UNITED
STATES
 SECURITIES
AND EXCHANGE COMMISSION
 Washington,
D.C. 20549
 
 FORM
10-K
 
 Annual
Report Pursuant to Section 13 or 15(d) of The
 Securities
Exchange Act of 1934
 
 For
the fiscal year ended December 31, 2008
 
 Commission
file number 000-21129
 
 AWARE,
INC.
 (Exact
Name of Registrant as Specified in Its Charter)
  
  Massachusetts
              04-2911026(State or
      Other Jurisdiction of
                Incorporation or
      Organization)
              (I.R.S.
      Employer Identification No.)
   40 Middlesex Turnpike,
Bedford, Massachusetts  01730
 (Address
of Principal Executive Offices)
 (Zip
Code)
 
 (781)
276-4000
 (Registrant’s
Telephone Number, Including Area Code)
 
 Securities
registered pursuant to Section 12(b) of the Act:
  Title of Each
      Class
                Name of Each Exchange on Which
      RegisteredCommon Stock, par
      value $.01 per share
                The Nasdaq Global
      Market
 Securities
registered pursuant to Section 12(g) of the Act: None
 
 Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act. Yes o   No
x
 
 Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Exchange Act.
 Yes o   No
x
 
 Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days.    Yes x   No
o
  Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of registrant’s knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.  x
 
 Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting
company.  See definition of "large accelerated filer”, “accelerated filer",
and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  (Check
one):
 
 Large
Accelerated Filer oAccelerated Filer xNon-Accelerated
Filer oSmaller Reporting Company o
 
 Indicate by check mark whether the
registrant is a shell company (as defined in Rule 12b-2 of the Exchange
Act). Yes o   No
x
 
 As of
June 30, 2008 the aggregate market value of the registrant’s common stock held
by non-affiliates of the registrant, based on the closing sale price as reported
on the Nasdaq Global Market, was approximately $68,716,416.
 
 The
number of shares outstanding of the registrant’s common stock as of February 9,
2009 was 23,281,204.
 
 DOCUMENTS
INCORPORATED BY REFERENCE
 
 Portions
of the registrant’s definitive Proxy Statement to be delivered to shareholders
in connection with the registrant’s Annual Meeting of Shareholders to be held on
May 20, 2009 are incorporated by reference into Part III of this Annual Report
on Form 10-K.
 
  AWARE,
INC.
 FORM
10-K
 FOR
THE YEAR ENDED DECEMBER 31, 2008
 
 
 TABLE
OF CONTENTS
 
 
 PART
      IItem
      1.
                          
                          Business
                          3Item
      1A.
                          
                          Risk
      Factors
                          12Item
      1B.
                          
                          Unresolved
      Staff
      Comments
                          20Item
      2.
                          
                          Properties
                          21Item
      3.
                          
                          Legal
      Proceedings
                          21Item
      4.
                          
                          Submission
      of Matters to a Vote of Security
      Holders
                          21PART
      IIItem
      5.
                          
                          Market
      for Registrant’s Common Equity, Related Stockholder Matters and Issuer
      Purchases
                            of
      Equity Securities
                          22Item
      6.
                          
                          Selected
      Financial Data
                          25Item
      7.
                          
                          Management’s
      Discussion and Analysis of Financial Condition and Results
                            of
      Operations
                          26Item
      7A.
                          
                          Quantitative
      and Qualitative Disclosures About Market
      Risk
                          34Item
      8.
                          
                          Consolidated
      Financial Statements and Supplementary
      Data
                          35Item
      9.
                          
                          Changes
      in and Disagreements with Accountants on Accounting and
      Financial
                            Disclosure
                          54Item
      9A.
                          
                          Controls
      and
      Procedures
                          54Item
      9B.
                          
                          Other
      Information
                          54PART
      IIIItem
      10.
                          
                          Directors,
      Executive Officers and Corporate
      Governance
                          55Item
      11.
                          
                          Executive
      Compensation
                          55Item
      12.
                          
                          Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder
                            Matters
                          55Item
      13.
                          
                          Certain
      Relationships and Related Transactions, and Director
      Independence
                          55Item
      14.
                          
                          Principal
      Accountant Fees and
      Services
                          55PART
      IVItem
      15.
                          
                          Exhibits
      and Financial Statement
      Schedules
                          56Signatures
                          58
  2
  PART
I
 
 
 ITEM
1.   BUSINESS
 
 Company
Overview
 
 We have
been a leading innovator in digital communications and signal processing
technologies for telecommunications and imaging applications for well over a
decade.  These technologies form the basis of our product and services
offerings in Digital Subscriber Line (DSL) silicon intellectual property, DSL
test and diagnostics and biometrics and medical imaging.
 
 We
license DSL silicon intellectual property (“IP”) that enables customers to
manufacture and sell integrated circuits for the DSL industry.  Our
silicon IP products, which support all asymmetric DSL (“ADSL”) and very high
speed DSL (“VDSL”) standards for central office and customer premise equipment
applications, are based upon International Telecommunication Union (“ITU”) and
other relevant industry standards.  Silicon IP customers receive
rights to patents, digital and analog chip designs, run-time software and
support.  DSL continues to be the most widely used broadband wide-area
network technology worldwide. In recent years, third parties have also shown an
interest in licensing or purchasing our patents related to DSL as well as other
areas.
 
 Our test
and diagnostics products leverage our DSL technology and semiconductor customer
relationships.  We sell DSL test and diagnostics hardware and software
products to pre-qualify, monitor and troubleshoot DSL service. We sell our
hardware and software products to OEM suppliers of DSL test equipment, including
automated test-heads and handheld testers.  We also sell our software
products to telephone companies and network equipment
suppliers.   Our hardware products support all common DSL network
architectures in single platform, easy-to-integrate modules.  We
enable broad connectivity for DSL test and diagnostics applications by
supporting interoperability across an extensive footprint of central office and
customer premises equipment.  Our Dr. DSL® software products support
pre-qualification, provisioning, rate estimation, troubleshooting and
maintenance applications.  In addition, we sell an advanced test and
diagnostics server-based, line diagnostics platform (LDP) that provides a
comprehensive, centralized system for analysis and diagnostics of a service
provider’s DSL lines.   By leveraging existing equipment
infrastructure in place for DSL service delivery, LDP enables a cost-effective
means for service providers to ensure quality levels and troubleshoot their
networks.  As phone companies expand their DSL offerings to include
IPTV, video and triple play services, there is expected to be an increased need
for improved monitoring and troubleshooting of DSL networks.
 
 Our
biometrics software products leverage our imaging and biometrics
technology.  We license and sell a broad range of software products
that are used in government systems worldwide.  Our products provide
solutions suppliers and system integrators with interoperable,
standards-compliant, field-proven biometric functionality for enrollment of
fingerprints and facial images, ID personalization and reading, and
networking.  Our products are utilized in biometrics systems for
criminal justice, border management and credentialing applications through a
customer base of OEMs and system integrators.  We also sell to
end-users such as government agencies and commercial enterprises.  Our
server-based Biometrics Services Platform (BioSP)TM is a modular, flexible
software platform that enables developers and integrators to rapidly build and
deploy centralized multimodal biometric data processing solutions in support of
a service-oriented architecture.  The biometrics industry has
benefited from the emergence of industry standards and supportive legislation
since September 11, 2001.  The use of biometrics in security,
credentialing and border management applications is becoming pervasive. In
addition, we sell software products for medical and digital imaging applications
based upon industry standards such as JPEG 2000 and JPIP.
 
 We have
research and development activities underway to develop new forms of
communications, test, biometrics and imaging technologies.  We play an
active role at standards setting bodies so that we can anticipate and influence
technology advances and changes in industry requirements.
 
 During
2007 and 2008, approximately 70% and 59%, respectively, of our revenue came from
the licensing and sale of DSL silicon IP and patents as well as DSL test and
diagnostic hardware and software products.   The remainder of our
revenue in 2007 and 2008 came from the sale of software products for biometric
applications and medical imaging applications and from professional services for
biometrics applications.
 
 We are
headquartered in Bedford, Massachusetts.  Our telephone number is
(781) 276-4000, and our website is www.aware.com.  Incorporated in
Massachusetts in 1986, we employed 122 people as of December 31,
2008.   Our stock is traded on the Nasdaq Global Market under the
symbol AWRE.
 
 3
  Our
website provides a link to a third-party website through which our annual,
quarterly and current reports, and amendments to those reports, are available
free of charge.  We believe these reports are made available as soon
as reasonably practicable after we electronically file them with, or furnish
them to, the SEC.  We do not maintain or provide any information
directly to the third-party website, and we are not responsible for its
accuracy. You may also access our various SEC filings and reports at the SEC’s
website at www.sec.gov.
 
 
 Industry
Background
 
 DSL Industry
Background.  DSL technology allows telephone companies to offer
high-speed data services and Internet Protocol television (“IPTV”) over their
existing telephone wires.  Telephone companies began tests and trials
of ADSL technology in the mid 1990s.  Commercial deployment of ADSL
services began in modest volumes in 1999, and since then deployments of ADSL
services have grown dramatically, particularly outside of the United States.
According to announcements by major telephone companies and information compiled
by Point Topic Ltd., a company that provides analysis of broadband access to the
Internet, approximately 43 million, 42 million and 29 million new ADSL
subscribers were added in 2006, 2007, and the first nine months of 2008,
respectively.  As of the third quarter of 2008, there were
approximately 257 million global DSL subscribers worldwide, of which
approximately 35 million were in North America; approximately 106 million were
in Europe/Middle East/Africa; approximately 99 million were in the Asia Pacific
region; and the remainder were in Latin America.
 
 In order
to activate DSL service, one end of a telephone wire must be connected to DSL
equipment in a central office or remote location controlled by a telephone
company and the other end must be connected to a device in the customer’s
premises.  DSL central office and remote location equipment includes
DSL access multiplexers (“DSLAMs”), next generation digital loop carriers
(“NGDLCs”), and broadband loop carriers (“BLCs”).  Devices in the
customer’s premise are known as DSL customer premises equipment (“CPE”) and
include modems, routers and devices that support integrated voice and data,
known as integrated access devices or gateways.
 
 As the
demand for faster residential broadband service continues to grow, telephone
companies are upgrading their networks to increase the data rates that are
delivered to their residential customers.  With higher data rates
phone companies can offer IPTV, video and triple play services.  IPTV
provides phone companies a means to deliver a superior and differentiated TV
service by offering more channel selections, better quality and an improved user
experience with multiple viewing panes and instantaneous channel
switching.  IPTV is expected to drive increased demand for the fastest
versions of DSL service over the next several years.These network upgrades require
large financial expenditures and involve the deployment of fiber optic-based
communications to points deeper in the access networks that are closer to
residential customers than today’s central office locations.  The
resulting fiber-to-the-node (“FTTN”) networks require that new equipment
platforms be installed at fiber-fed points.  These equipment platforms
utilize the existing telephone wire infrastructure and ADSL2+ or VDSL2 standards
to provide increased data rates and reliability.
 
 There are
approximately 20.4 million worldwide IPTV subscribers today according to Market
Research Group (“MRG”), a provider of analyses and market intelligence. 
MRG forecasts growth to 89.1 million in 2012, with DSL subscribers as the main
base for IPTV growth.
 
 As phone
companies deploy higher data rates and video services, they also increasingly
look for improved solutions for testing, diagnosing and maintaining their DSL
networks and services.  The DSL test infrastructure can incorporate
dedicated hardware as well as software components and subsystems.  As
the size of the worldwide DSL footprint grows and the nature of service
offerings expands to include video and IPTV, there is an increased opportunity
for DSL test and diagnostics solutions.
 
 Equipment
manufacturers are able to purchase DSL chipsets for telephone company equipment
or CPE from suppliers such as Broadcom Corporation (“Broadcom”), Conexant
Systems, Inc. (“Conexant”), Ikanos Communications, Inc. (“Ikanos”), Infineon
Technologies AG (“Infineon”), and TrendChip Technologies Corporation
(“TrendChip”).
 
 Service
Providers are able to purchase DSL test and diagnostics products from a number
of companies including Alcatel-Lucent (“Alcatel”), Spirent Communications PLC
(“Spirent”), Tollgrade Communications, Inc. (“Tollgrade”), JDS Uniphase
Corporation (“JDS”), Teradyne, Inc. (“Teradyne”), Sunrise Communications, Inc.
(“Sunrise”), Fluke Corporation (“Fluke”), Kurth Electronic GmbH (“Kurth”) and
others.
 
 4
 
 DSL Technology
Background.DSL connects an end user to a central location in
a telephone company’s network such as a central office or remotely controlled
location.   DSL equipment is required at each end of the
telephone line.  ADSL2, ADSL2+ and VDSL2 technologies enable transmit
speeds between multiple megabits (“Mbps”) and 100 Mbps. Actual transmission speeds
depend on the length and condition of the existing wire.
 
 The ADSL
industry relies on international standards bodies to specify the technology used
for ADSL services.  Standards bodies that contribute specifications
include the American National Standards Institute (“ANSI”), the ITU, the
European Telecommunications Standards Institute (“ETSI”) and other
organizations.  The prevalence and influence of industry standards on
the ADSL industry make it similar to other communications and networking
technologies such as Code Division Multiple Access (“CDMA”), Universal Serial
Bus (“USB”), Global System for Mobile telecommunications (“GSM”), Global
Positioning System (“GPS”), Wireless Local Area Networking (“WLAN”), and
chip-connection technology for Dynamic Random Access Memory
(“DRAM”).  For the infrastructure and services that use these
technologies, standards and patents play a significant role in the formation of
the commercial landscape.
 
 In 2002,
the ITU approved a set of ADSL standards known as ADSL2 or G.992.3 and
G.992.4.  These standards provide numerous improvements over previous
ADSL standards, including line diagnostics, power management, power down and
power cutback, reduced framing and on-line configuration.  In 2003,
the ITU approved ADSL2+ or G.992.5.  ADSL2+ builds upon the ADSL2
standard by increasing achievable data rates to speeds up to 24 Mbps upstream on
phone lines as long as 3,000 feet (20 Mbps out to 5,000 feet).  While
the signal bandwidth of previous ADSL standards was about 1 MHz, ADSL2+
specifies signals with more than 2 MHz of bandwidth.
 
 ITU
standards for bonded ADSL, G.998.1 and G.998.2, were approved in January
2005.  These standards specify multi-pair ADSL bonding technology for
residential and business services.  Data rates are increased by a
factor equal to the number of lines that are bonded.  For example, if
two pairs are bonded, upstream and downstream data rates are
doubled.
 
 VDSL2 is
the fastest version of DSL.  In February 2006, the ITU approved the
G.993.2 VDSL2 standard which supports bandwidths from 8 MHz to 30 MHz and
specifies data rates up to 100 Mbps.  VDSL2 supports multiple
profiles, each requiring multiple upstream and downstream
bands.  VDSL2 also supports the functionality improvements found in
ADSL2 and ADSL2+.
 
 A new DSL
industry standard, called G.inp, is under development at the ITU that will
address improved reliability for real-world IPTV deployments over DSL
networks.
 
 
 DSL Test and Diagnostics Industry
Background.  The ADSL2+ and VDSL2 standards are the first
widely deployed DSL standards to incorporate test functionality for analyzing
and diagnosing DSL networks.  As deployments using these technologies
become more pervasive, this functionality will improve phone companies’ ability
to test and diagnose their networks.
 
 As IPTV,
video-based and triple play services become more widely offered through DSL
networks, the need for improved pre-qualification, provisioning and maintenance
will increase.  Television and video services require a higher degree
of reliability and robustness than data services.
 
 Service
assurance solutions have been put in place for telephone companies’ traditional
voice services and initial ADSL deployments.  We expect an increased
interest by phone companies for new service assurance solutions for ADSL2+ and
VDSL2 networks for IPTV and video-based services.
 
 Automated
test equipment (“ATE”) is used for testing and diagnosing DSL lines and
services.  The DSL ATE infrastructure typically involves the use of a
centrally located test-head platform.  At this location, information
is gathered from the telephone network and used for remotely provisioning or
troubleshooting DSL service.
 
 Information
about the DSL network is also gathered using hand-held testers.  The
information gathered in ATE and handhelds is generally made available to
telephone companies’ operations organizations through a complex software
network.  This information assists telephone companies in
pre-qualifying, analyzing and diagnosing problems encountered during service
deployment or during operation.
 
 5
  Test and
diagnostics functions are also performed by DSL network equipment (e.g. DSLAMs)
or DSL CPE, though typically to a lesser extent than those performed by
dedicated test equipment.
 
 Leading
suppliers of ATE hardware and software, handheld devices and operations software
include Alcatel, Spirent, Teradyne, Tollgrade, JDS, Sunrise, Fluke, and
others.
 
 
 Biometrics Industry
Background.  Biometric identification systems have
traditionally used fingerprints as the primary means to identify individuals and
they continue to be pervasive in government and commercial
applications.  These systems gather fingerprints at enrollment
stations and access control locations, and utilize transaction processing
hardware and software and matching systems for identification.  The
emergence of digital fingerprint acquisition devices, compression, and
standardized biometric transaction/interchange formats in the 1990s has
transformed these systems to electronic systems capable of faster transaction
processing and matching.  These electronic systems are also capable of
being upgraded to utilize biometrics other than or in addition to digital
fingerprints, such as iris and facial images.
 
 The
capture and secure storage of biometric information over the past ten years has
created a foundation for greater use of biometrics in government and commercial
activities.   There is increased interest in using biometrics to
improve security.  The emergence and adoption of industry standards
for border control and secure credential applications has increased the reach
and use of biometrics in security applications.  Legislation is
driving many government programs now underway that require the use of biometric
information in documents such as e-passports and personal identification
cards.   Personal identity verification (“PIV”) systems are being
employed by government agencies to standardize federal employee and contractor
IDs and utilize them to control access to government facilities and information
systems. The National Institute for Standards and Technology developed the FIPS
201 standard for PIV as mandated by HSPD-12.  Other biometrics
applications such as border management, and upgrades to state and local
automated fingerprint identification systems (“AFIS”) used for fingerprint
enrollments are also expected to present opportunities for vendors of biometrics
products in the next several years.  The use of biometric security
systems by regulated segments of the financial, transportation and healthcare
industries has also increased.  As biometric security systems gain
acceptance in new areas, and as infrastructure build-outs take hold, new
opportunities are emerging for biometrics solutions suppliers. The biometrics
security systems market is also expected to grow as the use of new biometrics,
other than or in addition to fingerprints, gain favor.
 
 Vendors
of the hardware and/or software component of biometric enrollment stations
include Lockheed Martin Corporation (“Lockheed”), Cross Match Technologies, Inc.
(“Cross Match”), Unisys Corporation (“Unisys”), Science Applications
International Corporation (“SAIC”), L1 Identity Solutions, Inc. (“L1”), Northrop
Grumman Corporation (“Northrop”), Hewlett-Packard Electronic Data Systems
(“EDS”) and NEC Corporation (“NEC”). Fingerprint matching and/or biometric
transaction management systems are provided by companies such as Motorola, Inc,
(“Motorola”), Sagem Telecommunications (“Sagem”), NEC, Cogent Communications
Group, Inc. (“Cogent”), and numerous system integrators.
 
 
 Aware
DSL Silicon Intellectual Property
 
 Aware has
been a pioneer of DSL technology since the mid-1990s.  We license our
StratiPHY2+TM and StratiPHY3TM silicon intellectual property products to
semiconductor companies to manufacture and sell chipsets that are compliant with
ITU standards.  StratiPHY2+ complies with the ADSL2+ standards and
StratiPHY-BondedTM ADSL2+ complies with the ITU G.bond
standard.   StratiPHY3 supports ADSL2, ADSL2+, VDSL1 and VDSL2
standards.  We offer licenses to StratiPHY silicon IP products that
include patent rights, copyrighted materials and trade
secrets.  Copyrighted materials include analog and digital chip
designs, available in Verilog or VHDL languages, and software, available in
assembly and C-code.  We license our copyrighted materials in source
code as well as object code form.  We have also manufactured limited
quantities of digital and analog chips using our StratiPHY designs.
 
 Customers
develop integrated circuits based upon our silicon IP for fabrication in their
own or third party manufacturing processes.  We also offer engineering
services to our customers for the development and support of their chips or
chipsets.  Our largest customers for StratiPHY have been Infineon and
Ikanos.
 
 We also
pursue the license and/or sale of patents, as part of our silicon IP offerings
as well as on a standalone basis.  In recent years, we have seen an
increased interest from third parties in purchasing or licensing our patents
relating to DSL.
 
 6
  Aware
DSL Test and Diagnostics Products
 
 We have
developed test and diagnostics hardware and software products based upon our
universal DMT (UDMTTM) and Dr. DSL technology.  These products are
designed to improve the ability of service providers to pre-qualify, provision,
monitor, and troubleshoot DSL networks by enabling them to collect important
information and diagnose problems regarding their service offerings. The primary
goal of these products is to reduce the costs associated with service set-up,
troubleshooting and maintenance.
 
 Aware’s
UDMT modem modules can be software-configured to emulate both DSLAMs and CPEs
across a broad range of DSL technologies, including ADSL, ADSL2+, legacy
VDSL1/1.5 and VDSL2. A single UDMT module will support all common DSL network
architectures so that test solutions can easily and cost-effectively
interoperate with installed DSLAMs and CPEs/gateways.
 
 Our
principal UDMT modem modules include the 450/455, 550 and 600 model
numbers.  Each of these are easy-to-integrate, standard-compliant,
modules for ADSL/2/2+ and VDSL networks.  Each can be software
configured to support DSLAM or CPE emulation.
 
 We
primarily sell our hardware products to OEMs who supply DSL automated test
equipment and DSL handheld testers.
 
 Aware’s
Dr. DSL software modules perform pre-qualification, fault detection, line
diagnostics and line analysis functionality.  Dr. DSL software is
utilized by our UDMT modules.
 
 Our Dr.
DSL Line Diagnostics Platform (“LDP”) is a server-based software platform that
provides a comprehensive, centralized system for analysis and diagnostics of a
service provider’s DSL lines.  With LDP, a service provider can use
existing infrastructure to provide provisioning and maintenance
services.  This enables telephone companies to perform analysis and
diagnostics of traditional POTS and traditional and advanced DSL services,
including IPTV and triple play services.
 
