**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, 2006**


**COMMISSION
      FILE NUMBER 000-21295**





**GVI
      SECURITY SOLUTIONS, INC.**


(Name
      of
      Business Issuer in Its Charter)


**Delaware**
              (State
                or Other Jurisdiction of Incorporation or Organization)
            **77-0436410**
              (I.R.S.
                Employer identification number)


**2801
      Trade Center Drive, Suite 120**


**Carrollton,
      Texas 75007**


**(972)
      245-7353**


(Address,
      including zip code, and telephone number,


including
      area code, of registrant’s principal executive offices)





**Securities
      registered pursuant to Section 12(b) of the Act: None**





**Securities
      registered pursuant to Section 12(g) of the Act: Common Stock
      $0** . **001
      par value**





Indicate
      by check mark whether the registrant is a well-know seasoned issuer (as defined
      in Rule 405 of the Securities Act.)  ̈ Yes   þ No




Indicate
      by check mark if the registrant is not required to file reports pursuant to
      Section 13 or 15 (d) of the Exchange Act.  ̈ Yes   þ No





Indicate
      by check mark whether the registrant: (1) has filed all reports required to
      be
      filed by Section 13 or 15(d) of the Exchange Act during the past 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.


þ Yes  ̈ No




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.  ̈




Indicate
      by check mark whether the registrant is a large accelerated filer, an
      accelerated filer, or a non-accelerated files. See definition of "accelerated
      filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check
      one):




Large
                accelerated filer ̈
            Accelerated
                filer ̈
            Non-accelerated
                filerþ






Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act.)       ̈ Yes   þ No




The
      aggregate market value of the voting and non-voting common equity held by
      non-affiliates of the registrant as of June 30, 2006 was approximately
      $8,632,050. The number of shares outstanding of the registrant’s Common Stock as
      of March 23, 2007 was 28,006,164.












**GVI
      SECURITY SOLUTIONS, INC** .


**2006
      FORM 10-K ANNUAL REPORT**


**TABLE
      OF CONTENTS**




PagePART
                I
            2Item
                1. Business
            2Item
                1A. Risk Factors
            6Item
                1B. Unresolved Staff Comments
            12Item
                2. Properties
            12Item
                3. Legal Proceedings
            12Item
                4. Submission of Matters to a Vote of Security Holders
            12PART
                IIItem
                5. Market for Registrant’s Common Equity, Related Stockholder Matters and
                Issuer Purchases of Equity Securities
            13Item
                6. Selected Financial Data
            14Item
                7. Management’s Discussion and Analysis of Plan of
                Operation
            15Item
                7A. Quantitative and Qualitative Disclosures about Market
                Risk
            26Item
                8. Financial Statements and Supplementary Data
            26Item
                9. Changes in and Disagreements With Accountants on Accounting and
                Financial Disclosure
            27Item
                9A. Controls and Procedures
            27Item
                9B. Other Information
            27PART
                IIIItem
                10. Directors, Executive Officers and Corporate Governance
            27Item
                11. Executive Compensation
            29Item
                12. Security Ownership of Certain Beneficial Owners and Management
                and
                Related Stockholder Matters
            38Item
                13. Certain Relationships and Related Transactions, and Director
                Independence
            40Item
                14. Principal Accountant Fees and Services
            41PART
                IVItem
                15. Exhibits, Financial Statement Schedules
            42









**CAUTIONARY
      NOTE REGARDING FORWARD-LOOKING STATEMENTS**




***This
      annual report on Form 10-K contains forward-looking statements relating to
      future events and our future performance within the meaning of Section 27A
      of
      the Securities Act of 1933, as amended, and Section 21E of the Securities
      Exchange Act of 1934, as amended, including, without limitation, statements
      regarding our expectations, assumptions, estimates, projections, beliefs,
      intentions or future strategies that are signified by the words “expects”,
“anticipates”, “intends”, “believes” or similar language. Actual results could
      differ materially from those anticipated in such forward-looking statements.
      All
      forward-looking statements included in this document are based on information
      available to us on the date hereof.***




**PART
      I**




**Item
      1. Business.** ****




**Overview**




Through
      our subsidiaries, we provide video surveillance and security solutions products, incorporating
      a complete line of video surveillance and detection systems, to the homeland
      security, professional and business-to-business market segments .
      We provide
      a
      strong combination of closed
      circuit televisions ( CCTVs),
      digital video recorders (DVRs), software
      systems and networking products that
      enhance life safety for both government agencies and the private sector.




Our
      customers include distributors and system integrators that specialize in video
      surveillance and security products and services, government agencies and private
      sector businesses. Our technology is available to the United States Government
      through a General Services Administration (GSA) contract.




Historically,
      Samsung Electronics has been the primary supplier of the security products
      that
      we distribute. We previously sold Samsung’s products under an agreement with
      Samsung that gave us the exclusive right to sell its products to the
      professional channel and to a major national retailer. Our
      exclusive agreement to distribute Samsung products to this retailer expired
      on
      December 31, 2005, and Samsung terminated our exclusive right to sell to the
      professional market in January 2006. As a result of the termination of this
      agreement and the decline in sales of our products in the retail channel, we
      discontinued sales of security products to the retail channel. We continue
      to
      sell Samsung security products to the professional market, and in October
      2006, we entered into a new agreement with Samsung under which we have been
      granted the right to distribute Samsung’s complete line of professional video
      surveillance and security products in North, Central and South America through
      December 31, 2010. Samsung has agreed to a limited non-compete in these
      territories.




We
      operate sales and distribution centers in Dallas, Texas, Mexico City, Mexico,
      Sao Paulo, Brazil and Bogotá, Colombia.




**Corporate
      History**




We
      were
      incorporated in Delaware in August 1996 as Thinking Tools, Inc. and initially
      engaged in developing and marketing business simulation software. In April
      1999,
      we eliminated substantially all of our operations and terminated substantially
      all of our personnel. In March 2000, we acquired the business of an Internet
      software and service provider. This business did not generate sufficient
      revenues to support our operations and was discontinued in December 2000.




From
      December 2000 until February 20, 2004, we had no active business. On February
      20, 2004, pursuant to an Agreement and Plan of Merger, GVI Security, Inc.,
      a
      Delaware corporation, merged with our newly-formed wholly-owned subsidiary,
      GVI
      Security Acquisition Corp., becoming our wholly owned subsidiary, and on April
      12, 2004, we changed our name to GVI Security Solutions, Inc.




On
      December 1, 2004, we acquired Rapor, Inc. in a merger for shares of our Common
      Stock. Rapor designs and manufactures high security building access portals.
      Management has concluded that the Rapor product


2




line
      no
      longer fits our existing distribution channels and market strategy and,
      accordingly, during the third quarter of 2006, wrote-off goodwill, trademarks and technology associated with this product
      line.
      We are currently evaluating opportunities to dispose of our Rapor products,
      and
      have discussed the licensing and/or sale of this business line with several
      parties.




On
      October 6, 2006, we completed a $5 million private placement, consisting of
      100
      Units at a price of $50,000 per unit. Each Unit consisted of 25,000 shares
      of
      Common Stock and a 6% Subordinated Secured Convertible Promissory Note in the
      principal amount of $45,000, convertible into 225,000 shares of Common Stock
      at
      a conversion price equal to $.20. On November 27, 2006, we effected a 50-for-1
      reverse stock split of the Common Stock, and all of the Convertible Notes
      (including approximately $40,460 of accrued interest) were converted to Common
      Stock. After giving effect to the reverse split and the conversion, we had
      outstanding 26,392,834 shares of Common Stock, of which 25,202,314 were issued
      to the purchasers of the Units (2,500,000 on the closing of the October 2006
      private placement and 22,702,314 upon conversion of the Convertible Notes in
      November 2006).




**Security
      Systems Markets**




According
      to a recent industry report, the combined market for the world video
      surveillance market totaled approximately $4.1 billion in 2003, and is estimated
      to grow to approximately $8.6 billion by the year 2010. According to this
      report, the global security market is expected to continue to grow at an average
      annual rate in excess of 9%, with the primary components of this growth being
      electronic integrated security systems. We believe that video surveillance
      products represent the largest components of a typical integrated security
      system. The industry continues to see significant growth throughout the world
      fueled by increased fear of terrorism and crime, heightened expectation of
      safety in public places and institutions, and higher expectations of
      performance, reliability and architectural appeal.




Video
      surveillance has undergone significant changes over the last few years, from
      the
      introduction of affordable digital cameras to the birth of digital recording.
      Cost effective digital video recorders (DVR) have enabled a shift from human
      surveillance to more sophisticated computer-driven surveillance that utilizes
      archiving, data mining and artificial intelligence with predictive behavior
      algorithms. A DVR is a computer with special interface cards that accepts camera
      input and converts video signals to digital data and stores this data on the
      hard disk drive of the computer. The benefits of the DVR are its capacity to
      store large volumes of data, the clarity of its pictures, the lack of distortion
      of images and its capability to perform rapid searches based upon certain
      pre-defined parameters. We believe that over the next few years we will see
      a
      full shift in the video surveillance segment of the electronic security systems
      industry from analog to digital equipment.




