had cumulativeundeclared dividends on the Series B Preferred Stock of approximately $21,000.

The Series C PreferredStock has a liquidation preference equal to its stated value, plus any accruedand unpaid dividends thereon and any other fees or liquidated damages owingthereon. The Series C Preferred Stock accrues cumulative dividends at the rateof 8.0% of the stated value per share per annum.  At the option of theCompany, the dividend payment may be made in the form of cash, after thepayment of cash dividends to the holders of Series B Preferred Stock, or commonstock issuable upon conversion of the Series C Preferred Stock.  Eachshare of Series C Preferred Stock is convertible at any time at the option ofthe holder into a number of shares of common stock equal to the stated value(initially $1,000 per share, subject to adjustment), plus any accrued andunpaid dividends, divided by the conversion price (initially $1.50 per share,subject to adjustment). Subject to certain limitations, the conversion priceper share shall be adjusted in the event of certain subsequent stock dividends,splits, reclassifications, dilutive issuances, rights offerings, andreclassifications.  The Series C Preferred Stock generally does not havevoting rights except as required by law, however, certain activities may not beundertaken by the Company without the affirmative vote of a majority of theholders of the outstanding shares of Series C Preferred Stock. As of March 31,2007, the Company had cumulative undeclared dividends on the Series D PreferredStock of approximately $75,000.

The Series D PreferredStock has a liquidation preference equal to its stated value, plus any accruedand unpaid dividends thereon and any other fees or liquidated damages owingthereon. The Series D Preferred Stock accrues cumulative dividends at the rateof 8.0% of the stated value per share per annum.  At the option of theCompany, the dividend payment may be made in the form of cash, after thepayment of cash dividends to the holders of Series B and Series C Preferred Stock,or common stock issuable upon conversion of the Series D Preferred Stock. Each share of Series D Preferred Stock is convertible at any time at the optionof the holder into a number of shares of common stock equal to the stated value(initially $1,000 per share, subject to adjustment), plus any accrued andunpaid dividends, divided by the conversion price (initially $1.90 per share,subject to adjustment). Subject to certain limitations, the conversion priceper share shall be adjusted in the event of certain subsequent stock dividends,splits, reclassifications, dilutive issuances, rights offerings, andreclassifications.  The Series D Preferred Stock generally does not havevoting rights except as required by law, however, certain activities may not beundertaken by the Company without the affirmative vote of a majority of theholders of the outstanding shares of Series C Preferred Stock. As of March 31,2007, the Company had cumulative undeclared dividends on the Series D PreferredStock of approximately $8,000.

**ITEM 6. EXHIBITS**
| (a)    | ** ** | **EXHIBITS**                                                                                                                                                                                                                                                              | ** ** |   |
|--------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------|
|   |       |                                                                                                                                                                                                                                                                      |       |   |
| 3.1    |       | Certificate of Incorporation (incorporated by  reference to Annex B to the Company’s Definitive Proxy Statement on Schedule  14A, filed November 15, 2005).                                                                                                          |
| 3.3    |       | Certificate of Designations of Preferences, Rights  and Limitations of Series C 8% Convertible Preferred Stock dated November 2,  2006, as amended (incorporated by reference to Exhibit 3.1 to the Company’s  Current Report on Form 8-K, filed November 20, 2006). |
| 3.4    |       | Certificate of Designations of Preferences, Rights  and Limitations of Series D 8% Convertible Preferred Stock dated March 8,  2007 (incorporated by reference to Exhibit 3.1 to the Company’s Current  Report on Form 8-K, filed March 15, 2007).                   |
| 10.1   |       | Securities Purchase Agreement, dated March 9, 2007,  by and among the Company and certain accredited investors (incorporated by  reference to Exhibit 10.1 to the Company’s Current Report on Form 8-K, filed  March 15, 2007).                                      |
| 10.2   |       | Registration Rights Agreement, dated March 9, 2007,  by and among the Company and certain accredited investors (incorporated by  reference to Exhibit 10.2 to the Company’s Current Report on Form 8-K, filed  March 15, 2007).                                      |
| 10.3   |       | Form of Warrant to Purchase Common Stock dated March  9, 2007 (incorporated by reference to Exhibit 10.3 to the Company’s Current  Report on Form 8-K, filed March 15, 2007.)                                                                                        |
| 31.1   |       | Certification  of  the  Principal Executive Officer pursuant to Rule 13a-14(a) and 15d-14(a)                                                                                                                                                                         |
| 31.2   |       | Certification  of the Principal Financial and Accounting Officer pursuant to Rule 13a-14(a)  and 15d-14(a)                                                                                                                                                                |
| 32.1   |       | Certification  by the Principal Executive Officer and Principal Financial and Accounting  Officer pursuant to 18 U.S.C. 1350 as adopted pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002                                                                        |
|        |            |                                                                                                                                                                                                                                                                           |            |        |  |  |

 

 

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**SIGNATURES**

Pursuantto the requirements of the Securities Exchange Act, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.
|                     | IMAGEWARE SYSTEMS, INC. |
|---------------------|-------------------------|
|                |                    |
|                |                    |
| Date: May 15,  2007 | 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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