 We
primarily sell our Dr. DSL software products to automated test equipment,
outside plant equipment, and DSL network equipment suppliers.  We also
sell to telephone companies.
 
 
 Aware
Biometrics and Imaging Products and Services
 
 Aware has
been a pioneer in the development of wavelet-based image compression technology
since the late 1980s.  Aware provides standards-compliant biometrics
software tools that enable integrators, solution providers, and government
agencies to compress, analyze, optimize, format, and transport biometric images
and data according to domestic and international standards.  We have
developed software products for biometrics applications that support industry
standards.
 
 Our
biometrics and imaging products address:
 
 ·
                Data
      formatting and interchange software components that support NIST, ISO,
      INCITS, ICAO, and FIPS 201 standards and enable
      interoperability.
 ·
                Image
      compression software components for fingerprint and facial image
      compression such as WSQ and
JPEG2000.
 ·
                Biometric
      ID cards.  Our PIVSuiteTM family of software development kits
      (SDKs) support registration, identity proofing, ID card personalization
      and issuance applications in compliance with FIPS
      201.  CaptureSuiteTM is a family of SDKs for automatic capture
      and processing of
fingerprints.
 ·
                Image
      processing for biometric quality analysis, capture and transaction
      processing applications.
 ·
                Networking
      software for building and deploying multimodal biometric data workflow
      solutions.  Our Biometrics Services Platform (BioSPTM)
      is a service-oriented platform for biometrics data processing and
      integration applications. BioSP supports the collection of biometrics from
      a distributed network, and subsequent aggregation, analysis, processing
      and integration of this data into larger
  systems.
  7
  We sell
our biometrics software products primarily to integrators, OEMs and government
agencies. We supply a broad range of fingerprint and facial biometric
functionality, including enrollment, ID personalization and reading, and
networking.  Our solutions address border control and management,
secure credentialing, and fingerprint background check applications. We also
sell medical imaging and digital imaging software solutions. We have a large
number of OEM customers in the biometrics, medical and digital imaging
markets.
 
 Beginning
in 2007, we expanded our presence in the biometrics market by adding a services
element to our offerings.  Our professional services are focused on
assisting customers with the design and development of systems for biometrics
applications. In 2008, we successfully sold professional services to a systems
integrator for a contract with a large U.S. government agency.
 
 
 Aware
Strategy
 
 We are a
technology innovation and product development company.  We promote our
technology through participation in industry standard setting organizations and
attempt to lead the market in obtaining relevant patent protection and in the
development of products that support industry standards.  We have
participated in the DSL and biometrics industries for more than ten years. We
primarily market and sell products for the DSL, biometrics and imaging
industries through an OEM business model, which allows us to expand the
addressable market for our products through the success of our customers. We
also market and sell DSL products to telephone companies and biometrics products
and services to government agencies.
 
 Key
elements of our strategy include:
 
 Lead in the development of
standards-based technologies.We actively promote our
technology at standards bodies with the goal of including it in new
specifications.  The use of technology that is compliant with industry
standards is prevalent in telecommunications applications and in the DSL
industry.  The use of standards in biometrics applications has
significantly increased since 2001 and is now widespread.  By leading
in technology developments for widely used standards, we believe that we are
better positioned to participate in the markets we are addressing.  We
have developed a broad portfolio of intellectual property assets including trade
secrets, copyrighted materials and US and foreign patents and patent
applications.
 
 Leverage our technology assets into
market presence.Our technology forms the basis for our product
developments in communications, biometrics and imaging
applications.  Our research and development activities focus primarily
on product developments that commercialize our technology into software and
hardware products that are easy-to-integrate by OEMs.  We are also
involved in licensing or selling our patents as a means to commercialize our
technology.
 
 Commercialize hardware and software
solutions for DSL test and diagnostics applications through an OEM business
model.We have developed hardware modules and software
solutions for pre-qualifying, provisioning, and troubleshooting DSL
networks.  These products leverage our DSL expertise, test
functionality inherent in ADSL2+ and VDSL2 standard-compliant solutions and our
semiconductor customer relationships.  We sell to automated test
equipment manufacturers, network equipment manufacturers and service
providers.  By selling primarily through OEMs, we gain broad exposure
to growth in spending by phone companies on DSL test and diagnostics
solutions.
 
 Commercialize software components
and server-based solutions for biometrics applications through an OEM business
model.We have developed software products for fingerprint
enrollment, border control and secure credential applications.  Our
Biometrics Services Plaftorm (BioSP) is a server-based software product for
enrollment of biometric data for personal identity verification and other
applications.  We sell products and services primarily to OEM
suppliers and systems integrators.  We have broad exposure to the
biometrics market through our customer base.
 
 
 Research
and Development
 
 Our
research and development activities are focused primarily on improving core
technologies in communications and imaging and product developments in DSL,
test, biometrics and medical imaging.
 
 8
  Our DSL
engineering activities involve developing analog front-end solutions for
broadband applications, developing new DSL technology in support of the emerging
G.inp standard and developing home networking technology in support of the ITU’s
G.hn standard.  G.inp is a new ITU standard that will address improved
reliability in the presence of impulse noise for IPTV deployments over DSL
networks.   G.hn is a new ITU standard focused on high-speed
networked communications throughout a home by utilizing premises wiring,
including coaxial cable, telephone wires and electrical wires, as well as
combinations of these broadband technologies.
 
 Our DSL
test and diagnostics engineering activities involve improving the functionality
of our DSL test and diagnostics hardware and software products to support phone
company requirements for pre-qualifying, monitoring and troubleshooting advanced
DSL services, including VDSL2 networks and IPTV deployments.  During
2008, we introduced new UDMT hardware modules, new functionality into our Dr.
DSL software products, and improvements to our LDP server-based software
platform for DSL test and diagnostic applications.
 
 Our
biometrics and imaging engineering activities are focused on improving our
software product functionality and broadening our exposure to biometrics,
medical and digital imaging applications. During 2008, we further improved the
functionality in our software components for PIV and fingerprint enrollment
applications, as well as in our BioSP server-based software
platform.
 
 As of
December 31, 2008, we had an engineering staff of 86 employees, representing 70%
of our total employee staff.  During the years ended December 31,
2008, 2007, and 2006, research and development expenses charged to operations
were $13.2 million, $10.9 million, and $10.6 million,
respectively.  In addition, because our agreements often call for us
to provide engineering development services to our customers, a portion of our
total engineering costs has been allocated to cost of contract
revenue.  We expect that we will continue to invest substantial funds
in research and development activities.
 
 
 Sales
and Marketing
 
 Our
principal sales and marketing strategy is to sell to OEMs and systems
integrators in the market segments we are targeting. We license DSL silicon
intellectual property to semiconductor manufacturers.  We license
and/or sell DSL test and diagnostics hardware and software products primarily to
OEM customers, and also to service providers.  We license and sell our
biometrics and digital imaging software products and provide professional
services primarily to OEMs and systems integrators and, to a lesser extent, to
government agencies.  We believe that decisions involving the
selection of our technology and products are frequently made at senior levels
within a prospective customer’s organization. Consequently, we rely
significantly on presentations by our senior management to key employees at
prospective customers.
 
 As of
December 31, 2008, we had 5 employees in our DSL licensing and test and
diagnostics sales and marketing organization.  As of December 31,
2008, there were 11 employees in our biometrics and digital imaging software
sales organization.
 
 Ikanos
and Infineon are selling and/or developing integrated circuits based upon our
StratiPHY2plus technology.  Infineon is also selling and/or developing
integrated circuits based upon our StratiPHY3 technology. We derived
approximately 12%, 19%, and 26% of our total revenue from Infineon in 2008,
2007, and 2006, respectively. Prior to 2006, Analog Devices, Inc. (“ADI”) was a
significant ADSL licensing customer. In February 2006, ADI sold its ADSL
business relating to Aware technology to Ikanos, and Ikanos replaced ADI as an
Aware customer. In 2006, we derived approximately 20% of our total revenue from
the combination of ADI and Ikanos.
 
 We also
sell and/or license patents to interested parties.  In 2008, we
derived approximately 28% of our total revenue from Daphimo Co. B.V. LLC
(“Daphimo”) for the sale of patents related to communications
technology.
 
 There
were no test and diagnostics customers that represented more than 10% of our
total revenue in 2008 or 2006.  In 2007, we derived approximately 16%
and 10% of our total revenue from Spirent and Alcatel,
respectively.
 
 There
were no biometrics customers that represented more than 10% of our total revenue
in 2007 or 2006. In 2008, we derived approximately 10% of our total revenue from
Technology Management Group, Inc. (“TMG”).
 
 All
revenue in 2008, 2007, and 2006 was derived from unaffiliated
customers.
 
 9
 
 Competition
 
 DSL
services compete with broadband technologies that use other network
architectures to provide high-speed data service.  These technologies
include cable modems, wireless and fiber-to-the-home services.  To
date, ADSL services have been more successful than high-speed cable services
outside of the United States; however cable services serve a larger number of
broadband subscribers than ADSL inside the United States. We can give no
assurance that these alternative network architectures will not be more
successful than DSL.
 
 As a
silicon IP supplier to the semiconductor industry, we face competition from
internal development teams within potential semiconductor
customers.  We must convince potential customers to license or buy
from us rather than develop technology internally.  Furthermore, our
semiconductor customers may choose to abandon joint development projects with us
or develop chipsets themselves without using our technology.  In
addition to competition from internal development teams, we may compete against
other independent suppliers of intellectual property for
DSL.  Semiconductor companies have also been reluctant to enter the
DSL market for competitive or strategic reasons.
 
 The
market for DSL chipsets is intensely competitive.  Our success as a
silicon IP supplier requires that DSL equipment manufacturers buy chipsets from
our semiconductor customers, and that telephone companies buy DSL equipment from
those equipment manufacturers.  Our customers’ chipsets compete with
products from other vendors of standards-based DSL chipsets, including Broadcom,
Conexant, and TrendChip.
 
 The
markets for our DSL test and diagnostics hardware and software products are
competitive and uncertain.  We can give no assurance that phone
companies will purchase significant quantities of products to test and maintain
their DSL networks, or that if they do they will use our
products.  Our success as a supplier of hardware and software products
for DSL test and diagnostics depends in large part on the willingness and
ability of OEM customers to design, build and sell automated test heads,
hand-held testers, and DSLAMs that incorporate or work with our
products.  Our success also depends upon our ability to market and
sell to service providers.
 
 The
markets for our biometrics, medical and digital imaging software products and
services are competitive and uncertain. We can give no assurance that the
biometrics industry will grow.  We can give no assurance that our
products and services will succeed in the market.  We can give no
assurance that we will be able to compete effectively or that competitive
pressures will not seriously harm our business.
 
 Our DSL,
biometrics, and medical and digital imaging customers and/or their competitors
have significantly greater financial, technological, manufacturing, marketing
and personnel resources than we do.   We can give no assurance
that our OEM customers will continue to purchase products from us or that we
will be able to compete effectively or that competitive pressures will not
seriously harm our business.
 
 
 Patents
and Intellectual Property
 
 We rely
on a combination of nondisclosure agreements and other contractual provisions,
as well as patent, trademark, trade secret and copyright law to protect our
proprietary rights.  We have an active program to protect our
proprietary technology through the filing of patents.  As of December
31, 2008, we had approximately 42 U.S. patents, 95 foreign patents, and a number
of pending patent applications pertaining to telecommunications and signal
processing technology, image compression, video compression, audio compression,
seismic data compression and optical applications.
 
 Although
we have patented certain aspects of our technology, we rely primarily on trade
secrets to protect our intellectual property.  We attempt to protect
our trade secrets and other proprietary information through agreements with our
customers, suppliers, employees and consultants, and through security
measures.  Each of our employees is required to sign a non-disclosure
and non-competition agreement.  Although we intend to protect our
rights vigorously, we cannot assure you that these measures will be
successful.  In addition, effective intellectual property protection
may be unavailable or limited in certain foreign countries.
 
 Third
parties may assert exclusive patent, copyright and other intellectual property
rights to technologies that are important to us.  In the past, we have
received letters from third parties suggesting that we may be obligated to
license such intellectual property rights.  If we were found to have
infringed any third party’s patents, we could be subject to substantial damages
or an injunction preventing us from conducting our business.
 
 10
 
 Manufacturing
 
 We rely
on one third party contract manufacturer to assemble and test substantially all
of our DSL hardware products.  If this company was to terminate its
arrangement with us or fail to provide the required capacity and quality on a
timely basis, we would be unable to manufacture our products until replacement
contract manufacturing services could be obtained. To qualify a new contract
manufacturer, familiarize it with our products, quality standards and other
requirements, and commence production is a costly and time-consuming process. We
cannot assure you that we would be able to establish alternative manufacturing
relationships on acceptable terms.  Although we make reasonable
efforts to ensure that our contract manufacturer performs to our standards, our
reliance on a single source limits our control over quality assurance and
delivery schedules. Defects in workmanship, unacceptable yields, and
manufacturing disruptions and difficulties may impair our ability to manage
inventory and cause delays in shipments and cancellation of orders that may
adversely affect our relationships with current and prospective customers. 
As a result, our revenues and operating results may be harmed.
 
 Our
internal manufacturing capacity is limited to final test and assembly of certain
products. Our current manufacturing systems have been adequate to manage current
volumes of hardware products. However, our manufacturing systems have not been
extensively tested under more complex hardware products or in volumes higher
than that of our current volumes. If our manufacturing systems are inadequate or
have other problems, our revenues and operating results may be
harmed.
 
 We rely
on single source suppliers for components and materials used in our DSL hardware
products. Our dependence on single source suppliers involves several risks,
including limited control over pricing, availability, quality, and delivery
schedules. Any delays in delivery of such components or shortages of such
components could cause delays in the shipment of our products, which could
significantly harm our business. Because of our reliance on these vendors, we
may also be subject to increases in component costs. These increases could
significantly harm our business. If any one or more of our single source
suppliers cease to provide us with sufficient quantities of our components in a
timely manner or on terms acceptable to us, we would have to seek alternative
sources of supply. We could incur delays while we locate and engage alternative
qualified suppliers and we might be unable to engage alternative suppliers on
favorable terms. We could incur substantial hardware and software redesign costs
if we are required to replace the components.  Any such disruption or
increased expenses could harm our commercialization efforts and adversely affect
our ability to generate revenues.
 
 
 Employees
 
 At
December 31, 2008, we employed 122 people, including 86 in engineering, 19 in
sales and marketing, 3 in manufacturing and 14 in finance and
administration.  Of these employees, 116 were based in
Massachusetts.  None of our employees is represented by a labor
union.  We consider our employee relations to be good.
 
 We
believe that our future success will depend in large part on the service of our
technical, sales, marketing and senior management personnel and upon our ability
to retain highly qualified technical, sales and marketing and managerial
personnel.  We cannot assure you that we will be able to retain our
key managers and employees or that we will be able to attract and retain
additional highly qualified personnel in the future.
 
 11
  ITEM
1A.  RISK FACTORS
 
 Some
of the information in this Form 10-K contains forward-looking statements that
involve substantial risks and uncertainties.  You can identify these
statements by forward-looking words such as “may,” “will,” “expect,”
“anticipate,” “believe,” “estimate,” “continue” and similar
words.  You should read statements that contain these words carefully
because they: (1) discuss our future expectations; (2) contain projections of
our future operating results or financial condition; or (3) state other
“forward-looking” information.  However, we may not be able to predict
future events accurately.  The risk factors listed in this section, as
well as any cautionary language in this Form 10-K, provide examples of risks,
uncertainties and events that may cause our actual results to differ materially
from the expectations we describe in our forward-looking
statements.  You should be aware that the occurrence of any of the
events described in these risk factors and elsewhere in this Form 10-K could
materially and adversely affect our business.  We assume no obligation
to update any forward-looking statements.
 
 
 Our
Quarterly Results are Unpredictable and May Fluctuate Significantly
 
 Our
quarterly revenue and operating results are difficult to predict and may
fluctuate significantly from quarter-to-quarter due to the unpredictably of our
revenue components.
 
 It is
difficult for us to make accurate forecasts of product
revenues.  Product revenues consist of sales of test and diagnostics
hardware as well as biometrics, medical imaging and test and diagnostics
software. Sales of hardware and software products fluctuate based upon demand by
our customers which is difficult to predict.  Since our product
revenues include the sales of hardware products which typically have lower gross
margins than our other sources of revenue, product gross margins and overall
profitability are also difficult to predict.
 
 Contract
revenues are also unpredictable. Making accurate predictions of contract
revenues from new customers is difficult. The contract negotiation process can
be lengthy and the fiscal period in which a new agreement will be entered into,
if at all, and the financial terms of such an agreement are difficult to
predict.  Making accurate predictions of contract revenues from
existing customers is also difficult, because such revenues are affected by the
level of cooperation we receive from customers; the level of engineering
services desired by customers; and the potential of contract termination once a
project starts. In addition, customers may not pay us as anticipated under our
contracts.
 
 It is
also difficult for us to make accurate forecasts of royalty
revenues.  Royalties are typically recognized in the quarter when we
receive a report from a customer detailing sales and royalties due from the
prior quarter, such as from the shipment of licensed integrated circuits.
Royalties depend upon customer revenues which can be affected by factors beyond
our ability to control or assess in advance. These factors include our
customers’ ability to generate sales and fluctuating sales volumes and prices of
products containing our technology.
 
 Our
business is subject to a variety of additional risks, which could materially
adversely affect quarterly and annual operating results, including:
 
 ·
              market
      acceptance of broadband technologies we supply by semiconductor or
      equipment companies;
 ·
              the
      extent and timing of new transactions with
  customers;
 ·
              changes
      in our and our customers’ development schedules and levels of expenditure
      on research and development;
 ·
              the
      loss of a strategic relationship or termination of a project by a
      customer;
 ·
              equipment
      companies' acceptance of integrated circuits produced by our
      customers;
 ·
              the
      loss by a customer of a strategic relationship with an equipment company
      customer;
 ·
              announcements
      or introductions of new technologies or products by us or our
      competitors;
 ·
              delays
      or problems in the introduction or performance of enhancements or of
      future generations of our
technology;
 ·
              failures
      or problems in our hardware or software
  products;
 ·
              price
      pressure in the biometrics or test and diagnostics markets from our
      competitors;
 ·
              delays
      in the adoption of new industry standards or changes in market perception
      of the value of new or existing
standards;
 ·
              competitive
      pressures resulting in lower contract revenues or royalty
      rates;
 ·
              competitive
      pressures resulting in lower software or hardware product
      revenues;
 
 
 
 
 
 
 
 
 
  12
 ·
                personnel
      changes, particularly those involving engineering, technical, sales and
      marketing personnel;
 ·
                costs
      associated with protecting our intellectual
  property;
 ·
                the
      potential that customers could fail to make payments under their current
      contracts;
 ·
                ADSL
      or VDSL market-related issues, including lower ADSL or VDSL chipset unit
      demand brought on by excess channel inventory and lower average selling
      prices for ADSL or VDSL chipsets as a result of market
      surpluses;
 ·
                hardware
      manufacturing issues, including yield problems in our hardware platforms,
      and inventory buildup and
obsolescence;
 ·
                product
      gross margin may be affected by various factors including, but not limited
      to, product mix, product life cycle, and provision for excess and obsolete
      inventory;
 ·
                significant
      fluctuations in demand for our hardware
  products;
 ·
                new
      laws, changes to existing laws, or regulatory developments;
      and
 ·
                general
      economic trends and other factors.
 As a
result of these factors, we believe that period-to-period comparisons of our
revenue levels and operating results are not necessarily
meaningful.  You should not rely on our quarterly revenue and
operating results to predict our future performance.
 
 
 We
Experienced Net Losses
 
 We had a
net annual loss during 2001, 2002, 2003, 2004, and 2005.  We may
experience losses in the future if:
  ·
              the
      test and diagnostics, semiconductor, telecommunications or biometrics
      markets decline;
 ·
              new
      and/or existing customers do not choose to use our software or hardware
      products;
 ·
              new
      and/or existing customers do not choose to license and/or buy our patents;
      or
 ·
              new
      and/or existing customers do not choose to license our silicon IP for new
      chipset products or do not maintain or increase their revenues from sales
      of chipsets with our technology.
 
 
 Our
DSL Licensing and DSL Test and Diagnostic Businesses Depend Upon a Limited
Number of Customers, Therefore We Derive a Significant Amount of Revenue from a
Small Number of Customers
 
 There are
a relatively limited number of companies to which we can sell our DSL technology
and a limited number of OEM suppliers to which we can sell our DSL test and
diagnostic products in a manner consistent with our business model. If we fail
to maintain relationships with our current customers or fail to establish a
sufficient number of new customer relationships, our business could be seriously
harmed.  In the recent past, three of our DSL silicon IP customers
decided to exit the DSL chipset business, and therefore we do not expect to
generate additional revenue from these customers. In addition, our current and
prospective customers may use their superior size and bargaining power to demand
terms that are unfavorable to us.
  
 Due to
the limited number of customers to which we can license and/or sell our DSL
technology and patents and our DSL hardware and software products, we derive a
significant amount of revenue from a small number of customers. In 2008, we
derived approximately 28% and 12% of our total revenue from Daphimo and
Infineon, respectively.  In 2007, we derived approximately 19%, 16%,
and 10% of our total revenue from Infineon, Spirent, and Alcatel, respectively.
In 2006, we derived approximately 26% and 20% of our total revenue from Infineon
and ADI/Ikanos, respectively.  On February 17, 2006 ADI sold its ADSL
business relating to Aware technology to Ikanos and Ikanos replaced ADI as an
Aware customer.
 
 
 Our
Business is Subject to Rapid Technological Change
 
 The
semiconductor and telecommunications industries for high-speed network access
technologies are characterized by rapid technological change.  The
biometrics industry is also subject to rapid technological change and
uncertainty. In these industries, new generations of products are introduced
regularly and evolutionary improvements to existing products are
required.  Therefore, we face risks that others could introduce
competing technology that renders our DSL or biometrics technology and products
less desirable or obsolete.  Also, the announcement of new
technologies could cause our customers or their customers to delay or defer
entering into arrangements for the use of our existing
technology.  Either of these events could seriously harm our
business.
 