**Strategies**




Our
      objective is to provide our customers and partners with a wide range of security
      products designed to meet the specific needs of the end user. Our goal is to
      provide our customers with excellent service and superior technology at
      competitive prices. Our customers consist of wholesale distributors as well
      as
      security system installers and IT integrators.




We
      believe that by delivering the highest levels of customer service, we can
      strengthen our reputation as a reliable and cost-effective provider in the
      electronic security systems industry and develop customer loyalty. We strive
      to
      anticipate and meet our customers’ needs by increasing the range of products and
      services we offer by entering into new business alliances and by pursuing
      acquisitions of complementary businesses enabling us to offer new products
      and
      services. Our goals include further developing our expertise and products in
      the
      digital video recording sector, as well as developing other products and
      services to supplement and complement our existing product line, with a focus
      on
      increasing sales of our products in the Professional Channel, which typically
      generate higher gross margins than Retail Channel sales, which we recently
      discontinued. Further, we intend to grow our business by expanding and
      diversifying our distribution channels and capitalizing on domestic and
      international expansion opportunities.




Our
      growth strategy also includes identifying and acquiring businesses engaged
      in
      similar or complementary industries. However, there can be no assurance that
      we
      will consummate any additional acquisitions


3




or
      that
      any business we acquire will be successful. In addition, the acquisition of
      a
      business through the issuance of our securities will result in dilution to
      our
      existing stockholders.




**Products
      and Services**




We
      are
      committed to setting new standards in quality, performance and value by
      providing highly functional and competitive integrated security products. We
      offer a range of video surveillance and security systems to our customers,
      including products that can be used on a stand-alone basis or that can be
      integrated into a larger more sophisticated security system. We serve the
      import, support, marketing, inventory, warranty and distribution needs of our
      customers.




***Products***




Our
      objective is to provide complete security solutions for our customers by
      providing a suite of fully-integrated products. We sell the following products
      separately and as part of our fully integrated suite of video surveillance
      and
      integrated security solutions:




·
            a
                full line of black and white and color cameras, which include motion
                detection, low light day/night and high resolution, all with systems
                integration capabilities




·
            a
                range of waterproof and weather resistant
                cameras




·
            high
                speed, remote controlled, dome and pinhole cameras and
                casings




·
            a
                complete range of lenses




·
            a
                range of black and white, color, plasma and flat screen
                monitors




·
            real
                time and time lapse videocassette and digital recorders and hard
                disk
                recorders




·
            video
                transmission equipment




·
            digital
                video processors and recorders, switchers and video management
                systems




·
            digital
                video recording software




·
            hardware
                and software which enable intelligent video
                surveillance.




We
      rely
      on original equipment manufacturer relationships for a number of our standard
      products. In some instances, we purchase products that meet our specifications
      from a manufacturer and distribute these products under the GVI TM label.
      When assembly of our products is required, it is done in our Dallas, Texas
      facility.




***Customer
      Support***




We
      believe that our ability to establish and maintain long-term relationships
      with
      our customers and differentiate ourselves from the competition depends
      significantly on the strength of our customer support operations and staff.
      We
      operate customer support centers in Dallas, Texas, Mexico City, Mexico, Sao
      Paulo, Brazil and Bogotá, Colombia and also utilize a number of independent
      service providers in the other territories that we service.




**Distribution
      and Marketing**




We
      offer
      our products and services through local, regional and national system
      integrators and distributors who resell our products to professional security
      providers. System integrators utilize our products to develop and install a
      fully integrated security suite for end users. We also utilize regional sales
      executives who often support


4




sales
      across all of our product offerings. We use a combination of our internal sales
      force and independent representatives to sell our products to dealers and
      systems integrators.




**Competition**




The
      electronic security systems industry is highly competitive and has become more
      so over the last several years as security issues and concerns have become
      a
      primary consideration at both government and private facilities worldwide.
      Competition is intense among a wide range and fragmented group of product and
      service providers, including electronic security equipment manufacturers,
      distributors, providers of integrated security systems, systems integrators,
      and
      others that provide competitive systems or individual elements of a system.




We
      believe that the range of our product and service offerings and our distribution
      channels enable us to compete favorably in the market for the security products
      and services that we offer. However, some of our competitors have greater name
      recognition, longer operational histories and greater financial, marketing
      and
      managerial resources than we do.




The
      key
      factors which drive competition in the video surveillance and security industry
      are price, quality, product performance, ease of integration and customer
      service and support. There are a number of distributors of highly sophisticated,
      technologically advanced security components. Very few of these distributors,
      however, offer fully integrated security suites that can be customized to meet
      the specific needs of the end user. We believe that we have distinguished
      ourselves in this market by providing our customers with superior levels of
      customer service. Our main competitors are Pelco, Sony, Panasonic and Speco
      Technologies, among many others.




In
      addition, Samsung Techwin, a company distinct from Samsung Electronics but
      related through common ownership, manufactures electronic security products
      that
      are competitive with the Samsung Electronics products we sell. Samsung Techwin
      distributes its products in the United States through Samsung 360, a competitor
      of ours.




**Strategic
      Vendor Relationship**




Historically,
      Samsung Electronics has been our primary supplier for the security products
      that
      we distribute. For the years ended December 31, 2006, 2005 and 2004, 67%, 50%
      and 68%, respectively, of our revenues (excluding revenues from discontinued
      operations), were attributable to products manufactured by Samsung whose
      products we sold under an agreement that gave us the exclusive right to sell
      its
      products in the Professional Channel and the exclusive right to sell its
      products in the Retail Channel to a major national retailer. Our exclusive
      right
      to sell Samsung products to the major national retailer expired on December
      31,
      2005, and Samsung terminated the remaining portion of its agreement with us
      in
      January 2006. Samsung was entitled to terminate the distribution agreement
      because we did not purchase the minimum amounts required to be purchased
      thereunder during the 2005 calendar year. Following the termination of our
      agreement with Samsung, our Board of Directors approved the discontinuation
      of
      sales to the Retail Channel.




On
      October 2, 2006, we entered into a new Distributorship Agreement with Samsung
      under which we have been granted the right to distribute Samsung’s complete line
      of professional video surveillance and security products in the “Territory”
comprising North, Central and South America through December 31, 2010. Pursuant
      to the Distributorship Agreement, Samsung has agreed to a limited non-compete
      in
      the Territory. The Distributorship Agreement provides for minimum annual
      purchase amounts of $21 million and $27 million for the years ending December
      31, 2006 and 2007, respectively. Samsung may terminate the Distributorship
      Agreement at any time if we do not purchase those annual amounts, as well as
      upon a breach of our other obligations thereunder. For the year ended December
      31, 2006, we purchased approximately $21.3 million under the Distributorship
      Agreement with Samsung.




We
      are
      also a party to distribution arrangements with other high technology
      manufacturers who supply us with other products such as digital video recorders,
      and internet and networking products.


5




**Intellectual
      Property**




We
      have
      several registered trademarks for “GVI” in connection with the products we
      sell.




**Employees**




As
      of
      March 23, 2007, we had approximately 42 full-time employees. None of our
      employees are represented by a labor union or are subject to
      collective-bargaining agreements. We believe that we maintain good relationships
      with our employees.





**Item
      1A. Risk Factors.**




**RISKS
      RELATED TO OUR INDUSTRY AND OUR BUSINESS**





**THE
      REPORT OF OUR INDEPENDENT AUDITORS ON OUR FINANCIAL STATEMENTS CONTAINS AN
      EXPLANATORY PARAGRAPH ON OUR ABILITY TO CONTINUE AS A GOING
      CONCERN.**





The
      report of our independent auditors contains an explanatory paragraph raising
      substantial doubt about our ability to continue as a going concern because
      of
      our history of operating losses and limited capital resources. Our financial
      statements do not include any adjustments that might result from the outcome
      of
      this uncertainty. We have taken steps to reduce our costs and increase sales
      of
      our professional products. Although we completed financings in October 2006
      and
      January 2007 raising approximately $6,028,000 of aggregate gross proceeds,
      if we
      are not successful in improving our operating results in the near term we may
      need to raise additional capital to finance our operations and sustain our
      business model. We may not be able to obtain additional financing on acceptable
      terms, or at all. In addition, any financing we obtain in the future may result
      in dilution to our existing stockholders.





**WE
      CONTINUE TO EXPERIENCE OPERATING LOSSES AND MAY INCUR ADDITIONAL OPERATING
      LOSSES IN THE FUTURE.**





We
      incurred a net loss of approximately $16.5 million for the year ended December
      31, 2006, as well as net losses of approximately $13.0 million and $7.2 million
      for the years ended December 31, 2005 and 2004, respectively. Our net losses
      have primarily resulted from increased administrative, accounting, finance
      and
      legal costs following our February 2004 merger, write-downs of both retail
      and
      professional channel inventory, returns of retail products previously sold
      by
      us, and write downs of goodwill and other assets associated with our Rapor
      products. Our 2006 loss included a $4.5 million non-cash charge from a
      beneficial conversion feature from a convertible note. We will not be profitable
      in the future unless we increase sales of our products and reduce our costs.
      Although we are taking steps to reduce our costs and increase sales of our
      products and have discontinued sales of retail products to focus on our higher
      margin professional products, there can be no assurance that we will be
      profitable in the future.