 13
  We expect
that our business will depend to a significant extent on our ability to
introduce new generations of communications and biometrics products as well as
new technologies and products that keep pace with changes in these industries.
We must continually devote significant engineering resources to achieving
technical innovations and product developments.  These developments
are complex and require long development cycles.  Moreover, we may
have to make substantial investments in technological innovations and product
developments before we can determine their commercial viability.  We
may lack sufficient financial resources to fund future
development.  Also, our customers may decide not to share certain
research and development costs with us.  Revenue from technological
innovations, even if successfully developed, may not be sufficient to recoup the
costs of development.
 
 One
element of our business strategy is to assume the risks of technology
development failure while reducing such risks for our customers.  In
the past, we have spent significant amounts on development projects that did not
produce any marketable technologies or products, and we cannot assure you that
it will not occur again.
 
 
 We
Face Intense Competition from a Wide Range of Competitors
 
 Our
ability to generate revenues from our DSL technology depends largely on the
willingness and ability of semiconductor manufacturers to design, build and sell
integrated circuits based on our intellectual property.  The DSL
semiconductor industry is intensely competitive and has been characterized by
price erosion, rapid technological change, short product life cycles, cyclical
market patterns and increasing foreign and domestic competition.
 
 As a
silicon intellectual property supplier to the semiconductor industry, we face
competition from internal development teams within potential semiconductor
customers.  We must convince potential customers to license or buy
from us rather than develop technology internally.  Furthermore, our
semiconductor customers may choose to abandon joint development projects with us
or develop chipsets themselves without using our technology.  In
addition to competition from internal development teams, we may compete against
other independent suppliers of intellectual property for DSL.  New
chipset suppliers have also demonstrated a reluctance to enter the DSL
market.
 
 The
market for DSL chipsets is intensely competitive.  Our success as a
silicon IP supplier requires that DSL equipment manufacturers buy chipsets from
our semiconductor customers, and that telephone companies buy DSL equipment from
those equipment manufacturers.  Our customers’ chipsets compete with
products from other vendors of standards-based DSL chipsets, including Broadcom,
Conexant, and TrendChip.
 
 The
markets for our DSL test and diagnostics hardware and software products are
competitive and uncertain.  We can give no assurance that phone
companies will purchase significant quantities of products to test and maintain
their DSL networks, or that if they do they will use our
products.  Our success as a supplier of hardware and software products
for DSL test and diagnostics depends in large part on the willingness and
ability of OEM customers to design, build and sell automated test heads,
hand-held testers, and DSLAMs that incorporate or work with our
products.  Our success also depends upon our ability to market and
sell to service providers.
  Our DSL
customers and their competitors have significantly greater financial,
technological, manufacturing, marketing and personnel resources than we
do.   We can give no assurance that our OEM customers will
continue to purchase products from us or that we will be able to compete
effectively or that competitive pressures will not seriously harm our
business.
 
 Our DSL
licensing and DSL test and diagnostic revenues are dependent upon the success of
ADSL and VDSL services. ADSL and VDSL services offered over copper telephone
networks also compete with alternative broadband transmission technologies that
use other network architectures.  Alternative technologies that use
other network architectures to provide high-speed data service include cable
modems using cable networks, wireless solutions using wireless networks, and
optics technology using fiber optic networks. These alternative broadband
transmission technologies may be more successful than ADSL or VDSL and we may
not be able to participate in the markets involving these alternative
technologies.
 
 The
markets for our biometrics products and services as well as our medical and
digital imaging software products are competitive and uncertain. Many of our
biometric software competitors have significantly greater financial,
technological, marketing and personnel resources than we do. Also, we face
intense competition from internal development teams within potential
customers.  We must convince potential customers to purchase products
and services from us rather than develop software or perform services
internally.  Furthermore, customers, who have already purchased from
us, may choose to stop purchasing our software and develop their own
software.
 
 14
  We may be
unable to compete successfully in our DSL licensing, DSL test and diagnostics,
and biometrics and imaging businesses, and our competitive position may be
adversely affected in the future by one or more of the factors described in this
section.
 
 
 Our
Intellectual Property is Subject to Limited Protection
 
 Because
we are a technology provider, our ability to protect our intellectual property
and to operate without infringing the intellectual property rights of others is
critical to our success.  We regard our technology as proprietary. Our
patent portfolio includes approximately 42 U.S. patents and 95 foreign patents
as well as a number of pending patent applications.  We also rely on a
combination of trade secrets, copyright and trademark law and non-disclosure
agreements to protect our unpatented intellectual property.  Despite
these precautions, it may be possible for a third party to copy or otherwise
obtain and use our technology without authorization.
 
 As part
of our silicon IP agreements, we typically work closely with our customers, who
may also be potential competitors, and provide them with proprietary know-how
necessary for their development of customized chipsets based on our DSL
technology.  Although our agreements contain non-disclosure provisions
and other terms protecting our proprietary know-how and technology rights, it is
possible that, despite these precautions, some of our customers might obtain
from us proprietary information that they could use to compete with us in the
marketplace.  Although we intend to defend our intellectual property
as necessary, the steps we have taken may be inadequate to prevent
misappropriation.
 
 In the
future, we may be involved in legal action to enforce our intellectual property
rights relating to our patents, copyrights or trade secrets.  Any such
litigation could be costly and time-consuming for us, even if we were to
prevail.  Moreover, even if we are successful in protecting our
proprietary information, our competitors may independently develop technologies
substantially equivalent or superior to our technology.  The
misappropriation of our technology or the development of competitive technology
could seriously harm our business.
 
 Our
technology, software or hardware may infringe the intellectual property rights
of others.  A large and increasing number of participants in the
telecommunications and compression industries have applied for or obtained
patents.  Some of these patent holders have demonstrated a readiness
to commence litigation based on allegations of patent and other intellectual
property infringement.  Third parties may assert patent, copyright and
other intellectual property rights to technologies that are important to our
business.  In the past, we have received claims from other companies
that our technology infringes their patent rights.  Intellectual
property rights can be uncertain and can involve complex legal and factual
questions.  We may infringe the proprietary rights of others, which
could result in significant liability for us.  If we were found to
have infringed any third party’s patents, we could be subject to substantial
damages or an injunction preventing us from conducting our
business.
 
 
 Our
Ability to Obtain or Enforce Patents Could be Affected by New Laws, Regulations
or Rules
 
 We have
an active program to protect our proprietary technology through the filing of
patents. We have also pursued the license and/or sale of patents, as part of our
silicon IP offerings as well as independently. New laws, regulations or rules
implemented either by Congress, the United States Patent and Trademark Office,
foreign patent offices, or the courts that impact the patent application
process, the patent enforcement process or the rights of patent holders could
significantly increase our expenses related to patent prosecution or decrease
revenues associated with our patents.  While we are not aware that any such
changes are likely to occur in the foreseeable future, we cannot assure you that
such changes will not occur.
 
 
 Our
DSL Silicon Intellectual Property Business Model Has Unique
Challenges
 
 Our
success as a licensor of DSL silicon IP depends upon our ability to license our
technology to semiconductor or equipment companies, and our customers’
willingness and ability to sell products that incorporate our
technology.
 
 15
  We face
numerous risks in successfully obtaining suitable customers on terms consistent
with our business model, including, among others:
 
 ·
              we
      must typically undergo a lengthy and expensive process of building a
      relationship with a potential customer before there is any assurance of an
      agreement with such party, and in some instances we must convince a
      potential customer to enter the DSL
market.
 ·
              we
      must persuade semiconductor and equipment manufacturers with significant
      resources to rely on us for critical technology on an ongoing basis rather
      than trying to develop similar technology
  internally;
 ·
              we
      must persuade potential customers to bear development costs associated
      with our technology applications and to make the necessary investment to
      successfully manufacture chipsets and products using our technology;
      and
 ·
              we
      must successfully transfer technical know-how to
  customers.
 
 Moreover,
the success of our business model also depends on the receipt of royalties from
customers. Royalties from our customers are often based on the selling prices of
their chipsets and products, over which we have little or no
control.  We also have little or no control over our customers’
promotional and marketing efforts.  They are not prohibited from
competing against us.
 
 Our
success depends upon our ability to obtain suitable customers, and is threatened
if our current customers cancel or put DSL programs utilizing our technology on
hold, or if our customers do not successfully market and sell chipsets or
products incorporating our technology.
 
 
 There
Has Been and May Continue to be a Cyclical Demand for DSL Chipsets, and There is
Intense Competition for DSL Chipsets, Which Has Caused Our Royalty Revenue to
Decline
 
 The
royalties we receive are influenced by many of the risks faced by the DSL market
in general, including cyclical demand which may result in reduced average
selling prices (“ASPs”) for DSL chipsets during periods of surplus.  In the
past, the DSL industry has experienced an oversupply of DSL chipsets, central
office equipment or customer premises equipment.  Excessive inventory
levels led to soft chipset demand, which in turn led to declining ASPs. 
ASPs have also been under pressure because of intense competition in the DSL
chipset marketplace. As a result of the soft demand and declining ASPs for ADSL
chipsets, our royalty revenue has decreased substantially. Price decreases for
ADSL or VDSL chipsets, and the corresponding decreases in per unit royalties
received by us, can be sudden and dramatic.  Pricing pressures may continue
during 2009 and beyond.  Our royalty revenue may decline over the long
term.
 
 
 The
Success of Our DSL Licensing Business Requires Acceptance of Our Technology by
Equipment Companies
 
 The
success of our DSL licensing business is dependent on our ability to generate
meaningful royalties from our licensing arrangements with customers. Our ability
to generate such royalties is materially affected by the willingness of
equipment companies to purchase integrated circuits that incorporate our
technology.  There are other competitive solutions available for
equipment companies seeking to offer broadband communications
products.  We face the risk that equipment manufacturers will choose
those alternative solutions. Generally, our ability to influence equipment
companies’ decisions whether to purchase integrated circuits that incorporate
our technology is limited.
 
 We also
face the risk that equipment companies that elect to use integrated circuits
that incorporate our technology into their products will not compete
successfully against other equipment companies.  Many factors beyond
our control could influence the success or failure of a particular equipment
company that uses integrated circuits based on our technology. Even if equipment
companies incorporate chipsets based on our intellectual property into their
products, their products may not achieve commercial acceptance or result in
meaningful royalties to us.
 
 
 The
Success of Our DSL Licensing and Test and Diagnostics Products Businesses
Requires Telephone Companies to Install DSL Service in Volume
 
 The
success of our DSL licensing and test and diagnostics products businesses
depends upon telephone companies installing DSL service in significant
volumes.  If telephone companies do not install DSL service in
significant volumes, or if telephone companies install broadband service based
on other technologies such as cable or fiber-to-the-home, our business will be
seriously harmed.
 
 16
  Moreover,
our DSL licensing and test and diagnostics products businesses depend on capital
equipment spending by telephone companies.  If telephone companies
reduce their budgets for or decide not to install or utilize equipment dedicated
to DSL service or test infrastructure, our business will be severely
harmed.
 
 
 The
Success of Our DSL Test and Diagnostic Products Depends On a Number of
Factors
 
 Our
success in developing, introducing, selling, and supporting new and enhanced
test and diagnostic products depends upon a variety of factors, including timely
and efficient completion of hardware and software design and development,
implementation of manufacturing processes, and effective sales, marketing, and
customer service.  Because of the complexity of our test and
diagnostic products, significant delays may occur between a hardware product's
initial introduction and commencement of volume production. If we are
unsuccessful in developing, introducing, selling and supporting new and enhanced
test and diagnostic products, our DSL test and diagnostic business could be
seriously harmed.
 
 
 If
Our Test and Diagnostic Hardware and Software Products Have Quality Problems,
Our Business Could Be Harmed
 
 If our
test and diagnostic products have actual or perceived reliability, quality,
functionality or other problems, we may suffer reduced orders, higher
manufacturing costs, inability to recognize revenue, delays in collecting
accounts receivable and higher service, support and warranty expenses or
inventory write-offs, among other effects. We believe that the acceptance,
volume production, timely delivery and customer satisfaction of our test and
diagnostic products is important to our future financial results. As a result,
any inability to correct any technical, reliability, parts shortages or other
difficulties or to manufacture and ship our test and diagnostic products on a
timely basis meeting customer requirements could damage our relationships and
reputation with current and prospective customers, which would harm our revenues
and operating results.  Any product problems that may require repair
or replacement may adversely affect our customer and/or vendor relationships and
have an impact on support costs, warranty reserves, or inventory reserves, among
other effects.
 
 17
 
 We
are Dependent On a Single Source Contract Manufacturer for the Manufacture of
Our DSL Hardware Products, the Loss of Which Would Harm Our
Business
 
 We
currently depend on one contract manufacturer to manufacture our DSL hardware
products. If this company was to terminate its arrangement with us or fail to
provide the required capacity and quality on a timely basis, we would be unable
to manufacture our products until replacement contract manufacturing services
could be obtained. To qualify a new contract manufacturer, familiarize it with
our products, quality standards and other requirements, and commence production
is a costly and time-consuming process. We cannot assure you that we would be
able to establish alternative manufacturing relationships on acceptable
terms.  Although we make reasonable efforts to ensure that our
contract manufacturer performs to our standards, our reliance on a single source
limits our control over quality assurance and delivery schedules. Defects in
workmanship, unacceptable yields, and manufacturing disruptions and difficulties
may impair our ability to manage inventory and cause delays in shipments and
cancellation of orders that may adversely affect our relationships with current
and prospective customers.  As a result, our revenues and operating results
may be harmed.
 
 
 Our
Manufacturing Systems May Not Be Adequate For Our DSL Test and Diagnostics
Hardware Product Offerings
 
 Our
current manufacturing systems adequately address hardware products we are
currently manufacturing in limited volumes.  Our manufacturing systems have
not been extensively tested under anticipated, more complex hardware products or
in volumes higher than that of our current hardware products.  If our
manufacturing systems are inadequate or have other problems, our revenues and
operating results may be harmed.
 
 
 We
are Dependent on Single Source Suppliers for Components in Our DSL Hardware
Products
 
 We rely
on single source suppliers for components and materials used in our DSL hardware
products. Our dependence on single source suppliers involves several risks,
including limited control over pricing, availability, quality and delivery
schedules. Any delays in delivery of such components or shortages of such
components could cause delays in the shipment of our products, which could
significantly harm our business. Because of our reliance on these vendors, we
may also be subject to increases in component costs. These increases could
significantly harm our business. If any one or more of our single source
suppliers cease to provide us with sufficient quantities of our components in a
timely manner or on terms acceptable to us, we would have to seek alternative
sources of supply. We could incur delays while we locate and engage alternative
qualified suppliers and we might be unable to engage alternative suppliers on
favorable terms. We could incur substantial hardware and software redesign costs
if we are required to replace the components.  Any such disruption or
increased expenses could harm our commercialization efforts and adversely affect
our ability to generate revenues.
 
 
 Biometrics
Software Business Risks
 
 Our
biometrics software business is subject to a variety of additional risks, which
could materially adversely affect quarterly and annual revenue and operating
results, including:
 
 —
              market
      acceptance of our biometric technologies and
  products;
 —
              changes
      in contracting practices of government or law enforcement
      agencies;
 —
              the
      failure of the biometrics market to experience continued
      growth;
 —
              announcements
      or introductions of new technologies or products by our
      competitors;
 —
              delays
      or problems in the introduction or performance of enhancements or of
      future generations of our
technology;
 —
              failures
      or problems in our biometric software
products;
 —
              the
      risk that current or potential customers might decide to develop their own
      software rather than buy it from
us;
 —
              delays
      in the adoption of new industry biometric standards or changes in market
      perception of the value of new or existing
  standards;
 —
              growth
      of proprietary biometric systems which do not conform to industry
      standards;
 —
              competitive
      pressures resulting in lower software product
  revenues;
 —
              personnel
      changes, particularly those involving engineering, technical and sales and
      marketing personnel;
 —
              costs
      associated with protecting our intellectual
  property;
 —
              litigation
      by third parties for alleged infringement of their proprietary
      rights;
 —
              the
      potential that customers could fail to make payments under their current
      contracts;
 —
              new
      laws, changes to existing laws, or regulatory developments;
      and
 —
              general
      economic trends and other factors.
 
  Biometrics
Services Business Risks
 
 We began
to perform engineering services under biometric technology contracts in the
fourth quarter of 2007.  Over the last several quarters, our
biometrics services business has contributed a more meaningful portion of
contract revenue. This business is subject to additional risks, which could
materially adversely affect quarterly and annual revenue and operating results,
including:
 
 —
              our
      ability to structure and price technology contracts in a manner that is
      consistent with our business model;
 —
              our
      ability to deliver contract milestones: i) in a timely and cost efficient
      manner, and ii) in a form and condition acceptable to
      customers;
 —
              the
      risk that customers could terminate
projects;
 —
              the
      risk that we rely substantially on third party contractors and consultants
      to deliver certain contract milestones;
and
 —
              the
      potential that customers could fail to make payments under their
      contracts.
  18
 
 Current
economic conditions, including the credit crisis affecting the financial markets
and the possibility of a global recession, could adversely affect our business,
results of operations and financial condition.
  The
world’s financial markets are currently experiencing turmoil, characterized by
reductions in available credit, increased costs of credit, volatility in
security prices, rating downgrades of investments and reduced valuations of
securities generally.  These events have materially and adversely impacted
the availability of financing to a wide variety of businesses, and the resulting
uncertainty has led to reductions in capital investments, overall spending
levels, future product plans, and sales projections across industries and
markets.  These trends could have a material adverse impact on our
business, our ability to achieve targeted results of operations and our
financial condition as a result of:
 
 ·
              reduced
      demand for our products or our customers’ products that incorporate our
      technology;
 ·
              increased
      risk of order cancellations or
delays;
 ·
              increased
      risk that customers may delay or terminate
  projects;
 ·
              increased
      pressure on the prices for our products or our customers’ products that
      incorporate our technology;
 ·
              greater
      difficulty in collecting accounts receivable;
  and
 ·
              risks
      to our liquidity, including the possibility that we might not have access
      to our cash when needed.
  We are
unable to predict the likely duration and severity of the current disruption in
financial markets and adverse economic conditions in the U.S. and other
countries, but the longer the duration the greater the risks we face in
operating our business.
 
 
 We
Must Make Judgments in the Process of Preparing Our Financial
Statements
 
 We
prepare our financial statements in accordance with generally accepted
accounting principles and certain critical accounting polices that are relevant
to our business.  The application of these principles and policies
requires us to make significant judgments and estimates.  In the event
that judgments and estimates we make are incorrect, we may have to change them,
which could materially affect our financial position and results of
operations.
  
 Moreover,
accounting standards have been subject to rapid change and evolving
interpretations by accounting standards setting organizations over the past few
years.  The implementation of new standards requires us to interpret
and apply them appropriately.  If our current interpretations or
applications are later found to be incorrect, our financial position and results
of operations could be materially affected.
 
 
 If
We are Unable to Maintain Effective Internal Controls Over Financial Reporting,
Investors Could Lose Confidence In The Reliability of Our Financial Statements,
Which Could Result In a Decline in the Price of Our Common Stock
 
 As a
public company, we are required to enhance and test our financial, internal and
management control systems to meet obligations imposed by the Sarbanes-Oxley Act
of 2002. Consistent with the Sarbanes-Oxley Act and the rules and regulations of
the SEC, management's assessment of our internal controls over financial
reporting and the audit opinion of our independent registered accounting firm as
to the effectiveness of our controls is required in connection with our filing
of our Annual Report on Form 10-K. If we are unable to timely identify,
implement and conclude that we have effective internal controls over financial
reporting or if our independent auditors are unable to conclude that our
internal controls over financial reporting are effective, investors could lose
confidence in the reliability of our financial statements, which could result in
a decrease in the value of our common stock. Our assessment of our internal
controls over financial reporting may also uncover weaknesses or other issues
with these controls that could also result in adverse investor
reaction.
  
 Our
Stock Price May Be Extremely Volatile
 
 Volatility
in our stock price may negatively affect the price you may receive for your
shares of common stock and increases the risk that we could be the subject of
costly securities litigation.  The market price of our common stock
has fluctuated substantially and could continue to fluctuate based on a variety
of factors, including:
 
 ·
              quarterly
      fluctuations in our operating
results;
 ·
              changes
      in future financial guidance that we may provide to investors and public
      market analysts;
 ·
              changes
      in our relationships with our
customers;
 ·
              announcements
      of technological innovations or new products by us, our customers or our
      competitors;
 
 
 
 
 
 
  19
 ·
                changes
      in DSL or biometrics market growth rates as well as investor perceptions
      regarding the investment opportunity that companies participating in the
      DSL or biometrics industry afford
them;
 ·
                changes
      in earnings estimates by public market
analysts;
 ·
                key
      personnel losses;
 ·
                sales
      of our common stock;
 ·
                our
      stock repurchase activities; and
 ·
                developments
      or announcements with respect to industry standards, patents or
      proprietary rights.
 In
addition, the equity markets have experienced volatility that has particularly
affected the market prices of equity securities of many high technology
companies and that often has been unrelated or disproportionate to the operating
performance of such companies. These broad market fluctuations may adversely
affect the market price of our common stock.
 
 
 Our
Business May Be Affected by Government Regulations
 
 The
extensive regulation of the telecommunications industry by federal, state and
foreign regulatory agencies, including the Federal Communications Commission,
and various state public utility and service commissions, could affect us
through the effects of such regulation on our customers and their
customers.  In addition, our business may also be affected by the
imposition of certain tariffs, duties and other import restrictions on
components that our customers obtain from non-domestic suppliers or by the
imposition of export restrictions on products sold internationally and
incorporating our technology.  Changes in current or future laws or
regulations, in the United States or elsewhere, could seriously harm our
business.
 
 
 ITEM 1B. UNRESOLVED STAFF
COMMENTS
 
 Not
applicable.
 
 20
  ITEM
2.   PROPERTIES
 
 We
believe that our existing facilities are adequate for our current needs and that
additional space sufficient to meet our needs for the foreseeable future will be
available on reasonable terms.  We currently occupy
approximately:
 
 1.
              72,000
      square feet of office space in Bedford, Massachusetts, which serves as our
      headquarters.  This site is used for our research and
      development, sales and marketing, and administrative
      activities.  We own this
facility.
 
 2.
              411
      square feet of research and development space in Orinda,
      California.  This facility is currently leased for a 3-year
      term, which expires on August 31,
2010.
 
 
 ITEM
3.   LEGAL PROCEEDINGS
 
 From time
to time we are involved in litigation incidental to the conduct of our
business.  We are not party to any lawsuit or proceeding that, in our
opinion, is likely to seriously harm our business.
 
 
 ITEM
4.   SUBMISSION OF MATTERS TO A VOTE OF SECURITY
HOLDERS
 
 There
were no matters submitted to a vote of security holders during the fourth
quarter ended December 31, 2008.
 
 21
  PART
II
 
 
 ITEM
5.  MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS
AND ISSUER PURCHASES OF EQUITY SECURITIES
 
 
 Our
common stock is the only class of stock we have outstanding, and it trades on
the Nasdaq Global Market under the symbol AWRE.  The following table
sets forth the high and the low sales prices of our common stock as reported on
the Nasdaq Global Market for the periods indicated from January 1, 2007 to
December 31, 2008.
 
 
 First
                    Second
                    Third
                    FourthQuarter
                    Quarter
                    Quarter
                    Quarter2008High
                    $4.30
                    $3.96
                    $3.39
                    $2.96Low
                    3.65
                    2.85
                    2.43
                    1.582007High
                    $6.25
                    $6.50
                    $6.74
                    $5.48Low
                    4.95
                    4.98
                    3.67
                    4.01
 
 
 As of
February 9, 2009, we had approximately 130 shareholders of
record.  This number does not include shareholders from whom shares
were held in a “nominee” or “street” name.  We have never paid cash
dividends on our common stock and we anticipate that we will continue to
reinvest any earnings to finance future operations.
 
 We did
not sell any equity securities that were not registered under the Securities Act
of 1933 during the three months ended December 31, 2008.
  22
  Performance
Graph
 
 The
following performance graph compares the performance of Aware’s cumulative
stockholder return with that of a broad market index, the Nasdaq Composite
Index, and a published industry index, the RDG Technology Composite
Index.  The cumulative stockholder returns for shares of Aware’s
common stock and for the market and industry indices are calculated assuming
$100 was invested on December 31, 2003.  Aware paid no cash dividends
during the periods shown.  The performance of the market and industry
indices is shown on a total return, or dividends reinvested, basis.
 
 
   Value of Investment
      ($)12/31/03
                  
                  
                  12/31/04
                  
                  
                  12/31/05
                  
                  
                  12/31/06
                  
                  
                  12/31/07
                  
                  
                  12/31/08Aware,
      Inc.
                  
                  $
                  100.00
                  
                  
                  $
                  166.90
                  
                  
                  $
                  153.13
                  
                  
                  $
                  183.41
                  
                  
                  $
                  144.53
                  
                  
                  $
                  64.35Nasdaq Composite
      Index
                  
                  
                  100.00
                  
                  
                  
                  110.08
                  
                  
                  
                  112.88
                  
                  
                  
                  126.51
                  
                  
                  
                  138.13
                  
                  
                  
                  80.47RDG Technology
      Composite
                  
                  
                  100.00
                  
                  
                  
                  104.00
                  
                  
                  
                  106.32
                  
                  
                  
                  115.97
                  
                  
                  
                  132.44
                  
                  
                  
                  75.00
  23
  Issuer Purchases of Equity
Securities
 
 Period
                        
                        (a)
                          Total Number
of
                          Shares
      Purchased
                        
                        (b)
                          Average Price
                          Paid per
    Share
                        
                        (c)
                          Total Number of Shares Purchased
      as Part of Publicly Announced Plans or Programs(1)
                        
                        (d)
                          Maximum Number(or Approximate Dollar Value) of
      Shares that May Yet Be Purchased
                          Under the
Plans
                          or ProgramsOctober 1, 2008 to October 31,
      2008
                        
                        10,100
                        
                        
                        $2.46
                        
                        702,331
                        
                        $7,646,321November 1, 2008 to November 30,
      2008
                        
                        18,800
                        
                        
                        $2.26
                        
                        721,131
                        
                        $7,603,874December 1, 2008 to December 31,
      2008
                        
                        -
                        
                        
                        -
                        
                        721,131
                        
                        $7,603,874
 
 
 (1)
              On
      August 28, 2007, we issued a press release announcing that our board of
      directors had approved the repurchase from time to time through December
      31, 2008 of up to $5,000,000 of our common stock. On October 29, 2008, we
      announced that our board of directors had approved an amendment to the
      program that increased the total amount of common stock that may be
      repurchased from $5,000,000 to $10,000,000.  The amendment also
      extended the period of time that shares may be repurchased from December
      31, 2008 to December 31, 2009.
  During
      2007and 2008, we purchased9,107 and 712,024shares, respectively,at a total cost of $38,716 and
      $2,357,410, respectively,under this
      plan.
 
 24
  ITEM
6.  SELECTED FINANCIAL DATA
 
 
 In the
table below, we provide you with our selected consolidated financial
data.  We have prepared this information using our audited
consolidated financial statements for the years ended December 31, 2008, 2007,
2006, 2005, and 2004. When you read this selected financial data, it is
important that you read it along with Management’s Discussion and Analysis of
Financial Condition and Results of Operations, our historical consolidated
financial statements, and the related notes to the financial statements, which
can be found in Item 8.
 
 
 Year
      ended December 31,
                
                2008
                
                
                2007
                
                
                2006
                
                
                2005
                
                
                2004(in
      thousands, except per share data)Statements of Operations
    DataRevenue
                
                $
                30,517
                
                
                $
                26,437
                
                
                $
                24,056
                
                
                $
                15,667
                
                
                $
                16,485Income
      (loss) from operations
                
                
                629
                
                
                
                (1,830
                )
                
                
                (399
                )
                
                
                (
      3,618
                )
                
                
                (1,925
                )Net
      income (loss)
                
                
                1,776
                
                
                
                160
                
                
                
                1,034
                
                
                
                (2,468
                )
                
                
                (1,367
                )Net
      income (loss) per share – basic
                
                $
                0.08
                
                
                $
                0.01
                
                
                $
                0.04
                
                
                $
                (0.11
                )
                
                $
                (0.06
                )Net
      income (loss) per share – diluted
                
                $
                0.07
                
                
                $
                0.01
                
                
                $
                0.04
                
                
                $
                (0.11
                )
                
                $
                (0.06
                )Balance Sheet DataCash
      and short-term investments
                
                $
                45,516
                
                
                $
                38,055
                
                
                $
                37,834
                
                
                $
                36,763
                
                
                $
                34,965Working
      capital
                
                
                47,288
                
                
                
                45,031
                
                
                
                41,372
                
                
                
                39,124
                
                
                
                37,168Total
      assets
                
                
                57,546
                
                
                
                56,383
                
                
                
                54,586
                
                
                
                49,741
                
                
                
                50,183Total
      liabilities
                
                
                3,023
                
                
                
                3,147
                
                
                
                3,216
                
                
                
                2,238
                
                
                
                1,427Total
      stockholders’ equity
                
                
                54,523
                
                
                
                53,236
                
                
                
                51,370
                
                
                
                47,503
                
                
                
                48,756
  25
  ITEM
7.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
 
 
 RESULTS
OF OPERATIONS
 
 The
following table sets forth, for the years indicated, certain line items from our
consolidated statements of operations stated as a percentage of total
revenue:
 
 Year
      ended December 31,Revenue:
                                                                      
                                                                      2008
                                                                      
                                                                      
                                                                      2007
                                                                      
                                                                      
                                                                      2006Product
      sales
                                                                      
                                                                      
                                                                      46
                                                                      %
                                                                      
                                                                      
                                                                      66
                                                                      %
                                                                      
                                                                      
                                                                      32
                                                                      %Contract
      revenue
                                                                      
                                                                      
                                                                      48
                                                                      
                                                                      
                                                                      
                                                                      24
                                                                      
                                                                      
                                                                      
                                                                      52Royalties
                                                                      
                                                                      
                                                                      6
                                                                      
                                                                      
                                                                      
                                                                      10
                                                                      
                                                                      
                                                                      
                                                                      16Total
      revenue
                                                                      
                                                                      
                                                                      100
                                                                      
                                                                      
                                                                      
                                                                      100
                                                                      
                                                                      
                                                                      
                                                                      100Costs
      and expenses:Cost
      of product
      sales
                                                                      
                                                                      
                                                                      8
                                                                      
                                                                      
                                                                      
                                                                      15
                                                                      
                                                                      
                                                                      
                                                                      4Cost
      of contract
      revenue
                                                                      
                                                                      
                                                                      14
                                                                      
                                                                      
                                                                      
                                                                      21
                                                                      
                                                                      
                                                                      
                                                                      22Research
      and
      development
                                                                      
                                                                      
                                                                      43
                                                                      
                                                                      
                                                                      
                                                                      41
                                                                      
                                                                      
                                                                      
                                                                      44Selling
      and
      marketing
                                                                      
                                                                      
                                                                      16
                                                                      
                                                                      
                                                                      
                                                                      14
                                                                      
                                                                      
                                                                      
                                                                      14General
      and
      administrative
                                                                      
                                                                      
                                                                      17
                                                                      
                                                                      
                                                                      
                                                                      16
                                                                      
                                                                      
                                                                      
                                                                      18Total
      costs and
      expenses
                                                                      
                                                                      
                                                                      98
                                                                      
                                                                      
                                                                      
                                                                      107
                                                                      
                                                                      
                                                                      
                                                                      102Income
      (loss) from
      operations
                                                                      
                                                                      
                                                                      2
                                                                      
                                                                      
                                                                      
                                                                      (7
                                                                      )
                                                                      
                                                                      
                                                                      (2
                                                                      )Interest
      income
                                                                      
                                                                      
                                                                      4
                                                                      
                                                                      
                                                                      
                                                                      8
                                                                      
                                                                      
                                                                      
                                                                      8Income
      before provision for income taxes
                                                                      
                                                                      
                                                                      6
                                                                      
                                                                      
                                                                      
                                                                      1
                                                                      
                                                                      
                                                                      
                                                                      6Provision
      for income
      taxes
                                                                      
                                                                      
                                                                      -
                                                                      
                                                                      
                                                                      
                                                                      -
                                                                      
                                                                      
                                                                      
                                                                      2Net
      income
                                                                      
                                                                      
                                                                      6
                                                                      %
                                                                      
                                                                      
                                                                      1
                                                                      %
                                                                      
                                                                      
                                                                      4
                                                                      %
 
 
 Product
Sales
 
 Product
sales consist primarily of revenue from the sale of hardware and software
products.  Hardware products consist of DSL test and diagnostics
hardware, including systems, modules, and modems. Software products consist of
software products for biometric, medical imaging and digital imaging
applications, as well as DSL test and diagnostics software.
 
 Product
sales decreased 20% from $17.5 million in 2007 to $14.0 million in
2008.  As a percentage of total revenue, product sales decreased from
66% in 2007 to 46% in 2008. The dollar decrease in product sales was primarily
due to a $5.4 million decrease in revenue from the sale of test and diagnostic
hardware and software, which was partially offset by a $1.9 million increase in
revenue from the sale of biometric software.  The decrease in revenue
from the sale of test and diagnostic products was mainly attributable to: 1)
significant sales to three OEM customers in 2007 that did not reoccur at those
volumes in 2008; and 2) a challenging telecommunications test equipment
environment.
  Product
sales increased 130% from $7.6 million in 2006 to $17.5 million in
2007.  As a percentage of total revenue, product sales increased from
32% in 2006 to 66% in 2007.  The dollar increase was primarily due to
a $4.9 million increase in revenue from the sale of software products and a $5.0
million increase from the sale of DSL test and diagnostics hardware
products.
 
 
 Contract
Revenue
 
 Contract
revenueconsists
of patent, license and engineering service fees that we receive under agreements
relating to the sale or license of Aware’s patents, DSL technology, DSL test and
diagnostic technology, and biometrics technology.
 
 26
  Contract
revenue increased 131% from $6.3 million in 2007 to $14.7 million in
2008.  As a percentage of total revenue, contract revenue increased
from 24% in 2007 to 48% in 2008.  The dollar increase was primarily
due to an $8.5 million sale of patents relating to communications technology in
2008, whereas there were no patent sales in 2007. We intend to continue to sell
and/or license additional patents in the future, subject to customer demand and
favorable terms and conditions. Also in 2008, contract revenue increased by $2.8
million for revenue from biometrics professional services contracts as a result
of our expansion into the biometrics services business. Contract revenue
increases from patent sales and biometrics professional services contracts were
partially offset by a $2.7 million decrease in revenue from DSL silicon IP
contracts with our semiconductor customers. The reasons for the DSL contract
revenue decline are discussed in the last paragraph of this
section.
 
 Contract
revenue decreased 50% from $12.6 million in 2006 to $6.3 million in
2007.  As a percentage of total revenue, contract revenue decreased
from 52% in 2006 to 24% in 2007.  The dollar decrease in 2007 was due
to $2.5 million that was recognized in 2006 from the transfer of certain
technology licenses as a result of the acquisition of a customer’s business that
did not reoccur in 2007; $2.0 million that was recognized in 2006 from a patent
licensing agreement with a new customer that did not reoccur in 2007; and a $1.8
decrease in revenue from DSL silicon IP contracts with semiconductor
customers.
 
 The
environment for licensing DSL technology over the last few years has been
characterized by uncertainty in the semiconductor and telecommunications
industries generally, and intense competition and falling prices for DSL
chipsets specifically. During the last several years, we have seen customers and
potential customers cautiously evaluate new chipset projects or delay or cancel
projects in the face of such conditions. Moreover, in the recent past, three of
our licensees decided to exit the DSL chipset business altogether.  As
a result of these conditions and customer actions, we expect that our ability to
grow or maintain revenue from these activities in the future will be
challenging.
 
 
 Royalties
 
 Royalties
consist of royalty payments that we receive under agreements with our
customers.  We receive royalties from customers for rights to Aware
technology and/or patents, typically associated with the incorporation of Aware
technology and/or patents in customer chipsets or solutions.
 
 Royalties
decreased 30% from $2.6 million in 2007 to $1.8 million in 2008.  As a
percentage of total revenue, royalties decreased from 10% in 2007 to 6% in
2008.  The dollar decrease in royalties was due to a $0.7 million
decrease in DSL royalties, and a $0.1 million decrease in biometrics and medical
imaging royalties.
 
 Royalties
decreased 33% from $3.9 million in 2006 to $2.6 million in 2007.  As a
percentage of total revenue, royalties decreased from 16% in 2006 to 10% in
2007.  The dollar decrease in royalties was due to a $1.1 million
decrease in DSL royalties, and a $0.2 million decrease in biometrics and medical
imaging royalties.
 
 Our
royalty revenue comes predominantly from ADSL chipset sales by Ikanos and ADSL
and VDSL chipset sales by Infineon.  Despite steady growth of
worldwide DSL subscribers over the last several years, the availability of DSL
chipsets from a number of suppliers has caused intense competition among those
suppliers.  We are uncertain as to whether our licensees will be able
to maintain their market shares and chipset prices in the face of such
competition, and whether our relationships with them will contribute meaningful
royalties to us in the future.
  
 
 Cost
of Product Sales
 
 Since the
cost of software product sales is minimal, cost of product sales consists
primarily of the cost of hardware product sales.
 
 Cost of
product sales decreased 35% from $4.0 million in 2007 to $2.6 million in
2008.  As a percentage of product sales, cost of product sales
decreased from 23% in 2007 to 18% in 2008, which resulted in gross margins on
product sales increasing from 77% to 82%. The dollar decrease in cost of product
sales in 2008 was attributable to a $2.8 million decrease in hardware product
sales.  The increase in gross margins on product sales was primarily
due to a greater proportion of software sales in the product sales
mix.
 
 27
 Cost of
product sales increased 336% from $0.9 million in 2006 to $4.0 million in
2007.  As a percentage of product sales, cost of product sales
increased from 12% in 2006 to 23% in 2007.  The dollar increase in
cost of product sales in 2007 was attributable to an increase in hardware
product sales.  The decrease in overall product margins from 88% in
2006 to 77% in 2007 was principally due to a greater percentage of hardware
sales in the sales mix in 2007, which was partially offset by improved margins
on hardware products.
 
 
 Cost
of Contract Revenue
 
 Cost of
contract revenue consists primarily of compensation costs for engineers and
expenses for consultants, technology licensing fees, recruiting, supplies,
equipment, depreciation and facilities associated with customer development
projects.  Our total engineering costs are allocated between cost of
contract revenue and research and development expense.  In a given
period, the allocation of engineering costs between cost of contract revenue and
research and development is a function of the level of effort expended on each.
Commencing in the fourth quarter of 2007, cost of contract revenue also includes
direct expenses for third party contractors and consultants for biometrics
professional services contracts.
 
 Cost of
contract revenue decreased 23% from $5.4 million in 2007 to $4.2 million in
2008.  As a percentage of contract revenue, cost of contract revenue
decreased from 86% in 2007 to 29% in 2008, which resulted in gross margins on
contract revenue increasing from 14% to 71%. The $1.2 million decrease in cost
of contract revenue was primarily due to lower DSL contract
revenue.  Lower cost of contract revenue from DSL contracts was
partially offset by increased cost of contract revenue from biometrics
professional services contracts, which was due to increased revenue from such
contracts.  The significant increase in gross margins on contract
revenue was due to: 1) an $8.5 million patent sale which has no cost of contract
revenue associated with it; and 2) an increase in contract revenue from
biometrics contracts, which have higher margins than DSL contracts.
 
 Cost of
contract revenue increased 5% from $5.2 million in 2006 to $5.4 million in
2007.  As a percentage of contract revenue, cost of contract revenue
increased from 41% in 2006 to 86% in 2007.  The $0.2 million dollar
increase was primarily due to higher compensation and fringe benefit expenses,
which were partially offset by lower stock-based compensation expense. The
decrease in contract revenue margins from 59% in 2006 to 14% in 2007 was
principally due to the proportions of license fees and engineering services fees
in the contract revenue sales mix. Cost of contract revenue is primarily driven
by the level of engineering services delivered to meet engineering milestones
for customer projects, whereas the cost of contract revenue associated with
license fees is minimal.  The license fee component of contract
revenue declined significantly in 2007, whereas the engineering services fee
component remained relatively constant. Accordingly, the cost of contract
revenue remained relatively constant despite a significant decrease in total
contract revenue.
 
 
 Research
and Development Expense
 
 Research
and development expense consists primarily of compensation costs for engineers
and expenses for consultants, recruiting, supplies, equipment, depreciation and
facilities related to engineering projects to improve our communications, test,
biometrics and imaging technology, as well as our software and hardware
products. Our total engineering costs are allocated between cost of contract
revenue and research and development expense.  In a given period, the
allocation of engineering costs between cost of contract revenue and research
and development is a function of the level of effort expended on
each.
 
 Research
and development expense increased 21% from $10.9 million in 2007 to $13.2
million in 2008.  As a percentage of total revenue, research and
development expense increased from 41% in 2007 to 43% in 2008.  The
dollar increase in research and development expense was primarily due to a shift
of engineering resources from DSL customer contracts (i.e., cost of contract
revenue) to internal development projects (i.e., research and development
expense). This resource shift reduced the amount of engineering expenses we
allocated to cost of contract revenue, which increased research and development
expense to reflect our increased focus on internal projects.
 
 Our
research and development spending in 2008 was principally focused on developing
analog and digital silicon IP solutions for broadband communications
applications, developing test and diagnostics hardware and software, and
developing biometrics and imaging software.
 
 28
  Research
and development expense increased 3% from $10.6 million in 2006 to $10.9 million
in 2007.  As a percentage of total revenue, research and development
expense decreased from 44% in 2006 to 41% in 2007.  The dollar
increase was primarily from higher compensation and fringe benefit costs of $0.9
million, higher depreciation costs of $0.2 million, and other operating costs of
$0.1 million. These cost increases were partially offset by lower stock-based
compensation expense of $0.4 million; lower spending on outside services and
consultants of $0.3 million; and $0.2 million more expense classified from
research and development expense to cost of contract revenue.
 
 
 Selling
and Marketing Expense
 
 Selling
and marketing expense consists primarily of compensation costs for sales and
marketing personnel, travel, advertising and promotion, recruiting, and
facilities expense.
 
 Sales and
marketing expense increased 27% from $3.7 million in 2007 to $4.7 million in
2008.  As a percentage of total revenue, sales and marketing expense
increased from 14% in 2007 to 16% in 2008.  The dollar increase in
sales and marketing expense was mainly attributable to headcount growth in the
biometrics sales organization, sales commissions on higher biometrics software
sales, and sales commissions related to higher contract revenue.
 
 Sales and
marketing expense increased 11% from $3.4 million in 2006 to $3.7 million in
2007.  As a percentage of total revenue, sales and marketing expense
was unchanged at 14% in 2006 and 2007. The dollar increase was primarily due to
higher compensation and fringe benefit costs of $0.4 million and management
consultants of $0.1 million, which were partially offset by lower stock-based
compensation expense of $0.2 million.  Higher compensation costs were
primarily attributable to sales commissions and bonus payments related to higher
hardware and software product sales.
 
 
 General
and Administrative Expense
 
 General
and administrative expense consists primarily of compensation costs for
administrative personnel, facility costs, bad debt, audit, legal, stock exchange
and insurance expenses.
 
 General
and administrative expense increased 23% from $4.2 million in 2007 to $5.2
million in 2008.  As a percentage of total revenue, general and
administrative expense increased from 16% in 2007 to 17% in 2008.  The
dollar increase in general and administrative expense was mainly attributable to
higher legal fees related to patent filings and a lawsuit we filed against a
customer, merit salary increases, and higher stock-based compensation
expense.
 
 General
and administrative expense decreased 4% from $4.4 million in 2006 to $4.2
million in 2007.  As a percentage of total revenue, general and
administrative expense decreased from 18% in 2006 to 16% in 2007.  The
dollar decrease was mainly attributable to lower stock-based compensation
expense of $0.2 million and lower director’s fees and expenses of $0.1 million,
which were partially offset by an increase in compensation and fringe expense of
$0.1 million.
 