**WE
      HAVE DISCONTINUED SALES OF OUR PRODUCTS IN THE RETAIL CHANNEL, WHICH PREVIOUSLY
      CONSTITUTED A SIGNIFICANT PORTION OF OUR SALES.**





Historically,
      sales of our products in the Retail Channel have accounted for a large portion
      of our revenues. For the years ended December 31, 2005, 2004 and 2003, 25%,
      46%
      and 56% of our revenues, including revenues from discontinued operations, were
      from sales in the Retail Channel. However, over the last three quarters of
      2005,
      we had nominal sales of our products in the Retail Channel. Among other reasons,
      the decline in sales of our retail products resulted from the replacement of
      our
      products by the major national retailer that accounted for substantially all
      of
      our Retail Channel sales, with those manufactured by a competitor. In addition,
      our exclusive agreement to distribute Samsung products in the Retail Channel
      to
      this retailer expired on December 31, 2005. As a result, in the first quarter
      of
      2006 our board of directors approved the discontinuance of our sales to the
      Retail Channel so that we can focus our efforts on sales to the Professional
      Channel.


6





**A
      SUBSTANTIAL PORTION OF OUR BUSINESS HAS BEEN ATTRIBUTABLE TO A SINGLE
      SUPPLIER.**




Historically,
      Samsung Electronics has been our primary supplier for the security products
      that
      we distribute. For the years ended December 31, 2006, 2005 and 2004, 67%, 50%
      and 68%, respectively, of our revenues (excluding revenues from discontinued
      operations) were attributable to products manufactured by Samsung, whose
      products we sold under an exclusive distribution agreement. O ur
      exclusive agreement to distribute Samsung products in the Retail Channel to
      a
      major national retailer expired on December 31, 2005, and Samsung
      terminated the remaining portion of its agreement with us in January 2006.
      Samsung was entitled to terminate the distribution agreement because we did
      not
      purchase the minimum amounts required to be purchased thereunder during the
      2005
      calendar year. Following the termination of our agreement with Samsung, our
      Board of Directors approved the discontinuation of sales to the Retail
      Channel.




On
      October 2, 2006, we entered into a new Distributorship Agreement with Samsung
      under which we have been granted the right to distribute Samsung’s complete line
      of professional video surveillance and security products in the “territory”
comprising North, Central and South America through December 31, 2010. Pursuant
      to the Distributorship Agreement, Samsung has agreed to a limited non-compete
      in
      the territory. Although we consider our relationship with Samsung to be good,
      in
      the event we fail to purchase the minimum amount of products required under
      the
      Distribution Agreement or breach any other provision of the agreement, Samsung
      can again terminate its agreement with us and sell products to our competitors.
      Further, if Samsung fails to perform its obligations under the Distribution
      Agreement or we are unable to renew our agreement with Samsung, our business,
      financial condition and results of operations will be materially adversely
      affected. ****




**SAMSUNG
      SUBJECTS US TO CREDIT LIMITS, WHICH CAN LIMIT OUR ABILITY TO PURCHASE THEIR
      PRODUCTS AND SELL THOSE PRODUCTS TO OUR CUSTOMERS.**





Samsung
      sets credit limits with respect to amounts owed by us to Samsung for products
      purchased by us from Samsung. To the extent the amount we owe Samsung at a
      given
      time exceeds these limits, Samsung will not ship to us additional products
      unless we pay for those products in cash or provide Samsung with a letter of
      credit. During
      the third quarter of 2006, Samsung suspended shipment of products to us as
      a
      result of a reduction in our credit limit, causing us to maintain lower levels
      of inventory during the remainder of the year, negatively impacting our sales
      during the third and fourth quarter of 2006. In
      conjunction with our new agreement with Samsung that we entered into on October
      2, 2006, and our payment of $3 million for past-due amounts, Samsung resumed
      shipments to us. However,
      in the future, i f
      we
      exceed Samsung’s credit limits and have insufficient cash to purchase products
      from Samsung, we may be unable to meet the demands of our customers and our
      business and relationships with our customers may be materially adversely
      affected.





**IF
      WE ARE UNABLE TO RESPOND TO THE RAPID TECHNOLOGICAL CHANGES IN OUR INDUSTRY
      AND
      CHANGES IN OUR CUSTOMERS' REQUIREMENTS AND PREFERENCES, OUR BUSINESS, FINANCIAL
      CONDITION AND RESULTS OF OPERATIONS COULD BE MATERIALLY ADVERSELY
      AFFECTED.**





If
      we are
      unable, for technological, legal, financial or other reasons, to adapt in a
      timely manner to changing market conditions or customer requirements, we could
      lose customers and market share. The electronic security systems industry is
      characterized by rapid technological change. Sudden changes in customer
      requirements and preferences, the frequent introduction of new products and
      services embodying new technologies and the emergence of new industry standards
      and practices could render our existing products, services and systems obsolete.
      The emerging nature of products and services in the electronic security systems
      industry and their rapid evolution will require that we continually improve
      the
      performance, features and reliability of our products and services. Our success
      will depend, in part, on our ability:





·
            to
                enhance our existing products and
                services;




·
            to
                anticipate changing customer requirements by designing, developing,
                and
                launching new products and services that address the increasingly
                sophisticated and varied needs of our current and prospective customers;
                and





·
            to
                respond to technological advances and emerging industry standards
                and
                practices on a cost-effective and timely
                basis.




7




The
      development of additional products and services involves significant
      technological and business risks and requires substantial expenditures and
      lead
      time. If we fail to introduce products with new technologies in a timely manner,
      or adapt our products to these new technologies, our business, financial
      condition and results of operations will be adversely affected. We cannot assure
      you that even if we are able to introduce new products or adapt our products
      to
      new technologies that our products will gain acceptance among our customers.
      In
      addition, from time to time, we or our competitors may announce new products,
      product enhancements or technological innovations that have the potential to
      replace or shorten the life cycles of our products and that may cause customers
      to defer purchasing our existing products, resulting in inventory
      obsolescence.





**WE
      MAY NOT BE ABLE TO MAINTAIN OR IMPROVE OUR COMPETITIVE POSITION BECAUSE OF
      STRONG COMPETITION IN THE ELECTRONIC SECURITY SYSTEMS INDUSTRY, AND WE EXPECT
      THIS COMPETITION TO CONTINUE TO INTENSIFY.**





The
      electronic security systems industry is highly competitive and has become more
      so over the last several years as security issues and concerns have become
      a
      primary consideration at both government and private facilities worldwide.
      Competition is intense among a wide range and fragmented group of product and
      service providers, including electronic security equipment manufacturers,
      distributors, providers of integrated security systems, systems integrators,
      consulting firms and engineering and design firms and others that provide
      competitive systems or individual elements of a system. Some of our competitors
      are larger than us and possess significantly greater name recognition, assets,
      personnel, sales and financial resources. These entities may be able to respond
      more quickly to changing market conditions by developing new products and
      services that meet customer requirements or are otherwise superior to our
      products and services and may be able to more effectively market their products
      than we can because they have significantly greater financial, technical and
      marketing resources than we do. They may also be able to devote greater
      resources to the development, promotion and sale of their products than we
      can.
      Increased competition could require us to reduce our prices, result in our
      receiving fewer customers orders, and result in our loss of market share. We
      cannot assure you that we will be able to distinguish ourselves in a competitive
      market. To the extent that we are unable to successfully compete against
      existing and future competitors, our business, operating results and financial
      condition would be materially adversely affected.





**WE
      DEPEND ON OUR MANUFACTURERS, SOME OF WHICH ARE OUR SOLE SOURCE FOR SPECIFIC
      PRODUCTS. OUR BUSINESS AND REPUTATION WOULD BE SERIOUSLY HARMED IF THESE
      MANUFACTURERS FAIL TO SUPPLY US WITH THE PRODUCTS WE REQUIRE AND ALTERNATIVE
      SOURCES ARE NOT AVAILABLE.**





We
      have
      relationships with a number of manufacturers for the supply of our products.
      Our
      success depends in part on whether our manufacturers are able to fill the orders
      we place with them and in a timely manner. If any of our manufacturers fail
      to
      satisfactorily perform their contractual obligations or fill purchase orders
      we
      place with them, we may be required to pursue replacement manufacturer
      relationships. If we are unable to find replacements on a timely basis, or
      at
      all, we may be forced to either temporarily or permanently discontinue the
      sale
      of certain products and associated services, which could expose us to legal
      liability, loss of reputation and risk of loss or reduced profit. Although
      we
      continually evaluate our relationships with our manufacturers and plan for
      contingencies if a problem should arise with a manufacturer, finding new
      manufacturers that offer a similar type of product would be a complicated and
      time consuming process and we cannot assure you that if we ever need to find
      a
      new manufacturer for certain of our products we would be able to do so on a
      completely seamless basis, or at all. Our business, results of operation and
      reputation would be adversely impacted if we are unable to provide our products
      to our customers in a timely manner. ****





**WE
      HAVE SUBSTANTIAL INDEBTEDNESS TO LAURUS MASTER FUND SECURED BY SUBSTANTIALLY
      ALL
      OF OUR ASSETS. IF AN EVENT OF DEFAULT OCCURS UNDER THE SECURED NOTES ISSUED
      TO
      LAURUS, LAURUS MAY FORECLOSE ON OUR ASSETS AND WE MAY BE FORCED TO CURTAIL
      OUR
      OPERATIONS OR SELL SOME OR ALL OF OUR ASSETS TO REPAY THE
      NOTES.**





On
      May
      27, 2004, we borrowed $15,000,000 from Laurus pursuant to secured promissory
      notes and related agreements. Our indebtedness to Laurus as of December 31,
      2006
      was approximately $8.3 million. The notes and agreements provide for the
      following events of default (among others):


8




·
            failure
                to pay interest and principal when
                due,





·
            an
                uncured breach by us of any material covenant, term or condition
                in any of
                the notes or related agreements,





·
            a
                breach by us of any material representation or warranty made in any
                of the
                notes or in any related agreement,





·
            any
                money judgment or similar final process is filed against us for more
                than
                $250,000, and





·
            any
                form of bankruptcy or insolvency proceeding is instituted by or against
                us, and





·
            our
                Common Stock is suspended from our principal trading market for five
                consecutive days or five days during any ten consecutive
                days.





Upon
      the
      occurrence of an event of default under our agreements with Laurus, Laurus
      may
      enforce its rights as a secured party and we may lose all or a portion of our
      assets, be forced to materially reduce our business activities or cease
      operations. In addition, our obligations to Laurus become due on December 31,
      2007. We will not be able to repay our obligations to Laurus at maturity unless
      we receive replacement financing or extend our current financing. There can
      be
      no assurance that we will be able to obtain such financing.





**OUR
      FUTURE SUCCESS DEPENDS IN PART ON ATTRACTING AND RETAINING KEY SENIOR MANAGEMENT
      AND QUALIFIED TECHNICAL AND SALES PERSONNEL. WE ALSO FACE CERTAIN RISKS AS
      A
      RESULT OF THE RECENT CHANGES TO OUR MANAGEMENT TEAM.**





Our
      future success depends in part on the contributions of our management team
      and
      key technical and sales personnel and our ability to attract and retain
      qualified personnel. In particular, our success depends on our new management
      team, consisting of Steven Walin, our Chief Executive Officer, and Joseph
      Restivo, our Chief Financial Officer, both of whom joined us in March 2006.
      Mr.
      Walin and Mr. Restivo are each a party to an employment agreement with us that
      expires in March 2009. There is significant competition in our industry for
      qualified managerial, technical and sales personnel and we cannot assure you
      that we will be able to retain our key senior managerial, technical and sales
      personnel or that we will be able to attract, integrate and retain other such
      personnel that we may require in the future. **** We
      also
      cannot assure you that our employees will not leave and subsequently compete
      against us. If we cannot work together effectively to overcome any operational
      challenges that arise during the integration process, if our new management
      team
      cannot master the details of our business and our market or if we are unable
      to
      attract and retain key personnel in the future, our business, financial
      condition and results of operations could be adversely affected.





**WE
      RELY ON INDEPENDENT DEALERS AND DISTRIBUTORS TO SELL OUR PRODUCTS. DISRUPTION
      TO
      THIS DISTRIBUTION CHANNEL WOULD HARM OUR BUSINESS.**





Because
      we sell a significant portion of our products to independent dealers and
      distributors, we are subject to many risks, including risks related to their
      inventory levels and support for our products. In particular, if dealers and
      distributors do not maintain sufficient levels of inventory to meet customer
      demand, our sales could be negatively impacted.




Our
      dealers and distributors also sell products offered by our competitors. If
      our
      competitors offer our dealers and distributors more favorable terms, those
      dealers and distributors may de-emphasize or decline to carry our products.
      In
      the future, we may not be able to retain or attract a sufficient number of
      qualified dealers and distributors. If we are unable to maintain successful
      relationships with dealers and distributors or to expand our distribution
      channels, our business could suffer.


9





**OUR
      BUSINESS AND REPUTATION AS A DISTRIBUTOR OF HIGH QUALITY VIDEO SURVEILLANCE
      AND
      SECURITY EQUIPMENT MAY BE ADVERSELY AFFECTED BY PRODUCT** **DEFECTS
      OR SUBSTANDARD PERFORMANCE.**





We
      believe that we offer state-of-the art products that are reliable and
      competitively priced. In the event that our products do not perform to
      specifications, we and/or the manufacturer of such products might be required
      to
      redesign or recall those products or pay substantial damages or warranty claims.
      Such an event could result in significant expenses, disrupt sales and affect
      our
      reputation and that of our products. In addition, product defects could result
      in substantial product liability. Although we currently maintain product
      liability insurance, we cannot assure you that it is adequate or that it will
      remain available on acceptable terms. If we face liability claims that exceed
      our insurance or that are not covered by our insurance, our business, financial
      condition and results of operation would be adversely affected.




**OUR
      GROWTH STRATEGY INCLUDES MAKING ACQUISITIONS IN THE FUTURE, WHICH COULD SUBJECT
      US TO SIGNIFICANT RISKS, ANY OF WHICH COULD HARM OUR
      BUSINESS.**





Our
      growth strategy includes identifying and acquiring or investing in suitable
      candidates on acceptable terms. Over time, we may acquire or make investments
      in
      other providers of product offerings that complement our business and other
      companies in the security industry.





Acquisitions
      involve a number of risks and present financial, managerial and operational
      challenges, including:





·
            diversion
                of management's attention from running our existing
                business;





·
            increased
                expenses, including travel, legal, administrative and compensation
                expenses resulting from newly hired
                employees;





·
            increased
                costs to integrate personnel, customer base and business practices
                of the
                acquired company with our own;





·
            adverse
                effects on our reported operating results due to possible write-down
                of
                goodwill or other assets associated with
                acquisitions;





·
            potential
                disputes with sellers of acquired businesses, technologies, services
                or
                products; and





·
            dilution
                to stockholders if we issue securities in any
                acquisition.





Moreover,
      performance problems with an acquired business, technology, product or service
      could also have a material adverse impact on our reputation as a whole. In
      addition, any acquired business, technology, product or service could
      significantly under-perform relative to our expectations, and we may not achieve
      the benefits we expect from our acquisitions. For all these reasons, our pursuit
      of an acquisition and investment strategy or any individual acquisition or
      investment, could have a material adverse effect on our business, financial
      condition and results of operations.




In
      December 2004 we completed the acquisition of Rapor, Inc. During the third
      quarter of 2006, we recorded impairment costs of approximately $977,000 related
      to Rapor. These
      costs resulted from the write-off of goodwill of approximately $544,000, as
      well
      as the write-off of the remaining net book values of trademark and technology
      associated with the Rapor products of approximately $433,000. Management
      has concluded that the Rapor product line no longer fits our existing
      distribution channels and market strategy and, accordingly wrote-off goodwill, trademarks and technology associated with this product
      line.
      We are currently evaluating opportunities to dispose of our Rapor products,
      and
      have discussed the licensing and/or sale of this business line with several
      parties.


10




**OUR
      PRODUCT OFFERINGS INVOLVE A LENGTHY SALES CYCLE AND WE MAY NOT ANTICIPATE SALES
      LEVELS APPROPRIATELY, WHICH COULD IMPAIR OUR
      PROFITABILITY.**




Some
      of
      our products and services are designed for medium to large commercial,
      industrial and government facilities desiring to protect valuable assets and/or
      prevent intrusion into high security facilities in the United States and abroad.
      Given the nature of our products and the customers that purchase them, sales
      cycles can be lengthy as customers conduct intensive investigations and
      deliberate between competing technologies and providers. For these and other
      reasons, the sales cycle associated with some of our products and services
      is
      typically lengthy and subject to a number of significant risks over which we
      have little or no control.





If
      sales
      in any period fall significantly below anticipated levels, our financial
      condition and results of operations could suffer. In addition, our operating
      expenses are based on anticipated sales levels, and a high percentage of our
      expenses are generally fixed in the short term. As a result of these factors,
      a
      small fluctuation in timing of sales can cause operating results to vary from
      period to period.





**WE
      FACE LABOR, POLITICAL AND CURRENCY RISKS BECAUSE SAMSUNG ELECTRONICS' FACTORIES
      ARE LOCATED IN KOREA AND CHINA, AND WE MAY FACE OTHER RISKS IF WE CONTINUE
      TO
      EXPAND OUR BUSINESS INTERNATIONALLY.**





Since
      our
      primary suppliers are located in Korea and China, we may face a number of
      additional risks, including those arising from the current political tension
      between North and South Korea. While we have not faced any problems to date,
      in
      the future, as we continue to expand our business internationally, we may
      face:





·
            regulatory
                limitations imposed by foreign
                governments,




·
            price
                increases due to fluctuations in currency exchange
                rates,




·
            political,
                military and terrorist risks,




·
            disruptions
                or delays in shipments caused by customs brokers or government
                agencies,




·
            unexpected
                changes in regulatory requirements, tariffs, customs, duties and
                other
                trade barriers, and




·
            potentially
                adverse tax consequences resulting from changes in tax
                laws.




We
      cannot
      assure you that one or more of the factors described above will not have a
      material adverse effect on our business, financial condition and results of
      operation.