 
 Interest
Income
 
 Interest
income decreased 42%, or $0.8 million, from $2.0 million in 2007 to $1.2 million
in 2008.  The dollar decrease in interest income was primarily due to
a significant fall in money market interest rates during 2008. The decrease was
also due to our decision to liquidate our portfolio of auction rate securities
and longer term debt instruments early in 2008 and invest the proceeds into a
lower-yielding, shorter-term, money market fund.
 
 Interest
income increased 10% or $0.2 million from $1.8 million in 2006 to $2.0 million
in 2007.  The dollar increase was primarily due to higher interest
rates earned on our investments throughout 2007.
 
 
 Income
Taxes
 
 We are
subject to income taxes in the United States and we use estimates in determining
our provisions for income taxes. We account for income taxes in accordance with
SFAS 109, Accounting for Income Taxes, which is the asset and liability
method for accounting and reporting for income taxes. Under SFAS 109,
deferred tax assets and liabilities are recognized based on temporary
differences between the financial reporting and income tax bases of assets and
liabilities using statutory rates.
  29
  As of
December 31, 2008, we had U.S. federal net operating loss carryforwards for
income tax purposes of $46.5 million that expire beginning in 2009 and state net
operating loss carryforwards of $11.4 million that expire beginning in
2009. We also had U.S. federal tax credits of $12.8 million that expire
beginning in 2009 and state research and development credits of $6.6 million
that expire beginning in 2009. The Internal Revenue Code contains provisions
that limit the net operating loss and tax credit carryforwards available to be
used in any given year in the event of certain circumstances, including
significant changes in ownership interests, as defined.
 
 Our
income tax expense consists primarily of provisions associated with state
taxes.  Due to the uncertainty surrounding the realization of our
deferred tax assets, based principally on our significant historical operating
losses, we have provided a full valuation allowance against our various tax
attributes. We will assess the level of valuation allowance required in future
periods. Should more positive than negative evidence regarding the realizability
of tax attributes exist at a future point in time, the valuation allowance may
be reduced or eliminated altogether. Reduction of the valuation allowance, in whole or in part, would result in a
non-cash reduction in income tax expense during the period of
reduction.
 
 30
 
 LIQUIDITY
AND CAPITAL RESOURCES
 
 Since our
inception in March 1986, we have financed our activities primarily through the
sale of stock.  In the years ended December 31, 2008, 2007, and 2006,
we received net proceeds from the issuance of stock under employee stock plans
of $0.4 million, $0.6 million, and $0.9 million, respectively.  In the
years ended December 31, 2008 and 2007, we used $2.4 million and $38,000,
respectively, to repurchase our stock under a program authorized by the board of
directors.
 
 In the
years ended December 31, 2008 and 2006, our operating activities provided net
cash of $9.4 million and $2.8 million, respectively. Cash provided by operating
activities in 2008 was primarily the result of net income of $1.8 million, which
was increased for non-cash items related to depreciation and amortization of
$0.9 million, and stock-based compensation expense of $1.5
million.  Also in 2008, we increased cash from operating activities by
$5.2 million by lowering our working capital requirements. Cash provided by
operating activities in 2006 was primarily the result of net income of $1.0
million, which was increased for non-cash items related to depreciation and
amortization of $0.7 million, and stock-based compensation expense of $1.9
million, which was offset by working capital requirements of $0.8
million.  In the year ended December 31, 2007, our operating
activities used net cash of $1.3 million.  Cash used in our operating
activities in 2007 was primarily the result of net income of $0.2 million, which
was increased for non-cash items related to depreciation and amortization of
$0.9 million, and stock-based compensation expense of $1.1 million, which was
more than offset by higher working capital requirements of $3.4
million.
 
 In the
years ended December 31, 2008, 2007, and 2006, we made capital expenditures of
$0.4 million, $0.6 million, and $0.7 million, respectively.  Capital
expenditures in all three years primarily consisted of spending on computer
hardware and software, laboratory equipment, and furniture used principally in
engineering activities.  We have no material commitments for capital
expenditures.
 
 At
December 31, 2008, we had cash and cash equivalents of $45.5
million.  While we can not assure you that we will not require
additional financing, or that such financing will be available to us, we believe
that our cash and cash equivalents will be sufficient to fund our operations for
at least the next twelve months.
 
 To date,
inflation has not had a material impact on our financial
results.  There can be no assurance, however, that inflation will not
adversely affect our financial results in the future.
 
 
 OFF-BALANCE
SHEET ARRANGEMENTS
 
 We do not
have any arrangements with unconsolidated entities, such as entities often
referred to as structured finance, special purpose entities or variable interest
entities which are often established for the purpose of facilitating off-balance
sheet arrangements or other contractually narrow or limited
purposes.  Accordingly, we are not exposed to any financing,
liquidity, market or credit risk that could arise if we had such
relationships.
 
 
 CONTRACTUAL
OBLIGATIONS
 
 We have
various contractual obligations impacting our liquidity.  The
following represents our contractual obligations as of December 31, 2008 (in
thousands):
 
 
 Payments
      Due By PeriodContractual Obligations
                    
                    Total
                    
                    
                    Less
      than
                      1
      year
                    
                    
                    1-3
      years
                    
                    
                    3-5
      years
                    
                    
                    More
      than
                      5
      yearsOperating
      leases
                    
                    $
                    22
                    
                    
                    $
                    13
                    
                    
                    $
                    9
                    
                    
                    $
                    -
                    
                    
                    $
                    -Purchase
      orders
                    
                    
                    442
                    
                    
                    
                    442
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    -Total
                    
                    $
                    464
                    
                    
                    $
                    455
                    
                    
                    $
                    9
                    
                    
                    $
                    -
                    
                    
                    $
                    -
  31
 
 CRITICAL
ACCOUNTING POLICIES
 
 We
consider certain accounting policies related to revenue recognition, stock-based
compensation, income taxes, inventories, and the allowance for doubtful accounts
to be critical policies.
  
 Revenue
recognition.  We derive our revenue from three sources (i)
product revenue, which includes revenue from the sale of hardware and software
products for the DSL test and diagnostics market and software products for the
biometrics, medical and digital imaging markets, (ii) contract revenue, which
includes patent, license and engineering service fees that we receive under
customer agreements, and (iii) royalties that we receive under customer
agreements.
 
 As
prescribed by Securities and Exchange Commission Staff Accounting Bulletin No.
104, “Revenue Recognition”, we recognize revenue when there is persuasive
evidence of an arrangement, the sales price is fixed or determinable, collection
of the related receivable is reasonably assured, and delivery has occurred or
services have been rendered.  We also apply the principles set forth
in AICPA Statement of Position No. 97-2, “Software Revenue Recognition”, when
recognizing software revenue.  Our revenue recognition policies are
described more fully in Note 2, Summary of Significant Accounting Policies, in
the Notes to our Consolidated Financial Statements.
 
 As
described below, we make significant judgments and estimates during the process
of determining revenue for any particular accounting period.
 
 In
determining revenue recognition, we assess whether fees associated with revenue
transactions are fixed or determinable and whether or not collection is
reasonably assured.  We make a judgment whether fees are fixed or
determinable based on the payment terms associated with that
transaction.  We assess collection based on a number of factors,
including past transaction history with the customer and the credit-worthiness
of the customer.  If we determine that collection of a fee is not
reasonably assured, we defer the fee and recognize revenue at the time
collection becomes reasonably assured.
 
 In
addition to these general revenue recognition judgments, we make specific
judgments and estimates with respect to the recognition of contract revenue.
When our agreements include the delivery of licensing rights and technology as
well as the provision of engineering services, we combine the total patent,
license and engineering service fees to be paid under the
agreement.  These total fees are recognized ratably over the expected
product development period, subject to the limitation that the cumulative
revenue recognized through the end of any period may not exceed cumulative
milestones achieved to date. We review assumptions regarding the product
development period on a regular basis and make adjustments as required.
Consistent with the principles of SAB 104, we believe that this method
represents the appropriate systematic method for revenue recognition for this
type of contract.
 
 After
customers enter into agreements, they often engage us to provide additional
engineering work that is beyond the scope of their original agreement. When
customers request additional services, both parties agree to engineering fees
that are based on the level of effort required.  We recognize revenue
from these agreements either as engineering services are performed or as
milestones are achieved.
 
 
 Stock-Based
Compensation. Stock-based compensation cost is measured at
the grant date, based on the fair value of the award, and is recognized as an
expense over the employee’s requisite service period (generally the vesting
period of the equity award) under the provisions of SFAS 123(R). We elected
to adopt the modified prospective transition method as provided by
SFAS 123(R) and, accordingly, financial statement amounts for the prior
periods have not been restated to reflect the fair value method of expensing
stock-based compensation.
 
 We
estimate the fair value of stock options using the Black-Scholes valuation
model.  This valuation model takes into account the exercise price of
the award, as well as a variety of significant assumptions.  These
assumptions used to estimate the fair value of stock options include the
expected term, the expected volatility of our stock over the expected term, the
risk-free interest rate over the expected term, and our expected annual dividend
yield.  We believe that the valuation technique and the approach
utilized to develop the underlying assumptions areappropriate in calculating
the fair values of stock options we grant to employees and directors which are
subject to SFAS 123(R) requirements.  Estimates of fair value are not
intended to predict actual future events or the value ultimately realized by
persons who receive equity awards.
 
 32
 
 Income
taxes.  As part of the process of preparing our consolidated
financial statements we are required to estimate our actual current tax
expense.  We must also estimate temporary and permanent differences
that result from differing treatment of certain items for tax and accounting
purposes.  These differences result in deferred tax assets and
liabilities, which are included in our consolidated balance sheet.  We
must then assess the likelihood that our deferred tax assets will be recovered
from future taxable income and to the extent that we believe that recovery is
not likely, we must establish a valuation allowance.  To the extent we
establish a valuation allowance or increase this allowance in a period for
deferred tax assets, which have been recognized, we must include an expense with
the tax provision in the statement of operations.
 
 Significant
management judgment is required in determining our provision for income taxes,
our deferred tax assets, and any valuation allowance recorded against our net
deferred tax assets.  Our deferred tax assets primarily relate to net
operating losses and research and development tax credits that we are carrying
forward into future tax periods.  As of December 31, 2008, we had a
total of $42.5 million of deferred tax assets for which we had recorded a full
valuation allowance.
 
 We
adopted the provisions of Financial Standards Accounting Board Interpretation
No. 48 Accounting for Uncertainty in Income Taxes (“FIN 48”) an interpretation
of FASB Statement No. 109 (“SFAS 109”) on January 1, 2007.  As a
result of the implementation of FIN 48, we recognized no material adjustment in
the liability for unrecognized income tax benefits.  At the adoption
date of January 1, 2007 and also at December 31, 2007 and 2008, we had no
unrecognized tax benefits.  We recognize interest and penalties
related to uncertain tax positions in income tax expense.
 
  Inventories.Inventories,
which include materials and our contract manufacturer’s labor and overhead, are
stated at the lower of cost (first-in, first-out basis) or net realizable value.
On a quarterly basis, we use consistent methodologies to evaluate all
inventories for net realizable value. We record provisions for both excess and
obsolete inventory when such write-downs or write-offs are identified through
the quarterly review process. The inventory valuation is based upon assumptions
about future demand, product mix and possible alternative uses.
 
 
 Allowance for
doubtful accounts.  We make judgments as to our ability to
collect outstanding receivables and provide allowances for receivables when
collection becomes doubtful.  Provisions are made based upon a
specific review of all significant outstanding invoices.  If the
judgments we make to determine the allowance for doubtful accounts do not
reflect the future ability to collect outstanding receivables, additional
provisions for doubtful accounts may be required.
 
 
 RECENT
ACCOUNTING PRONOUNCEMENTS
 
 Recent Accounting
Pronouncements – In September 2006, the FASB issued SFAS
No. 157 ("SFAS 157"), "Fair Value Measurements," which defines fair
value, establishes guidelines for measuring fair value and expands disclosures
regarding fair value measurements. SFAS 157 does not require any new fair
value measurements but rather eliminates inconsistencies in guidance found in
various prior accounting pronouncements. SFAS 157 is effective for fiscal
years beginning after November 15, 2007. However, on February 6, 2008, the
FASB issued FSP FAS 157-b which defers the effective date of SFAS 157
for one year for nonfinancial assets and nonfinancial liabilities that are
recognized or disclosed at fair value in the financial statements on a recurring
basis. We adopted SFAS 157 on January 1, 2008, except as it applies to
those nonfinancial assets and nonfinancial liabilities as noted in FSP
FAS 157-b. The partial adoption of SFAS 157 did not have a material
impact on our consolidated financial position, results of operations or cash
flows.  We are currently evaluating the impact of adopting FSP FAS
157-b.
 
 In
February 2007, the FASB issued Statement of Financial Accounting Standards
No. 159, “The Fair Value Option for Financial Assets and Financial
Liabilities, including an amendment of FASB Statements No. 115”
(“SFAS 159”). SFAS 159 permits entities to choose, at specified
election dates, to measure eligible items at fair value (the “fair value
option”). A business entity shall report unrealized gains and losses on items
for which the fair value option has been elected in earnings at each subsequent
reporting period. This accounting standard is effective as of the beginning of
an entity’s first fiscal year that begins after November 15,
2007.  We adopted SFAS 159 on January 1, 2008. The adoption of
SFAS 159 did not have a material impact on our consolidated financial
position, results of operations or cash flows as we have not elected the fair
value option for any of the financial assets and liabilities held during the
year ended December 31, 2008.
 
 33
  In
December 2007, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standard ("SFAS") No. 160, “Noncontrolling Interests in
Consolidated Financial Statements, an amendment of ARB No. 51.” SFAS 160
establishes accounting and reporting standards for the noncontrolling interest
in a subsidiary and for the deconsolidation of a subsidiary. This accounting
standard is effective for fiscal years beginning after December 15, 2008. As
such, we are required to adopt these provisions on January 1,
2009.  We are currently evaluating the impact of SFAS 160 on our
consolidated financial statements, but we do not expect it to have a material
impact.
 
 In
December 2007, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standard ("SFAS") No. 141(R), “Business Combinations.” SFAS
141(R) establishes principles and requirements for how the acquirer recognizes
and measures in its financial statements the identifiable assets acquired, the
liabilities assumed, an any noncontrolling interest in the acquiree, recognizes
and measures the goodwill acquired in the business combination or a gain from a
bargain purchase, and determines what information to disclose to enable users of
the financial statements to evaluate the nature and financial effects of the
business combination. This accounting standard is effective for fiscal years
beginning after December 15, 2008. SFAS 141(R) will be effective for us on
January 1, 2009, and will be applied to any business combination with an
acquisition date, as defined therein, that is subsequent to the effective
date.
 
 
 ITEM
7A.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK
 
 Our
exposure to market risk relates primarily to our investment portfolio, and the
effect that changes in interest rates would have on that
portfolio.  Our investment portfolio has included:
 
 ·
              Cash
      and cash equivalents, which consist of financial instruments with original
      maturities of three months or less;
 ·
              Short-term
      investments, which consist of financial instruments with remaining
      maturities of twelve months or less, and auction rate securities that
      typically have interest reset dates of  twenty-eight days;
      and
 ·
              Investments,
      which consist of financial instruments that mature in three years or
      less.
 
 All of
our investments meet the high quality standards specified in our investment
policy. This policy dictates the maturity period and limits the amount of credit
exposure to any one issue, issuer, and type of instrument.
 
 As of
December 31, 2008, our cash and cash equivalents of $45.5 million were invested
in money market accounts.  Due to the nature and short duration of
these financial instruments, we do not expect that an increase in interest rates
would result in any material loss to our investment portfolio. As of December
31, 2008, we had no investments that matured in more than twelve
months.  We do not use derivative financial instruments for
speculative or trading purposes.
 
 34
  ITEM
8.  CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY
DATA
 
 Report
of Independent Registered Public Accounting Firm
 
 To Board of Directors and
Stockholders of Aware, Inc.:
 
 In our
opinion, the consolidated financial statements listed in the indexappearing under Item 15
(a) (1) present fairly, in all material respects, the financial position of
Aware, Inc, and its subsidiary at December 31, 2008 and December 31, 2007 and
the results of their operations and their cash flows for each of the three years
in the period ended December 31, 2008 in conformity with accounting principles
generally accepted in the United States of America.  In addition, in
our opinion, the financial statement schedule listed in the index appearing
under Item 15 (a) (2) presents fairly, in all material respects, the information
set forth therein when read in conjunction with the related consolidated
financial statements.  Also in our opinion, the Company maintained, in
all material respects, effective internal control over financial reporting as of
December 31, 2008, based on criteria established in Internal Control -
Integrated Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO).  The Company's management is responsible
for these financial statements and financial statement schedule, for maintaining
effective internal control over financial reporting and for its assessment of
the effectiveness of internal control over financial reporting, included in
Management's Report on Internal Control Over Financial Reporting appearing under
Item 9A.  Our responsibility is to express opinions on these financial
statements, on the financial statement schedule, and on the Company's internal
control over financial reporting based on our integrated audits.  We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require
that we plan and perform the audits to obtain reasonable assurance about whether
the financial statements are free of material misstatement and whether effective
internal control over financial reporting was maintained in all material
respects.  Our audits of the financial statements included examining,
on a test basis, evidence supporting the amounts and disclosures in the
financial statements, assessing the accounting principles used and significant
estimates made by management, and evaluating the overall financial statement
presentation.  Our audit of internal control over financial reporting
included obtaining an understanding of internal control over financial
reporting, assessing the risk that a material weakness exists, and testing and
evaluating the design and operating effectiveness of internal control based on
the assessed risk.  Our audits also included performing such other
procedures as we considered necessary in the circumstances. We believe that our
audits provide a reasonable basis for our opinions.
  As
discussed in Note 2 to the financial statements, the Company changed its method
of accounting for share-based payments on January 1, 2006.
 
 A
company’s internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles.  A company’s internal
control over financial reporting includes those policies and procedures that
(i) pertain to the maintenance of records that, in reasonable detail,
accurately and fairly reflect the transactions and dispositions of the assets of
the company; (ii) provide reasonable assurance that transactions are
recorded as necessary to permit preparation of financial statements in
accordance with generally accepted accounting principles, and that receipts and
expenditures of the company are being made only in accordance with
authorizations of management and directors of the company; and
(iii) provide reasonable assurance regarding prevention or timely detection
of unauthorized acquisition, use, or disposition of the company’s assets that
could have a material effect on the financial statements.
 
 Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements.  Also, projections of any evaluation
of effectiveness to future periods are subject to the risk that controls may
become inadequate because of changes in conditions, or that the degree of
compliance with the policies or procedures may deteriorate.
 
 /s/
PricewaterhouseCoopers LLP
 
 PricewaterhouseCoopers
LLP
 Boston,
Massachusetts
 February
13, 2009
 
 35
  AWARE,
INC.
 CONSOLIDATED
BALANCE SHEETS
 (in
thousands, except share data)
 December
      31,2008
                            
                            
                            2007ASSETSCurrent
      assets:Cash
      and cash
      equivalents
                            
                            $
                            45,516
                            
                            
                            $
                            1,806Short-term
      investments
                            
                            
                            -
                            
                            
                            
                            36,249Accounts
      receivable (less allowance for doubtfulaccounts
      of $30 in 2008 and $55 in
      2007)
                            
                            
                            2,211
                            
                            
                            
                            7,661Inventories
                            
                            
                            1,656
                            
                            
                            
                            1,424Prepaid
      expenses and other current
      assets
                            
                            
                            598
                            
                            
                            
                            708Total
      current
      assets
                            
                            
                            49,981
                            
                            
                            
                            47,848Property
      and equipment,
      net
                            
                            
                            7,463
                            
                            
                            
                            7,872Investments
                            
                            
                            -
                            
                            
                            
                            494Other
      assets,
      net
                            
                            
                            102
                            
                            
                            
                            169Total
      assets
                            
                            $
                            57,546
                            
                            
                            $
                            56,383LIABILITIES
      AND STOCKHOLDERS’ EQUITYCurrent
      liabilities:Accounts
      payable
                            
                            $
                            466
                            
                            
                            $
                            939Accrued
      expenses
                            
                            
                            241
                            
                            
                            
                            174Accrued
      compensation
                            
                            
                            1,480
                            
                            
                            
                            1,135Accrued
      professional
                            
                            
                            167
                            
                            
                            
                            156Deferred
      revenue
                            
                            
                            339
                            
                            
                            
                            413Total
      current
      liabilities
                            
                            
                            2,693
                            
                            
                            
                            2,817Long-term
      deferred
      revenue
                            
                            
                            330
                            
                            
                            
                            330Commitments
      and contingent liabilities (Note 7)Stockholders’
      equity:Preferred
      stock, $1.00 par value; 1,000,000 shares authorized,
                              none
      outstanding
                            
                            
                            -
                            
                            
                            
                            -Common
      stock, $.01 par value; shares authorized,
                              70,000,000
      in 2008 and 2007; issued
                              and
      outstanding, 23,281,204 in 2008 and 23,854,708 in 2007
                            
                            
                            233
                            
                            
                            
                            239Additional
      paid-in
      capital
                            
                            
                            83,143
                            
                            
                            
                            83,626Accumulated
      deficit
                            
                            
                            (28,853
                            )
                            
                            
                            (30,629
                            )Total
      stockholders’
      equity
                            
                            
                            54,523
                            
                            
                            
                            53,236Total
      liabilities and stockholders’
      equity
                            
                            $
                            57,546
                            
                            
                            $
                            56,383
 
 
 
 
 The
      accompanying notes are an integral part of the consolidated financial
      statements.
  36
  AWARE,
INC.
 CONSOLIDATED
STATEMENTS OF OPERATIONS
 (in
thousands, except per share data)
   Years
      ended December 31,2008
                      
                      
                      2007
                      
                      
                      2006Revenue:Product
      sales
                      
                      $
                      14,022
                      
                      
                      $
                      17,491
                      
                      
                      $
                      7,610Contract
      revenue
                      
                      
                      14,658
                      
                      
                      
                      6,337
                      
                      
                      
                      12,569Royalties
                      
                      
                      1,837
                      
                      
                      