**INVESTMENT
      RISKS**




**OUR
      COMMON STOCK IS THINLY TRADED ON THE**  **OTC
      BULLETIN BOARD, AND WE MAY BE UNABLE TO OBTAIN LISTING OF OUR COMMON STOCK
      ON A
      MORE LIQUID MARKET.**




Our
      Common Stock is quoted on the OTC
      Bulletin Board, which
      provides significantly less liquidity than a securities exchange (such as the
      American or New York Stock Exchange) or an automated quotation system (such
      as
      the NASDAQ National Market or NASDAQ Capital Market). There is uncertainty
      that
      we will ever be accepted for a listing on an automated quotation system or
      securities exchange.





**PENNY
      STOCK REGULATIONS MAY AFFECT YOUR ABILITY TO SELL OUR COMMON
      STOCK.**





To
      the
      extent the price of our Common Stock remains below $5.00 per share, our Common
      Stock will be subject to Rule 15g-9 under the Exchange Act, which imposes
      additional sales practice requirements on broker dealers which sell these
      securities to persons other than established customers and accredited investors.
      Under these rules, broker-dealers who recommend penny stocks to persons other
      than established customers and "accredited investors" must make a special
      written suitability determination for the purchaser and receive the purchaser's
      written agreement to a transaction prior to sale. Unless an exception is
      available, the regulations require the delivery, prior to any transaction
      involving a penny stock, of a disclosure schedule explaining the penny stock
      market and the


11





associated
      risks. The additional burdens imposed upon broker-dealers by these requirements
      could discourage broker-dealers from effecting transactions in our Common Stock
      and may make it more difficult for holders of our Common Stock to sell shares
      to
      third parties or to otherwise dispose of them.





**FUTURE
      SALES OF COMMON STOCK COULD RESULT IN A DECLINE IN THE MARKET PRICE OF OUR
      STOCK.**




The
      holders of approximately 1,065,520 shares of Common Stock are able to sell
      such
      shares without registering them under the Securities Act. In connection with
      our
      October 2006 and January 2007 private placements, after giving effect to our
      recent 50-for-1 reverse stock split and the conversion of the notes sold in
      our
      October 2006 private placement, we issued an aggregate of 26,915,650 shares
      of
      Common Stock. In February 2007, an S-1 registration statement providing for
      the
      resale of 8,150,789 of those shares of Common Stock was declared effective
      by
      the SEC. Sales of a significant number of shares of our Common Stock in the
      public market could result in a decline in the market price of our Common Stock,
      particularly in light of the illiquidity and low trading volume in our Common
      Stock.




**SUBSTANTIALLY
      ALL OF OUR SHARES OF COMMON STOCK ARE OWNED BY THE INVESTORS IN OUR OCTOBER
      2006
      PRIVATE PLACEMENT, WHICH LIMITS THE ABILITY OF OUR OTHER STOCKHOLDERS TO
      INFLUENCE CORPORATE MATTERS.**




As
      a
      result of our October 2006 private placement and conversion of the Convertible
      Notes issued in that private placement, the investors in the private placement
      as a group were the beneficial owners of approximately 96% of our outstanding
      shares of Common Stock. Accordingly, these stockholders can decide the outcome
      of any corporate transaction or other matter submitted to our stockholders
      for
      approval, including mergers, consolidations and the sale of all or substantially
      all of our assets, and also could prevent or cause a change in control. The
      interests of these stockholders may differ from the interests of our other
      stockholders. Third parties may be discouraged from making a tender offer or
      bid
      to acquire us because of this concentration of ownership.




**Item
      1** **B.
      Unresolved Staff Comments.**




Not
      applicable.




**Item
      2. Properties.**




We
      currently lease approximately 58,850 square feet of office and warehouse space
      in Carrollton, Texas under a lease agreement which expires in September 2009.
      In
      the opinion of our management, the leased properties are adequately insured.
      Our
      existing properties are in good condition and suitable for the conduct of our
      business.




**Item
      3. Legal Proceedings.**




We
      are
      not party to any material pending legal proceedings.




**Item
      4. Submission of Matters to a Vote of Security Holders.**




No
      matter
      was submitted to a vote of security holders during the fourth quarter of
      2006.


12




**PART
      II**




**Item
      5. Market for Registrant’s Common Equity and Related Stockholder Matters and
      Issuer Purchases of Equity Securities.**




Our
      Common Stock trades in the over-the-counter-market under the symbol “GVSS.” From
      April 14, 2004 until November 28, 2006, our Common Stock was quoted under the
      symbol “GVIS.” Prior to April 14, 2004, our Common Stock was quoted under the
      symbol “TSIM.” Trades in our Common Stock were reported by the OTC Bulletin
      Board from January 1, 2002 until June 9, 2002, and by Pink Sheets LLC from
      June
      9, 2002 until December 13,
      2004.
      Since December 13, 2004, trades of our Common Stock have been quoted on the
      OTC
      Bulletin Board. The following table sets forth the quarterly high and low bid
      prices of a share of our Common Stock as reported by the OTC Bulletin Board
      and
      Pink Sheets LLC, respectively. The quotations listed below reflect inter-dealer
      prices, without retail mark-ups, mark-downs or commissions and may not
      necessarily represent actual transactions. The prices below have not been
      adjusted for the one-for-50 reverse split of our Common Stock effected on
      November 27, 2006 or the one-for-65 reverse split of our Common Stock effected
      April 12, 2004.




**Price****High**
            
            **Low****2004**First
                quarter
            
            $
            0.51
            
            $
            0.02Second
                quarter
            
            $
            32.51
            
            $
            0.10Third
                quarter
            
            $
            6.00
            
            $
            1.10Fourth
                quarter
            
            $
            8.00
            
            $
            1.15**2005**First
                quarter
            
            $
            5.70
            
            $
            1.80Second
                quarter
            
            $
            2.45
            
            $
            0.70Third
                quarter
            
            $
            1.09
            
            $
            0.27Fourth
                quarter
            
            $
            0.39
            
            $
            0.10**2006**First
                quarter
            
            $
            0.37
            
            $
            0.15Second
                quarter
            
            $
            0.36
            
            $
            0.15Third
                quarter
            
            $
            0.17
            
            $
            0.03Fourth
                quarter
            
            $
            1.25
            
            $
            0.02





The
      number of holders of record for our Common Stock as of March 23, 2007 was
      approximately 153. This number excludes individual stockholders holding stock
      under nominee security position listings.





**Dividends**





We
      have
      not paid any dividends on our Common Stock since our inception and do not intend
      to pay any cash dividends to our stockholders in the foreseeable future. In
      addition, we are prohibited from paying dividends on our Common Stock under
      our
      agreements with Laurus. Nonetheless, the holders of our Common Stock are
      entitled to dividends when and if declared by our board of directors from
      legally available funds.





**Recent
      Sales of Unregistered Securities**





Pursuant
      to a consulting agreement dated November 8, 2006, we issued 25,000 shares of
      Common Stock to Protect-A-Life Inc., in consideration of investor relations
      services provided to us by Protect-A-Life Inc. The issuance was exempt from
      registration under Section 4(2) of the Securities Act.


13




**Item
      6. Selected Financial Data**




We
      present below our selected consolidated financial data. The selected
      consolidated statement of operations data for the years ended December 31,
      2006, 2005 and 2004 and the selected consolidated balance sheet data as of
      December 31, 2006 and 2005 have been derived from our audited consolidated
      financial statements and related notes. The selected consolidated statement
      of
      operations data for the year ended December 31, 2003 and 2002, and the
      selected consolidated balance sheet data as of December 31, 2004, 2003
      (Predecessor Business) and 2002 have been derived from our audited consolidated
      financial statements not included in this filing. You should read this
      information together with “Management’s Discussion and Analysis of Financial
      Condition and Results of Operations” and our audited consolidated financial
      statements and related notes. Our historical results are not necessarily
      indicative of the results to be expected in any future period.




In
      the
      first quarter of 2006, our board approved a plan to discontinue our Retail
      Channel business. Accordingly, this business is accounted for as discontinued
      operations and its operations are segregated in the statement of operations
      data
      below and in the accompanying financial statements. In connection with the
      discontinuance of the Retail Channel business, for the years ended December
      31,
      2006 and 2005, we wrote down assets identified with the retail business by
      approximately $2.4 million and $2.9 million, respectively, net of applicable
      tax
      benefit, to net realizable value. The write down to net realizable value was
      based on management’s best estimates of the amounts expected to be realized on
      the disposition of all related assets and liabilities held for disposition
      from
      the discontinued operations. At December 31, 2006, we had divested of
      substantially all retail inventory and other related assets.




2002(1)
            
            2003(1)
            
            2004
            
            2005
            
            2006**(In
                thousands, except per share data)****Statement
              of operations data:**Net
                sales
            
            $
            15,707
            
            $
            25,019
            
            $
            35,761
            
            $
            40,782
            
            $
            43,973Gross
                Profit
            
            
            3,514
            
            
            5,331
            
            
            4,927
            
            
            5,968
            
            
            6,584Operating
                loss
            
            
            (1,444
            )
            
            (1,930
            )
            
            (8,831
            )
            
            (9,388
            )
            
            (7,887
            )Interest
                expense
            
            
            244
            
            
            230
            
            
            691
            
            
            1,266
            
            
            5,916Loss
                from continuing operations before income (loss) from discontinued
                operations
            
            
            (1,744
            )
            
            (1,048
            )
            
            (8,414
            )
            
            (10,737
            )
            
            (13,817
            )Income
                (loss) from discontinued operations, net of taxes
            
            
            2,880
            
            
            2,305
            
            
            1,236
            
            
            (2,283
            )
            
            (2,674
            )Net
                income (loss)
            
            $
            1,136
            
            $
            1,257
            
            $
            (7,178
            )
            $
            (13,020
            )
            $
            (16,491
            )




**Basic
              and diluted income (loss) per share:**Continuing
                operations
            
            $
            (0.06
            )
            $
            (0.04
            )
            $
            (13.96
            )
            $
            (10.71
            )
            $
            (3.74
            )Discontinued
                operations
            
            $
            0.10
            
            $
            0.08
            
            $
            2.05
            
            $
            (2.28
            )
            $
            (0.72
            )Net
                income (loss) per share
              (basic
                and diluted)
            
            $
            0.04
            
            $
            0.04
            
            $
            (11.91
            )
            $
            (12.99
            )
            $
            (4.46
            )**Balance
                Sheet data:**Working
                capital
            
            $
            1,209
            
            $
            10,985
            
            $
            21,689
            
            $
            11,715
            
            $
            (2,003
            )Total
                assets
            
            
            11,501
            
            
            23,321
            
            
            51,605
            
            
            25,226
            
            
            16,472Senior
                debt
            
            
            3,378
            
            
            8,650
            
            
            9,057
            
            
            11,770
            
            
            8,291Total
                liabilities
            
            
            10,002
            
            
            20,831
            
            
            34.078
            
            
            20,623
            
            
            17,912Total
                stockholders’ equity
            
            
            1,499
            
            
            2,490
            
            
            51,605
            
            
            4,603
            
            
            (1,440
            )





**(1)**
            **Results
                associated with predecessor
                business**




14




**Item
      7.** **Management** **’** **s
      Discussion and Analysis of Financial Condition and Results of
      Operations** **.**




*This
      report contains forward-looking statements relating to future events and our
      future performance within the meaning of Section 27A of the Securities Act
      of 1933, as amended, and Section 21E of the Securities Exchange Act of
      1934, as amended, including, without limitation, statements regarding our
      expectations, beliefs, intentions or future strategies that are signified by
      the
      words “expects,” “anticipates,” “intends,” “believes” or*  *similar
      language. Actual results could differ materially from those anticipated in
      such
      forward-looking statements. All forward-looking statements included in this
      document are based on information available to us on the date hereof. We caution
      investors that our business and financial performance are subject to substantial
      risks and uncertainties. In evaluating our business, prospective investors
      should carefully consider the information set forth under the caption “Risk
      Factors” in addition to the other information set forth herein and elsewhere in
      our other public filings with the Securities and Exchange
      Commission.*




**Overview**





From
      December 2000 until we acquired GVI Security, Inc. in a merger transaction
      on
      February 20, 2004, we had no active business operations. As a result of the
      merger, GVI Security, Inc. became our wholly-owned subsidiary, and the business
      of GVI Security became our business. Following the merger, on April 12, 2004,
      we
      changed our name from Thinking Tools, Inc. to GVI Security Solutions, Inc.
      Since
      the former stockholders of GVI Security, Inc. acquired a majority of our voting
      interests in the merger, the transaction was treated as a reverse acquisition,
      with GVI Security, Inc. treated as the acquirer for accounting purposes.
      Accordingly, the pre-merger financial statements of GVI Security, Inc. are
      our
      historical financial statements.





Through
      our subsidiaries, we provide video surveillance and security solutions products, incorporating
      a complete line of video surveillance and detection systems, to the homeland
      security, professional and business-to-business market segments .
      We provide
      a
      strong combination of closed
      circuit televisions ( CCTVs),
      digital video recorders (DVRs), and
      networking products that
      enhance life safety for both government agencies and the private sector.





**Discontinuance
      of Retail Sales**





**** Historically,
      sales of our products in the Retail Channel have accounted for a substantial
      portion of our revenues. For the years ended December 31, 2005, 2004
      and
      2003, 25%, 46% and 56% of
      our
      revenues, including revenues from discontinued operations, were from sales
      in
      the Retail Channel. Among other reasons, the decline in sales of our retail
      products resulted from the replacement of our products by a major national
      retailer that accounted for substantially all of our Retail Channel sales with
      products manufactured by a competitor. In addition, our exclusive agreement
      to
      distribute Samsung products in the Retail Channel to this retailer expired
      on
      December 31, 2005. As a result, in the first quarter of 2006 our board of
      directors approved the discontinuance of our sales to the Retail Channel so
      that
      we can focus our efforts on sales to professionals and wholesale distributors. ****





**** The
      retail business is accounted for as discontinued operations and, accordingly,
      its operations are segregated in the accompanying financial statements. In
      connection with the discontinuance of the Retail Channel business for the years
      ended December 31, 2006 and 2005, we wrote down assets identified with the
      retail business by approximately $2.4 million and $2.9 million, respectively,
      to
      net realizable value. The write down to net realizable value was based on
      management’s best estimates of the amounts expected to be realized on the
      disposition of all related assets and liabilities held for disposition from
      the
      discontinued operations. At December 31, 2006, we had divested of substantially
      all retail inventory and other related assets The results of the discontinued
      operations do not include any allocation of corporate overhead during the
      periods presented.




**Reverse
      Stock Split**




As
      discussed below, on October 6, 2006, we completed a $5 million private
      placement, and in connection therewith, on November 27, 2006, we effected a
      50-for-1 reverse stock split of the Common Stock. After giving effect to the
      reverse split, we had outstanding 26,392,834 shares of Common Stock, of which
      25,202,314 were


15




issued
      to
      the purchasers of the Units. Unless otherwise indicated, a ll
      share
      and per share amounts in this Annual Report on Form 10-K, including the
      accompanying financial statements, give retroactive effect to the 1-for-50
      reverse stock split.








**CRITICAL
      ACCOUNTING POLICIES**





The
      preparation of financial statements in conformity with accounting principles
      generally accepted in the United States requires management 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 amounts of revenues and expenses during the
      reporting period. Actual results could differ from those estimates. We believe
      the following critical accounting policies have significant effect in the
      preparation of our consolidated financial statements.





**Revenue
      Recognition**





Our
      primary source of revenue is from sales of our products. We recognize revenue
      when the sales process is deemed complete and associated revenue has been
      earned. Our policy is to recognize revenue when risk of loss and title to the
      product transfers to the customer. Net sales is comprised of gross revenue
      less
      expected returns, trade discounts and customer allowances, which include costs
      associated with off-invoice mark downs and other price reductions, as well
      as
      trade promotions. These incentive costs are recognized at the later of the
      date
      on which we recognize the related revenue or the date on which we offer the
      incentive. For those incentives that require the estimate of sales volume or
      redemption rates, such as for volume rebates, we use historical experience
      and
      internal and customer data to estimate the sales incentives at the time revenue
      is recognized.





We
      allow
      customers to return defective products when they meet certain established
      criteria as outlined in our trade terms. We regularly review and revise, when
      deemed necessary, our estimates of sales returns which are primarily based
      on
      actual historical return rates. We record estimated sales returns as reductions
      to sales, cost of sales, and accounts receivable and an increase to inventory.
      Returned products which are recorded as inventory are valued based upon the
      amount we expect to realize upon their subsequent disposition. The physical
      condition and marketability of the returned products are the major factors
      considered by us in estimating realizable value. Actual returns, as well as
      realized values on returned products, may differ significantly, either favorably
      or unfavorably, from our estimates if factors such as customer inventory levels
      or competitive conditions differ from our estimates and expectations and, in
      the
      case of actual returns, if economic conditions differ significantly from our
      estimates and expectations.





**Allowance
      for Doubtful Accounts**





We
      maintain allowances for doubtful accounts for estimated losses from customers'
      inability to make payments. We assess each account that is more than 90 days
      delinquent and other accounts when information known to us indicates amounts
      may
      be uncollectible. In order to estimate the appropriate level of the allowance,
      we consider such factors as historical bad debts, current customer credit
      worthiness, changes in customer payment patterns and any correspondence with
      the
      customer. In 2006, 2005 and 2004 we experienced losses, or recorded provisions
      for potential losses, from customers' inability to make payments, totaling
      approximately $817,000, $166,000 and $254,000, which were equal to 1.8%, 0.4%
      and 0.7% of revenues, respectively. If the financial condition of our customers
      were to deteriorate and impair their ability to make payments, additional
      allowances might be required in future periods.





**Inventory**





Inventory
      is stated at the lower of cost (first-in, first-out method) or market and
      consists of goods held for resale and parts used for repair work. Reserves
      are
      recorded for slow-moving, obsolete, nonsaleable or unusable items based upon
      a
      product-level review, in order to reflect inventory balances at their net
      realizable value. Inventory reserve balances at December 31, 2006 and 2005
      were
      approximately $2,541,000 and $1,300,000, respectively.