                      2,609
                      
                      
                      
                      3,877Total
      revenue
                      
                      
                      30,517
                      
                      
                      
                      26,437
                      
                      
                      
                      24,056Costs
      and expenses:Cost
      of product
      sales
                      
                      
                      2,589
                      
                      
                      
                      3,998
                      
                      
                      
                      918Cost
      of contract
      revenue
                      
                      
                      4,180
                      
                      
                      
                      5,425
                      
                      
                      
                      5,182Research
      and
      development
                      
                      
                      13,171
                      
                      
                      
                      10,869
                      
                      
                      
                      10,591Selling
      and
      marketing
                      
                      
                      4,739
                      
                      
                      
                      3,738
                      
                      
                      
                      3,359General
      and
      administrative
                      
                      
                      5,209
                      
                      
                      
                      4,237
                      
                      
                      
                      4,405Total
      costs and
      expenses
                      
                      
                      29,888
                      
                      
                      
                      28,267
                      
                      
                      
                      24,455Income
      (loss) from
      operations
                      
                      
                      629
                      
                      
                      
                      (1,830
                      )
                      
                      
                      (399
                      )Interest
      income
                      
                      
                      1,163
                      
                      
                      
                      2,016
                      
                      
                      
                      1,840Income
      before provision for income taxes
                      
                      
                      1,792
                      
                      
                      
                      186
                      
                      
                      
                      1,441Provision
      for income
      taxes
                      
                      
                      16
                      
                      
                      
                      26
                      
                      
                      
                      407Net
      income
                      
                      $
                      1,776
                      
                      
                      $
                      160
                      
                      
                      $
                      1,034Net
      income per share –
      basic
                      
                      $
                      0.08
                      
                      
                      $
                      0.01
                      
                      
                      $
                      0.04Net
      income per share –
      diluted
                      
                      $
                      0.07
                      
                      
                      $
                      0.01
                      
                      
                      $
                      0.04Weighted
      average shares –
      basic
                      
                      
                      23,638
                      
                      
                      
                      23,738
                      
                      
                      
                      23,474Weighted
      average shares –
      diluted
                      
                      
                      23,697
                      
                      
                      
                      25,084
                      
                      
                      
                      24,965
  
 The
accompanying notes are an integral part of the consolidated financial
statements.
  37
  AWARE,
INC.
 CONSOLIDATED
STATEMENTS OF CASH FLOWS
 (in
thousands)
 
 Years
      ended December 31,2008
                        
                        
                        2007
                        
                        
                        2006Cash
      flows from operating activities:Net
      income
                        
                        $
                        1,776
                        
                        
                        $
                        160
                        
                        
                        $
                        1,034Adjustments
      to reconcile net income to net cash
                          provided
      by (used in) operating activities:Depreciation
      and
      amortization
                        
                        
                        921
                        
                        
                        
                        878
                        
                        
                        
                        686Provision
      for doubtful accounts
                        
                        
                        (25
                        )
                        
                        
                        (20
                        )
                        
                        
                        -Stock-based
      compensation
                        
                        
                        1,505
                        
                        
                        
                        1,138
                        
                        
                        
                        1,937Increase
      (decrease) from changes in assets and liabilities:Accounts
      receivable
                        
                        
                        5,475
                        
                        
                        
                        (2,903
                        )
                        
                        
                        (989
                        )Inventories
                        
                        
                        (232
                        )
                        
                        
                        (605
                        )
                        
                        
                        (733
                        )Prepaid expenses and other
      current assets
                        
                        
                        110
                        
                        
                        
                        160
                        
                        
                        
                        (103
                        )Accounts
      payable
                        
                        
                        (473
                        )
                        
                        
                        247
                        
                        
                        
                        85Accrued
      expenses
                        
                        
                        423
                        
                        
                        
                        69
                        
                        
                        
                        301Deferred
      revenue
                        
                        
                        (74
                        )
                        
                        
                        (386
                        )
                        
                        
                        592Net
      cash provided by (used in) operating activities
                        
                        
                        9,406
                        
                        
                        
                        (1,262
                        )
                        
                        
                        2,810Cash
      flows from investing activities:Purchases
      of property and
      equipment
                        
                        
                        (445
                        )
                        
                        
                        (559
                        )
                        
                        
                        (666
                        )Sales
      of
      investments
                        
                        
                        38,743
                        
                        
                        
                        24,497
                        
                        
                        
                        15,984Purchases
      of
      investments
                        
                        
                        (2,000
                        )
                        
                        
                        (30,009
                        )
                        
                        
                        (23,521
                        )Net
      cash provided by (used in) investing activities
                        
                        
                        36,298
                        
                        
                        
                        (6,071
                        )
                        
                        
                        (8,203
                        )Cash
      flows from financing activities:Proceeds
      from issuance of common
      stock
                        
                        
                        363
                        
                        
                        
                        647
                        
                        
                        
                        896Shares
      surrendered by employees to pay taxes related to
                          unrestricted
      stock
                        
                        
                        -
                        
                        
                        
                        (41
                        )
                        
                        
                        -Repurchase
      of common
      stock
                        
                        
                        (2,357
                        )
                        
                        
                        (38
                        )
                        
                        
                        -Net
      cash provided by (used in) financing activities
                        
                        
                        (1,994
                        )
                        
                        
                        568
                        
                        
                        
                        896Increase
      (decrease) in cash and cash equivalents
                        
                        
                        43,710
                        
                        
                        
                        (6,765
                        )
                        
                        
                        (4,497
                        )Cash
      and cash equivalents, beginning of year
                        
                        
                        1,806
                        
                        
                        
                        8,571
                        
                        
                        
                        13,068Cash
      and cash equivalents, end of
      year
                        
                        $
                        45,516
                        
                        
                        $
                        1,806
                        
                        
                        $
                        8,571
 
 
 The
accompanying notes are an integral part of the consolidated financial
statements.
  38
  AWARE,
INC.
 CONSOLIDATED
STATEMENTS OF STOCKHOLDERS’ EQUITY
 (in
thousands)
 
 Additional
                
                
                
                
                
                TotalCommon
      Stock
                
                
                Paid-In
                
                
                Accumulated
                
                
                Stockholders’Shares
                
                
                Amount
                
                
                Capital
                
                
                Deficit
                
                
                EquityBalance
      at December 31, 2005
                
                
                23,282
                
                
                $
                233
                
                
                $
                79,093
                
                
                $
                (31,823
                )
                
                $
                47,503Exercise
      of common stock options
                
                
                293
                
                
                
                3
                
                
                
                881
                
                
                
                
                
                
                
                884Issuance
      of unrestricted stock
                
                
                66
                
                
                
                -
                
                
                
                367
                
                
                
                
                
                
                
                367Issuance
      of common stock under
                  employee
      stock purchase plan
                
                
                2
                
                
                
                -
                
                
                
                12
                
                
                
                
                
                
                
                12Stock-based
      compensation expense
                
                
                -
                
                
                
                -
                
                
                
                1,570
                
                
                
                
                
                
                
                1,570Net
      income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                1,034
                
                
                
                1,034Balance
      at December 31, 2006
                
                
                23,643
                
                
                
                236
                
                
                
                81,923
                
                
                
                (30,789
                )
                
                
                51,370Exercise
      of common stock options
                
                
                198
                
                
                
                3
                
                
                
                632
                
                
                
                
                
                
                
                635Repurchase
      of common stock
                
                
                (9
                )
                
                
                -
                
                
                
                (38
                )
                
                
                
                
                
                
                (38
                )Issuance
      of unrestricted stock
                
                
                29
                
                
                
                -
                
                
                
                153
                
                
                
                
                
                
                
                153Shares
      surrendered by employees to
                  pay
      taxes related to unrestricted stock
                
                
                (8
                )
                
                
                -
                
                
                
                (41
                )
                
                
                
                
                
                
                (41
                )Issuance
      of common stock under
                  employee
      stock purchase plan
                
                
                2
                
                
                
                -
                
                
                
                12
                
                
                
                
                
                
                
                12Stock-based
      compensation expense
                
                
                -
                
                
                
                -
                
                
                
                985
                
                
                
                
                
                
                
                985Net
      income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                160
                
                
                
                160Balance
      at December 31, 2007
                
                
                23,855
                
                
                
                239
                
                
                
                83,626
                
                
                
                (30,629
                )
                
                
                53,236Exercise
      of common stock options
                
                
                136
                
                
                
                1
                
                
                
                358
                
                
                
                
                
                
                
                359Repurchase
      of common stock
                
                
                (712
                )
                
                
                (7
                )
                
                
                (2,350
                )
                
                
                
                
                
                
                (2,357
                )Issuance
      of common stock under
                  employee
      stock purchase plan
                
                
                2
                
                
                
                -
                
                
                
                4
                
                
                
                
                
                
                
                4Stock-based
      compensation expense
                
                
                -
                
                
                
                -
                
                
                
                1,505
                
                
                
                
                
                
                
                1,505Net
      income
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                1,776
                
                
                
                1,776Balance
      at December 31, 2008
                
                
                23,281
                
                
                $
                233
                
                
                $
                83,143
                
                
                $
                (28,853
                )
                
                $
                54,523
 
   The
accompanying notes are an integral part of the consolidated financial
statements.
  39
 AWARE,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
  1.
              NATURE
      OF BUSINESS
  We are a
leading technology and software supplier for the telecommunications and
biometrics industries. We license silicon intellectual property for Digital
Subscriber Line (“DSL”) applications, sell hardware and software products for
DSL test applications, and sell software products for biometrics and imaging
applications. We also sell and/or license portions of our patent portfolio
related to communications, signal processing, and compression
technologies.  We sell our DSL test hardware and software products
primarily through an OEM sales channel. We sell our software products for
biometrics, medical and digital imaging applications and professional services
for biometrics primarily through an OEM sales channel.
  
 2.
              SUMMARY
      OF SIGNIFICANT ACCOUNTING POLICIES
  Basis of
Presentation - The consolidated financial statements include the accounts
of Aware, Inc. and its subsidiary.  All significant intercompany
transactions have been eliminated.
  Fair Value
Measurements - In September 2006, the FASB issued SFAS No. 157 ("SFAS
157"), "Fair Value Measurements".  SFAS 157 defines fair value,
establishes a framework for measuring fair value in accordance with accounting
principles generally accepted in the United States, and expands disclosures
about fair value measurements. We adopted the provisions of SFAS 157 as of
January 1, 2008, for our financial instruments. Although the adoption of SFAS
157 did not materially impact our financial condition, results of operations, or
cash flow, we are now required to provide additional disclosures as part of our
financial statements.
 
 SFAS 157
establishes a three-tier fair value hierarchy, which prioritizes the inputs used
in measuring fair value.  These tiers include: Level 1, defined as
observable inputs such as quoted prices in active markets; Level 2, defined as
inputs other than quoted prices in active markets that are either directly or
indirectly observable; and Level 3, defined as unobservable inputs in which
little or no market data exists, therefore requiring an entity to develop its
own assumptions.
 
 For
recognition purposes, on a recurring basis we are required to measure
“available-for-sale” investments at fair value.  Our
available-for-sale investments had a fair value of $36.7 million as of December
31, 2007 and were included in short-term investments and investments on our
consolidated balance sheets.  The fair value of these investments was
determined using quoted prices in active markets and is considered a Level 1
input.  Changes in the fair value of these investments have
historically been insignificant.  We had no short-term investments or
investments, and hence no available-for sale investments, at December 31,
2008.
 
 Our cash
and cash equivalents, including money market securities, are also classified
within Level 1 of the fair value hierarchy because they are valued using quoted
market prices.
  Cash and Cash
Equivalents – Cash and cash equivalents consist primarily of demand
deposits and money market funds, which are stated at cost, which approximates
fair value.
  Investments
- At December 31, 2007, we categorized the securities we were holding as
available-for-sale, since we may have liquidated these investments before
maturity. In calculating realized gains and losses, cost is determined using
specific identification.  Unrealized gains and losses on
available-for-sale securities are excluded from earnings and reported in a
separate component of stockholders’ equity if material.  At December
31, 2007, unrealized gains and losses on securities held were not material.
Gross realized gains on available-for-sale securities were $65,506 in 2008, $0
in 2007, and $10 in 2006. Gross realized losses on available-for-sale securities
were $0 in 2008, $0 in 2007, and $3,387 in 2006.
 
 40
 AWARE,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 The cost
of securities, which approximates fair value, consisted of the following at
December 31, 2007 (in thousands):
  Short-term investments
                                
                                2007Auction
      variable rate notes
                                
                                $
                                17,955Corporate
      debt securities
                                
                                
                                2,033U.S.
      agency securities
                                
                                
                                16,261Total
                                
                                $
                                36,249
 
  Investments
                              
                              2007Corporate
      debt securities
                              
                              $
                              494Total
                              
                              $
                              494
 
 Short-term
investments were scheduled to mature within three to twelve months, and
investments were scheduled to mature within one to two years. All income
generated from these investments was recorded as interest income.
  Allowance for
Doubtful Accounts – Accounts are charged to the allowance for doubtful
accounts as they are deemed uncollectible based on a periodic review of the
accounts.
  Inventories– Inventories are stated at the lower of cost or net realizable value.
Cost is determined by the first-in, first-out (“FIFO”) method.  We
evaluate all inventories for net realizable value on a quarterly basis, and
record provisions for excess and obsolete inventory when required.
  Property and
Equipment – Property and equipment are stated at
cost.  Depreciation and amortization of property and equipment is
provided using the straight-line method over the estimated useful lives of the
assets. Upon retirement or sale, the costs of the assets disposed of and the
related accumulated depreciation are removed from the accounts and any resulting
gain or loss is included in the determination of income or
loss.  Expenditures for repairs and maintenance are charged to expense
as incurred.
  The
estimated useful lives of assets used by us are:
  Building
      and improvements
                          30
      yearsBuilding
      improvements
                          5
      to 20 yearsFurniture
      and fixtures
                          5
      yearsComputer,
      office & manufacturing equipment
                          3
      yearsPurchased
      software
                          3
      years
 
  Impairment of
Long-Lived Assets – We review long-lived assets for impairment whenever
events or changes in business circumstances indicate that the carrying amount of
the assets may not be fully recoverable or that the useful lives of these assets
are no longer appropriate.  Each impairment test is based on a
comparison of the undiscounted cash flows to the recorded value of the
asset.  If an impairment is indicated, the asset is written down to
its estimated fair value.  The cash flow estimates used to identify
the potential impairment reflect our best estimates using appropriate
assumptions and projections at that time.  We believe that no
significant impairment of our long-lived assets has occurred as of December 31,
2008 and 2007.
  Revenue
Recognition – Revenue is recognized in accordance with Staff Bulletin No.
104, “Revenue Recognition,” (“SAB 104”) and related
interpretations.  Accordingly, our general revenue recognition policy
is to recognize revenue when there is persuasive evidence of an arrangement, the
sales price is fixed or determinable, collection of the related receivable is
reasonably assured, and delivery has occurred or services have been
rendered.
  We derive
our revenue from three sources (i) product revenue, which includes revenue from
the sale of DSL hardware and software products and biometrics medical and
digital imaging software products, (ii) contract revenue, which includes patent,
license and engineering service fees that we receive under customer agreements,
and (iii) royalties that we receive under customer agreements.  In
addition to the above general revenue recognition principles prescribed by SAB
104, our specific revenue recognition policies for each revenue source are more
fully described below.
  41
 AWARE,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 Product sales. Product sales
consist primarily of revenue from the sale of: (i) hardware products, and (ii)
software products.
  ·
              Hardware
      products, including UDMT modem modules and DSL test and development
      systems, are standalone products that are sold independently of our
      silicon intellectual property products.  The terms of sales
      generally do not contain provisions that obligate us to provide additional
      products or services after shipment.  Additionally, we do not
      grant return rights other than normal warranty rights of
      return.  We recognize revenue: (i) upon shipment when products
      are shipped FOB shipping point, and (ii) upon delivery at the customer’s
      location when products are shipped FOB
  destination.
  ·
              Software
      products consist of software that is generally sold to OEM customers for
      integration into their products.  The terms of sale generally do
      not contain provisions that obligate us to provide additional products or
      services after shipment, other than technical telephone support for a
      brief period of time post sale. The cost of providing technical support is
      inconsequential because of the limited scope of the
      support.  Additionally, we do not grant return rights other than
      normal warranty rights of return, and we generally do not customize
      software for customers.   We also sell maintenance
      contracts that entitle customers to product updates, which we classify as
      product revenue.
  We
recognize software revenue by applying the principles set forth in SAB 104 and
American Institute of Certified Public Accountants (“AICPA”) Statement of
Position No. 97-2, “Software Revenue Recognition”.  Accordingly, we
recognize revenue for software licenses: (i) upon shipment when products are
shipped FOB shipping point, and (ii) upon delivery at the customer’s location
when products are shipped FOB destination.  We recognize revenue for
maintenance contracts ratably over the related contract period.
  Contract revenue. We enter
into nonexclusive agreements with customers that generally require us to deliver
patents, technology and/or provide engineering services.  In return,
we receive one or more of the following forms of consideration: (i) patent fees;
(ii) license fees; (iii) engineering service fees; and (iv) royalty
payments.
  License
fees, patent fees or engineering services fees are typically paid and the
revenue is recognized during the product development period as technology is
delivered or as engineering services milestones are
achieved.  Engineering milestones have historically been formulated to
correlate with the estimated level of effort and related costs.  We
classify license, patent and engineering service fees as contract
revenue.
  When our
agreements include both the delivery of licensing rights and technology and the
provision of engineering services, we combine the total patent, license and
engineering service fees to be paid under the agreement.  These total
fees are recognized ratably over the expected product development period,
subject to the limitation that the cumulative revenue recognized through the end
of any period may not exceed cumulative contract milestones achieved to date. We
review assumptions regarding the product development period on a regular basis
and make adjustments as required. We believe that this method represents the
appropriate systematic method for revenue recognition for this type of
contract.
 
 After
customers enter into agreements, they often engage us to provide additional
engineering work that is beyond the scope of their original agreement. When
customers request additional services, both parties agree to engineering fees
that are based on the level of effort required.  We recognize revenue
from these agreements either as engineering services are performed or as
milestones are achieved.
  When we
license and/or sell patents not in conjunction with an engineering development
project, we recognize revenue upon delivery provided there are no significant
post delivery obligations.
  42
 AWARE,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 Royalty
revenue.  Royalty revenue is generally recognized in the
quarter in which a report is received from a customer detailing sales for which
royalties are due, including shipments of products incorporating our
intellectual property.  This report is typically received in the
quarter following sales of products by our customer.  The terms of our
agreements generally require customers to give notification to us and to pay
royalties within 45 to 60 days of the end of the quarter during which sales of
products take place.
  Income
Taxes – We compute deferred income taxes based on the differences between
the financial statement and tax basis of assets and liabilities using enacted
rates in effect in the years in which the differences are expected to
reverse.  We establish a valuation allowance to offset temporary
deductible differences, net operating loss carryforwards and tax credits when it
is more likely than not that the deferred tax assets will not be
realized.
  Capitalization of
Software Costs – We capitalize certain internally generated software
development costs after technological feasibility of the product has been
established.  No software costs were capitalized for the years ended
December 31, 2008, 2007 and 2006, because such costs incurred subsequent to the
establishment of technological feasibility, but prior to commercial
availability, were immaterial.
  Research and
Development Costs – Costs incurred in the research and development of our
products are expensed as incurred.
  Concentration of
Credit Risk– At December 31, 2008 and 2007, we had cash and investments,
in excess of federally insured deposit limits of approximately $45.4 million and
$38.4 million, respectively
  Concentration
of credit risk with respect to net accounts receivable consists of $0.5 million,
$0.3 million, and $0.2 million, with three customers, respectively, at December
31, 2008 and $1.9 million, $1.3 million, $0.8 million, and $0.5 million with
four customers, respectively, at December 31, 2007.
  Stock-Based
Compensation– We grant stock options to our employees and
directors.  Such grants are for a fixed number of shares with an
exercise price equal to the fair value of the shares at the date of grant.
Effective January 1, 2006, we adopted the provisions of the Financial
Accounting Standards Board (“FASB”) Statement of Financial Accounting
Standards  No. 123 (revised 2004), “Share-Based Payment,”
(“SFAS 123(R)”), which establishes accounting for equity instruments
exchanged for employee services. Under the provisions of SFAS 123(R),
stock-based compensation cost is measured at the grant date, based on the fair
value of the award, and is recognized as an expense over the employee’s
requisite service period (generally the vesting period of the equity
award).  We use the Black-Scholes valuation model to estimate the fair
value of service condition awards.  This valuation model takes into
account the exercise price of the award, as well as a variety of significant
assumptions.  These assumptions used to estimate the fair value of
stock options include the expected term, the expected volatility of our stock
over the expected term, the risk-free interest rate over the expected term, and
our expected annual dividend yield.  We recognize compensation costs
on a straight-line basis over the requisite service period.
  We also
award unrestricted stock to our employees under the 2001 Plan. We record the
fair value of such awards as stock-based compensation expense in accordance with
the provisions of SFAS 123(R).
 
 Computation of
Earnings per Share– Basic earnings per share is computed by dividing
income available to common shareholders by the weighted average number of common
shares outstanding.  Diluted earnings per share is computed by
dividing income available to common shareholders by the weighted average number
of common shares outstanding plus additional common shares that would have been
outstanding if dilutive potential common shares had been issued.  For
the purposes of this calculation, stock options are considered common stock
equivalents in periods in which they have a dilutive effect.  Stock
options that are antidilutive are excluded from the calculation.
  43
 AWARE,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 Use of Estimates–The
preparation of our financial statements in conformity with generally accepted
accounting principles requires us to make estimates and assumptions that affect
the reported amounts of assets and liabilities and disclosure of contingent
assets and liabilities at the date of the financial statements and the reported
amount of revenues and expenses during the reporting
period.  Significant estimates include revenue recognition, reserves
for doubtful accounts, reserves for excess and obsolete inventory, useful lives
of fixed assets, valuation allowance for deferred income tax assets, and accrued
liabilities.  Actual results could differ from those
estimates.
  Fair Value of
Financial Instruments – The carrying amounts of cash and cash
equivalents, short-term investments, accounts receivable, accounts payable and
accrued expenses approximate fair value because of their short-term
nature.
  Comprehensive
Income -Comprehensive income is defined as the change in equity of a
business enterprise during a period from transactions and other events and
circumstances from non-owner sources, including foreign currency translation
adjustments and unrealized gains and losses on marketable
securities.  For the years ended December 31, 2008, 2007, and 2006,
comprehensive income was not materially different from net income.
 