16




**Long-Lived
      Assets**




We
      adopted the provisions of FASB Statement No. 144, “Accounting for the Impairment
      or Disposal of Long Lived Assets “ effective January 1, 2005.  When
      impairment indicators are present, we typically review the carrying value of
      its
      assets in determining the ultimate recoverability of their unamortized values
      using analyses of future undiscounted cash flows expected to be generated by
      the
      assets.  If such assets are considered impaired, the impairment recognized
      is measured by the amount by which the carrying amount of the asset exceeded
      its
      fair value.  Assets to be disposed of are reported at the lower of the
      carrying amount or fair value, less cost to sell.




**Goodwill
      and Intangible Assets**




We
      adopted the provisions of FASB Statement No. 142, “Goodwill and Other Intangible
      Assets,” effective January 1, 2005. SFAS No. 142 requires that goodwill and
      intangible assets with indefinite useful lives no longer be amortized, but
      instead be tested for impairment using the guidance for measuring impairment
      set
      forth in this statement.





During
      the year ended December 31, 2006, we concluded that the Rapor product line
      no
      longer fit the Company’s existing distribution channels and market strategy and,
      accordingly, recorded impairment costs of approximately $977,000 resulting
      from
      the write-off of goodwill of approximately $544,000, and the write-off of the
      remaining net book value of the trademark and technology associated with Rapor
      products totaling approximately $433,000, as prescribed under SFAS 142. No such
      impairment expense was recorded for the years ending December 31, 2005 and
      2004.





**Deferred
      Tax Asset Valuation Allowance**





Deferred
      tax liabilities and assets are classified as current or noncurrent based on
      the
      classification of the related asset or liability for financial reporting, or
      according to the expected reversal date of temporary differences not related
      to
      an asset or liability for financial reporting. Also, a valuation allowance
      is
      used, if necessary, to reduce deferred tax assets by the amount of any tax
      benefits that are not expected to be realized in the future based on available
      evidence.





**Stock-Based
      Compensation**




In
      December 2004, the Financial Accounting Standards Board issued Statement of
      Financial Accounting Standards 123R, “Share-Based Payment”. This statement
      requires that the cost resulting from all share-based payment transactions
      be
      recognized in the financial statements. This statement establishes fair value
      as
      the measurement objective in accounting for share-based payment arrangements
      and
      requires all entities to apply a fair-value based measurement method in
      accounting for share-based payment transactions with employees except for equity
      instruments held by employee share ownership plans. Effective January 1,
      2006, the Company adopted the fair value recognition provisions of SFAS 123R,
      using the modified prospective method. Under this method, the provisions of
      SFAS
      123R apply to all awards granted or modified after the date of adoption and
      all
      previously granted awards not yet vested as of the date of adoption. Prior
      periods have not been restated.




Prior
      to
      the January 1, 2006 adoption of SFAS 123R, the Company accounted for
      stock-based compensation using the intrinsic value method prescribed in
      Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to
      Employees” and related interpretations. Accordingly, no compensation expense had
      been recognized for stock options since all options granted had an exercise
      price equal to the market price on the date of grant. As permitted by SFAS
      123,
“Accounting for Stock-Based Compensation,” stock-based compensation was included
      as a pro forma disclosure in the notes to the consolidated financial statements.


17




**RESULTS
      OF OPERATIONS**





*FISCAL
      YEAR ENDED DECEMBER 31, 2006 COMPARED TO FISCAL YEAR ENDED DECEMBER 31,
      2005***




**Net
      Revenues From Continuing Operations**





Net
      revenues increased approximately $3.2 million, or 8% to approximately $44.0
      million during the year ended December 31, 2006 from approximately $40.8 million
      during the year ended December 31, 2005. The increase reflects a $5.0 million,
      or 13%, increase in sales of professional products, offset by a decrease of
      approximately $1.8 million, or 93%, in enterprise solutions revenues, which
      have
      been discontinued. The increase in revenues of our professional products
      reflected increased sales to distributors, integrators and installers of a
      variety of products manufactured by Samsung Electronics as well as other
      manufacturers. The reduction in enterprise solutions revenues reflects sales
      of
      the Rapor portal during the year ended December 31, 2005, with no corresponding
      sales during the year ended December 31, 2006. As previously noted, during
      the third quarter of 2006, management concluded that the Rapor product line
      no
      longer fit our existing distribution channels and market strategy, and.
      accordingly wrote-off intangibles associated with this product line. We are currently
      reviewing opportunities to dispose of our Rapor products, and have discussed
      the
      licensing and/or sale of this business line with several parties. We continue
      to
      introduce new products to complement our existing lines, and will continue
      to
      focus on the professional market through various channels.




**Cost
      Of Goods Sold From Continuing Operations**




Total **** cost
      of
      goods sold increased approximately $2.6 million, or 7% to approximately $37.4
      million for the year ended December 31, 2006, from approximately $34.8 million
      during the year ended December 31, 2005. This increase was due to the increased
      revenue volume from the sale of professional products, partially offset by
      improved margins on professional products, which resulted in an overall increase
      in cost of sales for professional products of $3.3 million for the year ended
      December 31, 2006 as compared to the period ended December 31, 2005. In
      addition, cost of sales related to enterprise sales decreased $1.3 million
      for
      the period ended December 31, 2006 as compared to the comparable period in
      2005
      as a result of the absence of sales of the Rapor product in 2006. Indirect
      costs
      included in cost of goods sold, related to salaries and expenses associated
      with
      our warehouse, assembly and technical support services departments, increased
      $600,000 during the year ended December 31, 2006 as compared to the year ended
      December 31, 2005. Other charges included in cost of goods sold during the
      year
      ended December 31, 2006 of approximately $1.6 million related to adjustments
      to
      reflect slow-moving inventory to their net realizable value, as compared to
      similar adjustments of approximately $630,000 during the year ended December
      31,
      2005.




As
      a
      result of the changes described above in revenues and cost of goods sold, gross
      profit for the year ended December 31, 2006 increased to approximately $6.6
      million from approximately $6.0 million for the year ended December 31, 2005,
      and gross profit as a percentage of revenues increased to 15.0% for the year
      ended December 31, 2006 compared with 14.6% for the comparable period ended
      December 31, 2005. Had we not taken $1.0 million of additional charges to
      write-down slow-moving inventory during the year ended December 31, 2006 (as
      compared to the prior year), our gross margins would have been 17.2% for the
      year ended December 31, 2006.




**Selling,
      General and Administrative Expenses**




Selling,
      general, and administrative expenses decreased 12% to approximately $13.5
      million for the year ended December 31, 2006 from approximately $15.2 million
      for the comparable period ended December 31, 2005, as follows:




**Sales
      and Marketing.** Sales
      and
      marketing expenses decreased approximately 30% to approximately $6.4 million
      for
      the year ended December 31, 2006 from approximately $9.1 million for the year
      ended December 31, 2005. The decrease was primarily due to (i) the
      elimination of approximately $800,000 of expense related to a licensing
      agreement entered into January 1, 2005, which was not renewed for 2006, (ii)
      decreases of approximately $356,000 in sales and marketing staff salaries and
      related benefits, (iii) a decrease of approximately $530,000 in


18




promotional
      expenses, (iv) a decrease in commissions of approximately $591,000, and (v)
      a
      reduction in travel and other various general and administrative expenses of
      $330,000.




**General
      and Administrative.** General
      and administrative expenses increased 17% to approximately $7.1 million for
      the
      year ended December 31, 2006 from approximately $6.1 for the comparable period
      ended December 31, 2005.  Major items resulting in the increased
      general and administrative expense were (i) approximately $710,000 in personnel
      termination costs, (ii) stock based compensation expense of approximately
      $332,000 recorded due to the adoption of SFAS 123R effective January 1, 2006,
      with no comparable expense in 2005, and (iii) an increase in bad debt expenses
      of approximately $746,000. These increases were partially offset by decreases
      in
      (i) professional fees of $240,000, (ii) contract and temporary labor of $272,000
      and (iii) various other general and administrative expenses of approximately
      $250,000.




**Impairment
      Of Long-Lived Assets**




During
      the year ended December 31, 2006, the Company recorded impairment costs of
      approximately $977,000. These costs resulted from the write-off of goodwill
      of
      approximately $544,000, and the write-off of the remaining net book value of
      the
      trademark and technology associated with the Rapor products of approximately
      $433,000. No similar impairment expenses were recorded in the year ended
      December 31, 2005.




**Interest
      Expense**




Interest
      expense for the year ended December 31, 2006 increased 367% to approximately
      $5.9 million, from approximately $1.3 million in the year ended December 31,
      2005. The increase was the result of (i) a charge of $4.5 million to record
      beneficial conversion features resulting from the issuance of convertible notes
      with exercise terms more favorable than prevailing market conditions, (ii)
      a
      charge of approximately $47,000 to reflect the fair value of warrants issued
      in
      conjunction with the October 2006 private placement transaction, and (iii)
      interest associated with convertible notes issued in conjunction with the
      October 2006 private placement transaction of approximately $40,000.