 Advertising Costs
–Advertising costs are expensed as incurred and were not material for
2008, 2007, and 2006.
 
 Recent Accounting
Pronouncements – In September 2006, the FASB issued SFAS
No. 157 ("SFAS 157"), "Fair Value Measurements," which defines fair
value, establishes guidelines for measuring fair value and expands disclosures
regarding fair value measurements. SFAS 157 does not require any new fair
value measurements but rather eliminates inconsistencies in guidance found in
various prior accounting pronouncements. SFAS 157 is effective for fiscal
years beginning after November 15, 2007. However, on February 6, 2008, the
FASB issued FSP FAS 157-b which defers the effective date of SFAS 157
for one year for nonfinancial assets and nonfinancial liabilities that are
recognized or disclosed at fair value in the financial statements on a recurring
basis. We adopted SFAS 157 on January 1, 2008, except as it applies to
those nonfinancial assets and nonfinancial liabilities as noted in FSP
FAS 157-b. The partial adoption of SFAS 157 did not have a material
impact on our consolidated financial position, results of operations or cash
flows.  We are currently evaluating the impact of adopting FSP FAS
157-b.
 
 In
February 2007, the FASB issued Statement of Financial Accounting Standards
No. 159, “The Fair Value Option for Financial Assets and Financial
Liabilities, including an amendment of FASB Statements No. 115”
(“SFAS 159”). SFAS 159 permits entities to choose, at specified
election dates, to measure eligible items at fair value (the “fair value
option”). A business entity shall report unrealized gains and losses on items
for which the fair value option has been elected in earnings at each subsequent
reporting period. This accounting standard is effective as of the beginning of
an entity’s first fiscal year that begins after November 15,
2007.  We adopted SFAS 159 on January 1, 2008. The adoption of
SFAS 159 did not have a material impact on our consolidated financial
position, results of operations or cash flows as we have not elected the fair
value option for any of the financial assets and liabilities held during the
year ended December 31, 2008.
 
 In
December 2007, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standard ("SFAS") No. 160, “Noncontrolling Interests in
Consolidated Financial Statements, an amendment of ARB No. 51.” SFAS 160
establishes accounting and reporting standards for the noncontrolling interest
in a subsidiary and for the deconsolidation of a subsidiary. This accounting
standard is effective for fiscal years beginning after December 15, 2008. As
such, we are required to adopt these provisions on January 1,
2009.  We are currently evaluating the impact of SFAS 160 on our
consolidated financial statements, but we do not expect it to have a material
impact.
 
 In
December 2007, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standard ("SFAS") No. 141(R), “Business Combinations.” SFAS
141(R) establishes principles and requirements for how the acquirer recognizes
and measures in its financial statements the identifiable assets acquired, the
liabilities assumed, an any noncontrolling interest in the acquiree, recognizes
and measures the goodwill acquired in the business combination or a gain from a
bargain purchase, and determines what information to disclose to enable users of
the financial statements to evaluate the nature and financial effects of the
business combination. This accounting standard is effective for fiscal years
beginning after December 15, 2008. SFAS 141(R) will be effective for us on
January 1, 2009, and will be applied to any business combination with an
acquisition date, as defined therein, that is subsequent to the effective
date.
 
 44
 AWARE,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 Reclassifications– Certain prior
period amounts have been reclassified to be consistent with the current period
presentation.
 
 Segments– We organize ourselves as
one segment reporting to the chief operating decision-maker.  We have
sales outside of the United States, which are described in Note
8.  All long-lived assets are maintained in the United
States.
 
 
 3.
              INVENTORIES
 
 Inventories
consisted of the following at December 31 (in thousands):
 
 2008
                              
                              
                              2007Raw
      materials
                              
                              $
                              1,650
                              
                              
                              $
                              1,424Finished
      goods
                              
                              
                              6
                              
                              
                              
                              -Total
                              
                              $
                              1,656
                              
                              
                              $
                              1,424
 
 
 
 4.
              PROPERTY
      AND EQUIPMENT
  Property
and equipment consisted of the following at December 31 (in
thousands):
 
 2008
                              
                              
                              2007Land
                              
                              $
                              1,080
                              
                              
                              $
                              1,080Building
      and improvements
                              
                              
                              8,869
                              
                              
                              
                              8,854Computer
      equipment
                              
                              
                              2,065
                              
                              
                              
                              7,168Purchased
      software
                              
                              
                              1,241
                              
                              
                              
                              3,129Furniture
      and fixtures
                              
                              
                              817
                              
                              
                              
                              944Office
      equipment
                              
                              
                              203
                              
                              
                              
                              364Manufacturing
      equipment
                              
                              
                              76
                              
                              
                              
                              292Total
                              
                              
                              14,351
                              
                              
                              
                              21,831Less
      accumulated depreciation and amortization
                              
                              
                              (6,888
                              )
                              
                              
                              (13,959
                              )Property
      and equipment, net
                              
                              $
                              7,463
                              
                              
                              $
                              7,872
 
 Depreciation
expense amounted to $0.9 million, $0.8 million, and $0.6 million in each of the
years ended December 31, 2008, 2007, and 2006, respectively.  In 2008,
we identified $7.9 million of fully depreciated assets no longer in use, and
retired the assets and related accumulated depreciation.
  5.
              INCOME
      TAXES
 
 Deferred
tax assets are attributable to the following at December 31 (in
thousands):
  2008
                            
                            
                            2007Federal
      net operating loss carryforwards
                            
                            $
                            15,679
                            
                            
                            $
                            15,662Research
      and development and other tax credit carryforwards
                            
                            
                            17,208
                            
                            
                            
                            16,744State
      net operating loss carryforwards
                            
                            
                            660
                            
                            
                            
                            704Capitalized
      research and development costs
                            
                            
                            6,245
                            
                            
                            
                            8,186Other
                            
                            
                            2,689
                            
                            
                            
                            1,529Total
                            
                            
                            42,481
                            
                            
                            
                            42,825Less
      valuation allowance
                            
                            
                            (42,481
                            )
                            
                            
                            (42,825
                            )Deferred
      tax assets, net
                            
                            $
                            -
                            
                            
                            $
                            -
  45
 AWARE,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 
 A
      reconciliation of the U.S. federal statutory rate to the effective tax
      rate is as follows:
 
 Year
      ended December 31,2008
                              
                              
                              2007
                              
                              
                              2006Federal
      statutory rate
                              
                              
                              34
                              %
                              
                              
                              34
                              %
                              
                              
                              34
                              %State
      rate, net of federal benefit
                              
                              
                              4
                              
                              
                              
                              (16
                              )
                              
                              
                              4Foreign
      tax expense
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              27Tax
      credits
                              
                              
                              (52
                              )
                              
                              
                              (545
                              )
                              
                              
                              (97
                              )Change
      in valuation allowance
                              
                              
                              12
                              
                              
                              
                              504
                              
                              
                              
                              43Nondeductible
      compensation expense
                              
                              
                              3
                              
                              
                              
                              31
                              
                              
                              
                              16Other
                              
                              
                              0
                              
                              
                              
                              6
                              
                              
                              
                              1Effective
      tax rate
                              
                              
                              1
                              %
                              
                              
                              14
                              %
                              
                              
                              28
                              %
 
 At
December 31, 2008, we had federal net operating loss ("NOL") and research and
development credit carryforwards of approximately $46.5 million and $12.8
million respectively, expiring in 2009 through various dates up through 2029. In
2008, approximately $784,000 of NOLs and $70,000 of research and development
credits expired unused.  Based on an analysis that we performed under
Internal Revenue Code Section 382 on our NOLs generated for the period 1997
through 2007, we have not experienced a change in ownership as defined by
Section 382, and, therefore, the NOLs are not currently under any Section 382
limitation.  We also have approximately $1.5 million of additional
federal NOLs and $68,000 of additional research and development credits for the
periods 1994 through 1995 that are currently being assessed under Section
382.  Until we complete our review, these NOLs and research and
development credits have not been included as a deferred tax asset and are not
included in the balance noted above.  If, upon completion of our
review, these NOLs are included as a deferred tax asset, they will likely be
subject to a full valuation allowance.  All NOLs incurred prior to
1994 have expired unused.
 
 For state
purposes, we had state NOLs and research and development credit carryforwards of
approximately $11.4 million and $6.6 million respectively, expiring in 2009
through various dates up to 2023.  In 2008, approximately $1.3 million
of state NOLs expired unused.
 
 Subsequent
ownership changes, as defined in Section 382, could limit the amount of net
operating loss carryforwards and research and development credits that can be
utilized annually to offset future taxable income.
 
 We
recorded a full valuation allowance against our deferred tax assets because we
determined that it was more likely than not that such deferred tax assets may
not be realized.  Our decision to reserve deferred tax assets was
primarily due to a history of net operating losses incurred in recent years, and
the uncertainty of the timing of future taxable income.  If we
generate sustained future taxable income against which these tax attributes may
be applied, some portion or all of the valuation allowance would be
reversed.
 
 We did
not record a provision for income taxes in 2008, 2007, and 2006 due to tax net
operating losses and the uncertainty of the timing of profitability in future
periods. However, in 2008 and 2007 we paid immaterial amounts of state excise
taxes, and in 2006 we paid $0.4 million of taxes to non-U.S. jurisdictions that
assess a source withholding tax.
 
 Deferred
tax assets include cumulative deductions for stock options, in excess of book
expense of $63.1 million.  None of the benefit related to these
options has been reflected in equity. Therefore, the portion of the deferred tax
asset valuation allowance related to the tax benefit of these options must be
recorded to equity, when the tax benefit is realized.  The estimated
federal amount of this benefit is $23.1 million, and the estimated state amount
is $2.0 for a total amount of $25.1 million.
 
 46
 AWARE,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 We
adopted the provisions of Financial Standards Accounting Board Interpretation
No. 48 Accounting for Uncertainty in Income Taxes (“FIN 48”) an interpretation
of FASB Statement No. 109 (“SFAS 109”) on January 1, 2007.  As a
result of the implementation of FIN 48, we recognized no material adjustment in
the liability for unrecognized income tax benefits.  At the adoption
date of January 1, 2007 and also at December 31, 2008, we had no unrecognized
tax benefits.
 
 We
recognize interest and penalties related to uncertain tax positions in income
tax expense.  As of December 31, 2008, we had no accrued interest or
penalties related to uncertain tax positions.
 
 6.
                EQUITY
      AND STOCK COMPENSATION PLANS
 At
December 31, 2008, we have three stock-based compensation plans, which are
described below:
  Fixed Stock
Option Plans – We have two fixed option plans.  Under the 1996
Stock Option Plan (“1996 Plan”), we may grant incentive stock options or
nonqualified stock options to our employees and directors for up to 6,100,000
shares of common stock.  Under the 2001 Nonqualified Stock Plan (“2001
Plan”), we may grant nonqualified stock options or stock awards to our employees
and directors for up to 8,000,000 shares of common stock.  Under both
plans, options are granted at an exercise price as determined by the Board of
Directors and have terms ranging from four to a maximum of ten years. Our
options generally vest over three to five years, although we have granted
options that are 50% or fully vested on the date of grant.  As of
December 31, 2008, there were 3,096,178 shares available for grant under the
2001 Plan, and no shares available under the 1996 Plan.
 
 During
2007 and 2006, we awarded unrestricted stock to our employees under the 2001
Plan.  In 2007 and 2006, a total of 20,744 and 65,464 net shares were
distributed representing $153,000 and $367,000 of stock-based compensation
expense, respectively.
 
 The
following table presents stock-based employee compensation expenses included in
our consolidated statements of operations (in thousands):
  2008
                                      
                                      
                                      2007
                                      
                                      
                                      2006Cost of product
      sales
                                      
                                      $
                                      11
                                      
                                      
                                      $
                                      13
                                      
                                      
                                      $
                                      15Cost of contract
      revenue
                                      
                                      
                                      135
                                      
                                      
                                      
                                      176
                                      
                                      
                                      
                                      149Research and
      development
                                      
                                      
                                      611
                                      
                                      
                                      
                                      483
                                      
                                      
                                      
                                      904Selling and
      marketing
                                      
                                      
                                      186
                                      
                                      
                                      
                                      119
                                      
                                      
                                      
                                      289General and
      administrative
                                      
                                      
                                      562
                                      
                                      
                                      
                                      347
                                      
                                      
                                      
                                      580Stock-based
      compensation expense
                                      
                                      $
                                      1,505
                                      
                                      
                                      $
                                      1,138
                                      
                                      
                                      $
                                      1,937
 
 We
estimate the fair value of stock options using the Black-Scholes valuation
model. This valuation model takes into account the exercise price of the award,
as well as a variety of significant assumptions. These assumptions used to
estimate the fair value of stock options include the expected term, the expected
volatility of our stock over the expected term, the risk-free interest rate over
the expected term, and our expected annual dividend yield. We believe that the
valuation technique and the approach utilized to develop the underlying
assumptions areappropriate in calculating
the fair values of our stock options granted in the years ended
December 31, 2008, 2007 and 2006. Estimates of fair value are not intended
to predict actual future events or the value ultimately realized by persons who
receive equity awards.
  Assumptions
used to determine the fair value of options granted during the years ended
December 31, 2008, 2007 and 2006, using the Black-Scholes valuation model
were:
 
 Year Ended
                  December 31,
      2008
                
                Year Ended
                  December 31,
      2007
                
                Year Ended
                  December 31,
      2006Expected
      term(1)
                
                6.70-7.16
    years
                
                6.25 years
                
                3.25-6.25
  yearsExpected volatility
      factor(2)
                
                51-54%
                
                51-56%
                
                60-67%Risk-free interest
      rate(3)
                
                2.17-3.16%
                
                3.80-4.73%
                
                4.55-4.99%Expected annual dividend
      yield
                
                —
                
                —
                
                —
  47
 AWARE,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
  
 (1)
                  The
      expected term for each grant for the year ended December 31, 2008 was
      determined based on the historical average term of grants issued over the
      past five years. The expected term for each grant for the years ended
      December 31, 2007 and 2006 was determined as the midpoint between the
      vesting date and the end of the contractual term, also known as the
      “simplified method” for estimating the expected term described by Staff
      Accounting Bulletin No. 107 (“SAB 107”).(2)
                  The
      expected volatility for each grant is estimated based on an average of
      historical volatility over a period of time which we believe to be
      representative of our future volatility.(3)
                  The
      risk-free interest rate for each grant is based on the U.S. Treasury yield
      curve in effect at the time of grant for a period equal to the expected
      term of the stock
option.
 
 We do not
estimate our forfeiture rates as the actual forfeiture rate is known at the end
of each reporting period due to the timing of our stock option
vesting.
 
 A summary
of the transactions of our two fixed stock option plans for the years ended
December 31, 2008, 2007, and 2006 are presented below:
 
 2008
                    
                    
                    2007
                    
                    
                    2006Shares
                    
                    
                    Weighted
                      Average
                      Exercise
                      Price
                    
                    
                    Shares
                    
                    
                    Weighted
                      Average
                      Exercise
                      Price
                    
                    
                    Shares
                    
                    
                    Weighted
                      Average
                      Exercise
                      PriceOutstanding
      at beginning of year
                    
                    
                    6,974,705
                    
                    
                    $
                    4.84
                    
                    
                    
                    6,489,812
                    
                    
                    $
                    4.80
                    
                    
                    
                    6,284,606
                    
                    
                    $
                    4.73Granted
                    
                    
                    1,093,200
                    
                    
                    
                    3.57
                    
                    
                    
                    737,000
                    
                    
                    
                    4.79
                    
                    
                    
                    697,000
                    
                    
                    
                    5.24Exercised
                    
                    
                    (136,158
                    )
                    
                    
                    2.64
                    
                    
                    
                    (197,853
                    )
                    
                    
                    3.21
                    
                    
                    
                    (293,394
                    )
                    
                    
                    3.01Forfeited
      or
      cancelled
                    
                    
                    (392,754
                    )
                    
                    
                    5.13
                    
                    
                    
                    (54,254
                    )
                    
                    
                    5.87
                    
                    
                    
                    (198,400
                    )
                    
                    
                    6.66Outstanding
      at end of year
                    
                    
                    7,538,993
                    
                    
                    $
                    4.68
                    
                    
                    
                    6,974,705
                    
                    
                    $
                    4.84
                    
                    
                    
                    6,489,812
                    
                    
                    $
                    4.80Options
      exercisable at year end
                    
                    
                    6,059,397
                    
                    
                    $
                    4.80
                    
                    
                    
                    5,809,280
                    
                    
                    $
                    4.80
                    
                    
                    
                    5,688,735
                    
                    
                    $
                    4.72
 
  All
options granted during the years ended December 31, 2008, 2007 and 2006 had
exercise prices equal to the fair market value of our common stock on the date
of grant, and the weighted average grant date fair values of options granted
were $1.97, $2.66, and $2.85, respectively.
 
 At
December 31, 2008, the weighted average remaining contractual term for both
options outstanding and options exercisable was approximately 6 years and 5
years, respectively.
 
 At
December 31, 2008, the aggregate intrinsic value of options outstanding and
options exercisable was zero for both as each group of options was out-of-the
money by approximately $21.2 million and $17.8 million, respectively. The
intrinsic value of a stock option is the amount by which the market value of the
underlying stock exceeds the exercise price of the option.  The
aggregate intrinsic value of options exercised during the year ended December
31, 2008 was approximately $151,000.
 
 48
 AWARE,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 The
following table summarizes the stock options outstanding at December 31,
2008:
 
  Options
      Outstanding
                
                Options
      ExercisableExercise Price
                  Range
                
                Number
                
                Weighted
                  Average
                  Exercise
                  Price
                
                Weighted Average
                  Remaining
                  Contractual
                  Term (in
      years)
                
                Number
                
                Weighted
                  Average
                  Exercise
                  Price$0 to $3
                
                799,036
                
                
                $2.89
                
                5.65
                
                793,408
                
                
                $2.90$3 to $4
                
                3,434,907
                
                
                3.38
                
                6.17
                
                2,601,117
                
                
                3.31$4 to $5
                
                443,650
                
                
                4.64
                
                8.82
                
                150,787
                
                
                4.67$5 to $6
                
                752,700
                
                
                5.19
                
                5.27
                
                442,956
                
                
                5.22$6 to $7
                
                1,976,950
                
                
                6.11
                
                5.22
                
                1,939,379
                
                
                6.11$7 to $10
                
                51,500
                
                
                7.76
                
                2.47
                
                51,500
                
                
                7.76$10 to $63
                
                80,250
                
                
                36.74
                
                0.81
                
                80,250
                
                
                36.747,538,993
                
                
                $4.68
                
                5.85
                
                6,059,397
                
                
                $4.80
   At
December 31, 2008, unrecognized compensation expense related to non-vested stock
options was approximately $2.7 million, which is expected to be recognized over
a weighted average period of 2 years.
 
 We issue
common stock from previously authorized but unissued shares to satisfy option
exercises and purchases under our Employee Stock Purchase Plan.
 
 Employee Stock
Purchase Plan - In June 1996, we adopted an Employee Stock Purchase Plan
(the “ESPP Plan”) under which eligible employees could purchase common stock at
a price equal to 85% of the lower of the fair market value of the common stock
at the beginning or end of each six-month offering period.  On
November 29, 2005 we amended the ESPP Plan to provide that eligible employees
may purchase common stock at a price equal to 95% of the fair market value of
the common stock as of the end of each six-month offering
period.  There is no stock-based compensation expense related to our
Employee Stock Purchase Plan because it is not considered a compensatory plan.
The plan does not have a look-back feature, and has a minimal discount of 5% of
the fair market value of the common stock as of the end of each six-month
offering period.  Participation in the ESPP Plan is limited to 6% of
an employee’s compensation, may be terminated at any time by the employee and
automatically ends on termination of employment.  A total of 350,000
shares of common stock have been reserved for issuance.  As of
December 31, 2008 there were 132,660 shares available for future issuance under
the ESPP Plan.  We issued 2,362, 2,465, and 2,320 common shares under
the ESPP Plan in 2008, 2007, and 2006, respectively.
 
 Stockholder
Rights Plan - In October 2001, our board of directors adopted a
stockholder rights plan and declared a dividend distribution of one share
purchase right (a "Right") for each outstanding share of our common stock to
stockholders of record at the close of business on October 15,
2001.  Each share of common stock issued after that date also will
carry with it one Right, subject to certain exceptions.  Each Right,
when it becomes exercisable, will entitle the record holder to purchase from us
one ten-thousandth of a share of series A preferred stock at an exercise price
of $40.00 subject to adjustment.
 
 The
Rights become exercisable upon the earliest of the following dates: (i) the date
on which we first publicly announce that a person or group has become an
acquiring person, or (ii) the date, if any, that our board of directors may
designate following the commencement of, or first public disclosure of an intent
to commence, a tender or exchange offer which could result in the potential
buyer becoming a beneficial owner of 15% or more of our outstanding common
stock.  Under these circumstances, holders of Rights will be entitled
to purchase, for the exercise price, the preferred stock equivalent of common
stock having a market value of two times the exercise price.  The
Rights expire on October 2, 2011, and may be redeemed by us for $.001 per
Right.
 
 49
 AWARE,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 On
September 6, 2007, our Board of Directors determined that it would be advisable
to amend the Rights Agreement to exempt John B. Stafford, Jr., John S. Stafford,
III, and James M. Stafford and their respective affiliates from the definition
of “Acquiring Person” in the Rights Agreement.  Accordingly, on
September 6, 2007, we executed Amendment No.1 to the Rights Agreement with
Computershare Trust Company, N.A. as successor rights agent to implement this
amendment.
 
 Share Repurchase
Program -On August 28, 2007, we announced a stock repurchase program to
purchase up to $5.0 million of our common stock, subject to market conditions
and other factors. Any purchases under our stock repurchase program may be made
from time to time without prior notice. On October 29, 2008, we announced that
the program had been amended to increase the total amount of common stock that
may be repurchased from $5.0 million to $10.0 million and to extend the period
of time that shares may be repurchased from December 31, 2008 to December 31,
2009. As of December 31, 2008, we had repurchased 721,131 shares of common
stock at a total cost of $2.4 million under this program.
   7.
              COMMITMENTS
      AND CONTINGENT LIABILITIES
  Lease
Commitments – We own our principal office and research facility in
Bedford, Massachusetts, which we have occupied since November
1997.  We conduct a portion of our activities in a leased facility in
California under a non-cancelable operating lease that expires in 2010. The
following is a schedule of future minimum rental payments (in
thousands):
  Year ended December 31,2009
                              
                              $
                              132010
                              
                              
                              9Total
      minimum lease payments
                              
                              $
                              22
 
 Rental
expense was approximately $21,000, $34,000, and $26,000 in 2008, 2007 and 2006,
respectively.
  Litigation
- There are no material pending legal proceedings to which we are a party or to
which any of our properties are subject which, either individually or in the
aggregate, are expected to have a material adverse effect on our business,
financial position or results of operations.
  Guarantees and
Indemnification Obligations–We enter into agreements in
the ordinary course of business that require us: i) to perform under the terms
of the contracts, ii) to protect the confidentiality of our customers’
intellectual property, and iii) to indemnify customers, including
indemnification against third party claims alleging infringement of intellectual
property rights.  We also have agreements with each of our directors
and executive officers to indemnify such directors or executive officers, to the
extent legally permissible, against all liabilities reasonably incurred in
connection with any action in which such individual may be involved by reason of
such individual being or having been a director or officer of the
Company.
  Given the
nature of the above obligations and agreements, we are unable to make a
reasonable estimate of the maximum potential amount that we could be required to
pay.  Historically, we have not made any significant payments on the
above guarantees and indemnifications and no amount has been accrued in the
accompanying consolidated financial statements with respect to these guarantees
and indemnifications.
  50
 AWARE,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 
 8.
              BUSINESS
      SEGMENTS AND MAJOR CUSTOMERS
  We manage
the business as one segment and conduct our operations in the United States. We
sell our products and technology to domestic and international
customers.  Revenues were generated from the following geographic
regions (in thousands):
  Year
      ended December 31,2008
                          
                          
                          2007
                          
                          
                          2006United
      States
                          
                          $
                          24,070
                          
                          
                          $
                          15,508
                          
                          
                          $
                          12,797Germany
                          
                          
                          4,881
                          
                          
                          
                          5,759
                          
                          
                          
                          6,630Rest
      of world
                          
                          
                          1,566
                          
                          
                          
                          5,170
                          
                          
                          
                          4,629$
                          30,517
                          
                          
                          $
                          26,437
                          
                          
                          $
                          24,056
 
  The
portion of total revenue that was derived from major customers was as
follows:
  Year
      ended December 31,2008
                          
                          
                          2007
                          
                          
                          2006Customer
      A
                          
                          
                          28
                          %
                          
                          
                          -
                          
                          
                          
                          -Customer
      B
                          
                          
                          12
                          %
                          
                          
                          19
                          %
                          
                          
                          26
                          %Customer
      C
                          
                          
                          10
                          %
                          
                          
                          -
                          
                          
                          
                          -Customer
      D
                          
                          
                          4
                          %
                          
                          
                          16
                          %
                          
                          
                          2
                          %Customer
      E
                          
                          
                          1
                          %
                          
                          
                          10
                          %
                          
                          
                          1
                          %Customer
      F
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          20
                          %
 
  9.
              EMPLOYEE
      BENEFIT PLAN
  In 1994,
we established a qualified 401(k) Retirement Plan (the “Plan”) under which
employees are allowed to contribute certain percentages of their pay, up to the
maximum allowed under Section 401(k) of the Internal Revenue
Code.  Our contributions to the Plan are at the discretion of the
Board of Directors.  Our contributions were approximately $326,000,
$297,000, and $316,000 in 2008, 2007 and 2006, respectively.
 
 10.
              NET
      INCOME PER SHARE
  Net
income per share is calculated as follows (in thousands, except per share
data):
  Year
      ended December 31,2008
                              
                              
                              2007
                              
                              
                              2006Net
      income
                              
                              $
                              1,776
                              
                              
                              $
                              160
                              
                              
                              $
                              1,034Weighted
      average common shares outstanding
                              
                              
                              23,638
                              
                              
                              
                              23,738
                              
                              
                              
                              23,474Additional
      dilutive common stock equivalents
                              
                              
                              59
                              
                              
                              
                              1,346
                              
                              
                              
                              1,491Diluted
      shares outstanding
                              
                              
                              23,697
                              
                              
                              
                              25,084
                              
                              
                              
                              24,965Net
      income per share –
      basic
                              
                              $
                              0.08
                              
                              
                              $
                              0.01
                              
                              
                              $
                              0.04Net
      income per share –
      diluted
                              
                              $
                              0.07
                              
                              
                              $
                              0.01
                              
                              
                              $
                              0.04
 
 For the
years ended December 31, 2008, 2007 and 2006, options to purchase 6,739,957,
2,471,025, and 2,423,242 shares of common stock at weighted average exercise
prices of $4.89, $7.13, and $7.18 per share, respectively, were outstanding, but
were not includedin
the computation of diluted EPS because the options’ exercise prices were greater
than the average market price of the common shares and thus would be
anti-dilutive.
 
 51
 AWARE,
INC.
 NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS
 
  11.
              QUARTERLY
      RESULTS OF OPERATIONS - UNAUDITED
 
 The
following table presents unaudited quarterly operating results for each of our
quarters in the two-year period ended December 31, 2008 (in thousands, except
per share data):
 
 2008
      Quarters EndedMarch
      31
                            
                            
                            June
      30
                            
                            
                            September
      30
                            
                            
                            December
      31Revenue
                            
                            $
                            5,876
                            
                            
                            $
                            6,167
                            
                            
                            $
                            6,390
                            
                            
                            $
                            12,084Gross
      profit
                            
                            
                            4,034
                            
                            
                            
                            4,414
                            
                            
                            
                            4,497
                            
                            
                            
                            10,803Income
      (loss) from operations
                            
                            
                            (1,656
                            )
                            
                            
                            (1,568
                            )
                            
                            
                            (904
                            )
                            
                            
                            4,757Net
      income (loss)
                            
                            
                            (1,282
                            )
                            
                            
                            (1,257
                            )
                            
                            
                            (663
                            )
                            
                            
                            4,978Net
      income (loss) per share – basic
                            
                            $
                            (0.05
                            )
                            
                            $
                            (0.05
                            )
                            
                            $
                            (0.03
                            )
                            
                            $
                            0.21Net
      income (loss) per share – diluted
                            
                            $
                            (0.05
                            )
                            
                            $
                            (0.05
                            )
                            
                            $
                            (0.03
                            )
                            
                            $
                            0.21
 
 2007
      Quarters EndedMarch
      31
                            
                            
                            June
      30
                            
                            
                            September
      30
                            
                            
                            December
      31Revenue
                            
                            $
                            5,800
                            
                            
                            $
                            6,429
                            
                            
                            $
                            7,456
                            
                            
                            $
                            6,753Gross
      profit
                            
                            
                            3,952
                            
                            
                            
                            3,329
                            
                            
                            
                            5,002
                            
                            
                            
                            4,732Income
      (loss) from operations
                            
                            
                            (593
                            )
                            
                            
                            (1,464
                            )
                            
                            
                            529
                            
                            
                            
                            (300
                            )Net
      income (loss)
                            
                            
                            (98
                            )
                            
                            
                            (968
                            )
                            
                            
                            1,034
                            
                            
                            
                            193Net
      income (loss) per share – basic
                            
                            $
                            0.00
                            
                            
                            $
                            (0.04
                            )
                            
                            $
                            0.04
                            
                            
                            $
                            0.01Net
      income (loss) per share – diluted
                            
                            $
                            0.00
                            
                            
                            $
                            (0.04
                            )
                            
                            $
                            0.04
                            
                            
                            $
                            0.01
 
 
 Quarterly
amounts may not sum to annual amounts due to rounding and dilution.
 
 52
 FINANCIAL
STATEMENT SCHEDULE
 
 
 Schedule
II - Valuation and Qualifying Accounts – Years ended December 31, 2008, 2007,
and 2006
 (in
thousands)
 
 
 Col.
      A
                                                            
                                                            Col.
      B
                                                            
                                                            
                                                            Col.
      C(1)
                                                            
                                                            
                                                            Col.
      C(2)
                                                            
                                                            
                                                            Col.
      D
                                                            
                                                            
                                                            Col.
      EAdditionsBalance
      at
                                                            
                                                            
                                                            Charged
      to
                                                            
                                                            
                                                            Charged
                                                            
                                                            
                                                            Deductions
                                                            
                                                            
                                                            BalanceBeginning
                                                            
                                                            
                                                            Costs
      and
                                                            
                                                            
                                                            to
      Other
                                                            
                                                            
                                                            Charged
      to
                                                            
                                                            
                                                            at
      Endof
      Period
                                                            
                                                            
                                                            Expenses
                                                            
                                                            
                                                            Accounts
                                                            
                                                            
                                                            Reserves
                                                            
                                                            
                                                            of
      PeriodAllowance
      for doubtful
                                                              accounts
      receivable:2008
                                                            
                                                            $
                                                            55
                                                            
                                                            
                                                            $
                                                            (25
                                                            )
                                                            
                                                            $
                                                            -
                                                            
                                                            
                                                            $
                                                            -
                                                            
                                                            
                                                            $
                                                            302007
                                                            
                                                            $
                                                            97
                                                            
                                                            
                                                            $
                                                            (20
                                                            )
                                                            
                                                            
                                                            -
                                                            
                                                            
                                                            $
                                                            22
                                                            
                                                            
                                                            $
                                                            552006
                                                            
                                                            $
                                                            97
                                                            
                                                            
                                                            
                                                            -
                                                            
                                                            
                                                            
                                                            -
                                                            
                                                            
                                                            
                                                            -
                                                            
                                                            
                                                            $
                                                            97Inventory
      reserves:2008
                                                            
                                                            $
                                                            409
                                                            
                                                            
                                                            $
                                                            316
                                                            
                                                            
                                                            $
                                                            13
                                                            
                                                            
                                                            $
                                                            -
                                                            
                                                            
                                                            $
                                                            7382007
                                                            
                                                            $
                                                            313
                                                            
                                                            
                                                            $
                                                            102
                                                            
                                                            
                                                            
                                                            -
                                                            
                                                            
                                                            $
                                                            6
                                                            
                                                            
                                                            $
                                                            4092006
                                                            
                                                            $
                                                            284
                                                            
                                                            
                                                            $
                                                            29
                                                            
                                                            
                                                            
                                                            -
                                                            
                                                            
                                                            
                                                            -
                                                            
                                                            
                                                            $
                                                            313Warranty
      reserves:2008
                                                            
                                                            $
                                                            0
                                                            
                                                            
                                                            $
                                                            118
                                                            
                                                            
                                                            $
                                                            -
                                                            
                                                            
                                                            $
                                                            -
                                                            
                                                            
                                                            $
                                                            1182007
                                                            
                                                            $
                                                            0
                                                            
                                                            
                                                            
                                                            -
                                                            
                                                            
                                                            
                                                            -
                                                            
                                                            
                                                            
                                                            -
                                                            
                                                            
                                                            $
                                                            02006
                                                            
                                                            $
                                                            0
                                                            
                                                            
                                                            
                                                            -
                                                            
                                                            
                                                            
                                                            -
                                                            
                                                            
                                                            
                                                            -
                                                            
                                                            
                                                            $
                                                            0Deferred
      tax asset
                                                              valuation
      allowance:2008
                                                            
                                                            $
                                                            42,825
                                                            
                                                            
                                                            $
                                                            -
                                                            
                                                            
                                                            $
                                                            (344
                                                            )
                                                            
                                                            $
                                                            -
                                                            
                                                            
                                                            $
                                                            42,4812007
                                                            
                                                            $
                                                            43,772
                                                            
                                                            
                                                            
                                                            -
                                                            
                                                            
                                                            $
                                                            (947
                                                            )
                                                            
                                                            
                                                            -
                                                            
                                                            
                                                            $
                                                            42,8252006
                                                            
                                                            $
                                                            42,977
                                                            
                                                            
                                                            
                                                            -
                                                            
                                                            
                                                            $
                                                            795
                                                            
                                                            
                                                            
                                                            -
                                                            
                                                            
                                                            $
                                                            43,772
  53
  ITEM
9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
 
 Not
applicable.
 
 
 ITEM
9A.  CONTROLS AND PROCEDURES
 
 Conclusion
Regarding the Effectiveness of Disclosure Controls and Procedures
 
 Under the
supervision and with the participation of our management, including our chief
executive officer and chief financial officer, we conducted an evaluation of our
disclosure controls and procedures, as such term is defined under Rule 13a-15(e)
promulgated under the Securities Exchange Act of 1934, as amended (the Exchange
Act).  Based on this evaluation, our chief executive officer and chief
financial officer concluded that our disclosure controls and procedures were
effective as of the end of the period covered by this annual
report.
 
 Evaluation
of Changes in Internal Control Over Financial Reporting
 
 Under the
supervision and with the participation of our management, including our chief
executive officer and chief financial officer, we concluded that there were no
changes in our internal control over financial reporting that occurred during
the quarterly period ended December 31, 2008 that have materially affected, or
are reasonably likely to materially affect, our internal control over financial
reporting.
 
 Management’s Report on Internal
Control Over Financial Reporting
 
 Our
management is responsible for establishing and maintaining adequate internal
control over financial reporting, as such term is defined in Exchange Act
Rule 13a-15(f). Under the supervision and with the participation of our
management, including our principal executive officer and principal financial
officer, we conducted an evaluation of the effectiveness of our internal control
over financial reporting based on the framework in Internal Control - Integrated
Frameworkissued by the Committee of Sponsoring Organizations of the
Treadway Commission. Based on our evaluation under the framework in Internal Control — Integrated
Framework, our management concluded that our internal control over
financial reporting was effective as of December 31, 2008.
 
 The
effectiveness of our internal control over financial reporting as of
December 31, 2008 has been audited by PricewaterhouseCoopers LLP, an
independent registered public accounting firm, as stated in their report which
is included herein.
 
 ITEM
9B.  OTHER INFORMATION
 
 None.
  54
 PART
III
 
 
 ITEM
10.  DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE
GOVERNANCE
 
 The
information required by Item 10 of Form 10-K is incorporated by reference from
the information contained in the sections captioned “Directors and Executive Officers”,
“Corporate Governance” and “Section 16(a) Beneficial Ownership Reporting
Compliance”in the Proxy Statement that will be delivered to our
shareholders in connection with our May 20, 2009 Annual Meeting of
Shareholders.
 
 ITEM
11.  EXECUTIVE COMPENSATION
 
 The
information required by Item 11 of Form 10-K is incorporated by reference from
the information contained in the section captioned “Executive Compensation” in
the Proxy Statement that will be delivered to our shareholders in connection
with our May 20, 2009 Annual Meeting of Shareholders.
 
 ITEM
12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
AND RELATED STOCKHOLDER MATTERS
 
 The
information required by Item 12 of Form 10-K is incorporated by reference from
the information contained in the section captioned “Security Ownership of Certain
Beneficial Owners and Management and Related Stockholder Matters” in the
Proxy Statement that will be delivered to our shareholders in connection with
our May 20, 2009 Annual Meeting of Shareholders.
  ITEM
13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR
INDEPENDENCE
 
 The
information, if any, required by Item 13 of Form 10-K is incorporated by
reference from the information contained in the sections captioned “Corporate Governance”
and“Certain Relationships and
Related Transactions” in the Proxy Statement that will be delivered to
our shareholders in connection with our May 20, 2009 Annual Meeting of
Shareholders.
  ITEM
14.  PRINCIPAL ACCOUNTANT FEES AND SERVICES
 
 The
information required by Item 14 of Form 10-K is incorporated by reference from
the information contained in the section captioned “Independent Accountants” in
the Proxy Statement that will be delivered to our shareholders in connection
with our May 20, 2009 Annual Meeting of Shareholders.
 
 55
 PART
IV
 
 ITEM
15.  EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
  The
following documents are filed as part of this report:
 
 (a)Financial Statements and
Exhibits:
 Page(1)
      Report of Independent Registered Public Accounting
      Firm
                        35Consolidated
      Balance Sheets as of December 31, 2008 and 2007
                        36Consolidated
      Statements of Operations for each of the three
                          years
      in the period ended December 31,
      2008
                        37Consolidated
      Statements of Cash Flows for each of the
                          three
      years in the period ended December 31, 2008
                        38Consolidated
      Statements of Stockholders’ Equity for each of
                          the
      three years in the period ended December 31, 2008
                        39Notes
      to Consolidated Financial Statements
                        40(2)
      Schedule II - Valuation and Qualifying
      Accounts
                        53(3)
      Exhibits:
 
 The
exhibits listed below are filed with or incorporated by reference in this
report.
 
 Exhibit No.
                            Description of Exhibit3.1
                            Amended
      and Restated Articles of Organization, as amended.3.2
                            Amended
      and Restated By-Laws (filed as Exhibit 3.1 to the Company’s Form 8-K filed
      with the Securities and Exchange Commission on December 10, 2007 and
      incorporated herein by reference).4.1
                            Rights
      Agreement dated as of October 2, 2001 between Aware, Inc. and Equiserve
      Trust Company, N.A., as Rights Agent (filed as Exhibit 4(a) to the
      Company’s Form 8-K filed with the Securities and Exchange Commission on
      October 3, 2001 and incorporated herein by reference).4.2
                            Terms
      of Series A Participating Cumulative Preferred Stock of Aware, Inc.
      (attached as Exhibit A to the Rights Agreement filed as Exhibit 4.1
      hereto).4.3
                            Form
      of Right Certificate (attached as Exhibit B to the Rights Agreement filed
      as Exhibit 4.1 hereto).4.4
                            Amendment
      No. 1 to Rights Agreement dated September 6, 2007 between Aware, Inc. and
      Computershare Trust Company, N.A., as Rights Agent (filed as Exhibit 4.1
      to the Company’s Form 8-K filed with the Securities and Exchange
      Commission on September 7, 2007 and incorporated herein by
      reference).10.1*
                            1996
      Stock Option Plan, as amended and restated (filed as Annex A to the
      Company’s Definitive Proxy Statement filed with the Securities and
      Exchange Commission on April 11, 2000 and incorporated herein by
      reference).10.2*
                            1996
      Employee Stock Purchase Plan, as amended and restated (filed as Exhibit
      99.1 to the Company’s Current Report on Form 8-K filed with the Securities
      and Exchange Commission on November 29, 2005 and incorporated herein by
      reference).10.3*
                            Form
      of Director and Officer Indemnification Agreement (filed as Exhibit 10.4
      to the Company’s Form 10-K for the year ended December 31, 2002 and
      incorporated herein by reference).10.4*
                            2001
      Nonqualified Stock Plan (filed as Exhibit 99(d)(4) to the Company’s
      Schedule TO filed with the Securities and Exchange Commission on March 3,
      2003 and incorporated herein by reference).10.5*
                            Form
      of Nonqualified Stock Option Agreement under the 2001 Nonqualified Stock
      Plan for options granted to executive officers and directors prior to May
      21, 2008 (filed as Exhibit 10.6 to Company’s Form 10-K for the year ended
      December 31, 2006 and incorporated herein by
reference).10.6*
                            Form
      of Nonqualified Stock Option Agreement under the 2001 Nonqualified Stock
      Plan for options granted to executive officers and directors from and
      after May 21, 2008 (filed as Exhibit 10.8 to Company’s Form 8-K on May 22,
      2008 and incorporated herein by
reference)
  56
  10.7*
                                      Offer
      letter dated December 17, 2007 by and between Richard Moberg and Aware,
      Inc. (filed as Exhibit 99.2 to Company’s Form 8-K filed with the
      Securities and Exchange Commission on December 18, 2007 and incorporated
      herein by reference).10.8*
                                      Consultant
      Agreement dated December 17, 2007 by and between Richard Moberg and Aware,
      Inc. (filed as Exhibit 99.3 to Company’s Form 8-K filed with the
      Securities and Exchange Commission on December 18, 2007 and incorporated
      herein by reference).21.1
                                      Subsidiaries
      of Registrant.23.1
                                      Consent
      of Independent Registered Public Accounting Firm.31.1
                                      Certification
      of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002.31.2
                                      Certification
      of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley
      Act of 2002.32.1
                                      Certification
      of Chief Executive Officer and Chief Financial Officer pursuant to Section
      906 of the Sarbanes-Oxley Act of
2002.
 *Management contract or
compensatory plan.
  57
 SIGNATURES
 
 Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
1934, the Registrant has duly caused this report to be signed on its behalf by
the undersigned, thereunto duly authorized.
  AWARE, INC.By:
                /s/ Michael
      A. TzannesMichael
      A. Tzannes, Chief Executive OfficerDate:
      February 13, 2009
 
 
 Pursuant
to the requirements of the Securities Exchange Act of 1934, this report has been
signed below by the following persons on behalf of the registrant and in the
capacities indicated on the 13th day of February 2009.
 
 
 
 Signature
              
              Title/s/
      Michael A. Tzannes
              
              Chief
      Executive Officer and DirectorMichael
      A. Tzannes
              
              (Principal
      Executive Officer)/s/
      Edmund C. Reiter
              
              President
      and DirectorEdmund
      C. Reiter/s/
      Richard P. Moberg
              
              Chief
      Financial OfficerRichard
      P. Moberg
              
              (Principal
      Financial and Accounting Officer)/s/
      John K. Kerr
              
              Chairman
      of the Board of DirectorsJohn
      K. Kerr/s/
      G. David Forney, Jr.
              
              DirectorG.
      David Forney, Jr./s/
      Adrian F. Kruse
              
              DirectorAdrian
      F. Kruse/s/
      Mark G. McGrath
              
              DirectorMark
      G. McGrath/s/
      Charles K. Stewart
              
              DirectorCharles
      K. Stewart
  
 58