**Income
      Tax Expense (Benefit)**




We
      recorded a provision for federal, state and local income tax of approximately
      $14,000 for the year ended December 31, 2006, as compared to an expense of
      approximately $83,000 for the comparable period ended December 31, 2005. The
      $14,000 expense relates to state franchise taxes due in various states in which
      we are licensed and transact business. We believe that any provision for federal
      and state tax benefits due to our loss for the year ended December 31, 2006
      would be offset by an equal increase in a valuation allowance as a result of
      our
      history of recurring operating losses.




**Discontinued
      Operations**




Loss
      from
      discontinued operations, net of tax, was approximately $2.7 million for the
      year
      ended December 31, 2006, compared to a loss from discontinued operations of
      approximately $2.3 million for the year ended December 31, 2005. The loss for
      the period ended December 31, 2006 reflects negative revenues and reserves
      recorded in connection with returns of retail products sold in prior periods,
      and write downs of returned retail inventories. In September 2006 we entered
      into an agreement with our former retail distribution agent whereby the parties
      terminated the alliance agreement and the respective rights and obligations
      of
      the parties thereunder. In addition, we transferred to the distribution agent
      substantially all of our remaining retail inventory in satisfaction of any
      and
      all remaining outstanding and future return obligations. In comparison to our
      negative revenues for the year ended December 31, 2006, we had net revenues
      of
      approximately $13.8 million for the comparable period ended December 31, 2005.
      Operating results from discontinued operations do not include any allocation
      of
      corporate overhead.


19




**Net
      Loss**




As
      a
      result of the items discussed above there was a net loss of approximately $16.5
      million for the year ended December 31, 2006 compared with a net loss of
      approximately $13.0 million for the year ended December 31, 2005.




***FISCAL
      YEAR ENDED DECEMBER 31, 2005 COMPARED TO FISCAL YEAR ENDED DECEMBER 31,
      2004*****




**Net
      Revenues from Continuing Operations**




Net
      revenues increased approximately $5.0 million, or 14.0% to approximately $40.8
      million for the year 2005 from approximately $35.8 million for the year 2004.
      Sales of professional products increased approximately $3.7 million, or 12.6%,
      and enterprise solutions revenues increased $1.3 million, or 196.5%. The
      increase in revenues of our professional products reflected increased sales
      to
      distributors, integrators and installers of a variety of products manufactured
      by Samsung Electronics as well as other manufacturers. Increased revenues of
      our
      enterprise solutions products reflected additional revenues from the Drug
      Enforcement Administration under our contract to supply it with our Rapid Access
      Portals.




**Cost
      of Goods Sold from Continuing Operations**




Total **** cost
      of
      good sold increased $4.0 million, or 12.9%, to approximately $34.8 million
      from
      approximately $30.8 million in 2004. The increase in costs is the result of
      approximately $3.2 million associated with increased sales of our professional
      and enterprise solutions products. Cost of goods sold for 2005 include
      increases in tech support costs and warranty costs of approximately $522,000.
      In
      addition, during 2004 we benefited from a one time reimbursement of $600,000
      from a major supplier relating to costs associated with a product defect. There
      was no comparable reimbursement in 2005.





As
      a
      result of the changes described above in revenues and cost of goods sold, gross
      profit in 2005 increased to approximately $6.0 million from approximately $4.9
      million in 2004, and gross profit as a percentage of revenues (i.e. gross
      margins) in 2005 was 14.6% compared with 13.8% for 2004. This increase was
      the
      result of a change in the product mix comprising our sales of professional
      products in respective periods. Gross margins on sales of our enterprise
      solutions products increased to 25.9% for 2005 compared to 22.8% in 2004,
      primarily as a result of higher margins on the sale of our Rapid Access Portal
      to the Drug Enforcement Administration.





**Selling,
      General and Administrative Expenses**





Selling,
      general and administrative expenses increased 11.4% to approximately $15.2
      million in 2005 from approximately $13.6 million in 2004, as follows.





*Sales
      and Marketing.* **** Sales
      and
      marketing expenses increased 41.5% to approximately $9.1 million in 2005 from
      approximately $6.5 million in 2004.  The
      increase was primarily due to (i) approximately $800,000 in expenses relating
      to
      a licensing agreement with Cybasec Ltd. entered into January 1, 2005 (which
      was
      terminated in accordance with its terms effective January 1, 2006), (ii) an
      increase of approximately $290,000 in sample and demonstration equipment costs,
      (iii) an increase of approximately $309,000 in advertising costs for print
      media, (iv) increased commissions on sales made by our independent sales
      representatives of approximately $442,000, (v) increased tradeshow costs of
      approximately $155,000, and (vi) a decrease of approximately $114,000 in
      contributions from our vendors to offset our marketing costs in 2005, as
      compared to vendor contributions we received in 2004 to cover these costs.





*General
      and Administrative.* **** General
      and administrative expenses decreased 16.3% to approximately $6.1 million for
      2005 from approximately $7.1 million in 2004.  Major
      items resulting in the  decreased
      general and administrative expense were (i) decreases of approximately
      $1,670,000 in administrative staff salaries and related benefits, (ii)
      reductions in bad debt provisions and other expenses of approximately $159,000,
      and (iii) reduced bank charges of approximately $129,000. These reductions
      were
      offset by (i) personnel termination costs during the year of approximately
      $335,000, (ii) an approximately $150,000 increase in office rent, (iii)
      approximately $149,000 of depreciation expense related to assets acquired in
      the
      Rapor acquisition in December 2004, with no comparable


20




expense
      in 2004, (iv) an increase of approximately $97,000 in legal and accounting
      fees,
      and (v) payment of $115,000 in directors fees.




**Interest
      Expense**





Interest
      expense for 2005 increased 83.2% to approximately $1,266,000 from approximately
      $691,000 in 2004. The increase was due to higher outstanding borrowings and
      a
      higher average interest rate during 2005 as well as the amortization of
      approximately $600,000 of loan origination fees in 2005 compared to amortization
      of approximately $334,000 of loan origination fees in 2004. The higher average
      interest rates resulted from a higher prime interest rate during the period
      as
      well as the interest rate provisions applicable to borrowings under the
      receivable facility. As a result of the conversion price under the facility
      exceeding the market price of our Common Stock for periods of 2005, the interest
      rate for those periods was equal to the prime rate plus two percent. If the
      market price of our Common Stock exceeds the conversion price of $2.22, at
      the
      end of a month, the interest rate under the receivable facility will be reduced
      to equal the prime rate minus two percent. The amount of interest expense for
      2005 reflects an offset of approximately $143,000 of interest income earned
      on
      bank balances during the period. Interest income earned in 2004 was
      approximately $2,000.





**Discontinued
      Operations**





Net
      revenues from our discontinued Retail Channel operations were approximately
      $13.8 million for the year ended December 31, 2005, compared with approximately
      $30.7 million in 2004. Loss from discontinued operations, net of tax, was
      approximately $2.3 million for the year ended December 31, 2005, compared to
      income from discontinued operations of approximately $1.2 million for the prior
      year ended December 31, 2004. These operating results do not include any
      allocation of corporate overhead. The loss for 2005 included a write down of
      approximately $1.4 million of assets identified with our retail business. Net
      realizable value of these assets reflects management’s best estimates of the
      amounts expected to be realized on the disposition of all related assets and
      liabilities from the discontinued operations.





**Income
      Tax Expense (Benefit)**





The
      provision for federal, state and local income tax is an expense of approximately
      $83,000 for 2005 compared to a benefit of approximately $413,000 for 2004 (comprised
      of approximately $1.1 million benefit from continuing operations and
      approximately $600,000 provision from discontinued operations) .
      The
      $83,000 expense relates to state franchise taxes that are not determined based
      on net income. Any provision for federal and state tax benefits due to our
      loss
      for 2005 would be offset by an equal increase in a valuation allowance. **** We
      established this allowance because, in light of our history, including our
      losses following our merger in February 2004, there is uncertainty as to whether
      we will have future income against which we can offset our losses to reduce
      our
      tax expense in future periods.





**Net
      Loss**




As
      a
      result of the items discussed above there was a net loss of approximately $13.0
      million in 2005 compared with a net loss of approximately $7.2 million in 2004.





***FISCAL
      YEAR ENDED DECEMBER 31, 2004 COMPARED TO FISCAL YEAR ENDED DECEMBER 31,
      2003*****




**Net
      Revenues** **from
      Continuing Operations**





Total
      net
      revenues increased 42.9% to approximately $35.8 million for the year 2004 from
      approximately $25.0 million in 2003. The increase was due to an increase in
      sales of our products consistent with our focus to provide complete solutions
      for our professional customers by providing a suite of fully-integrated
      products. Our fourth quarter of 2004 was negatively effected by reduced sales
      of
      a particular product to the Professional Channel. We were unable to sell this
      product during portions of the fourth quarter of 2004 as a result of a defect
      in
      the product. The manufacturer corrected the defect and we were able to continue
      selling the product at the beginning of the first quarter of 2005.


21




**Cost
      of Goods Sold** **from
      Continuing Operations** ****





Total
      cost of goods sold increased 56.6% to approximately $30.8 million in 2004 from
      approximately $19.7 million in 2003. Contributing to this increase were (i)
      charges of approximately $.8 million in connection with reserves established
      for
      slow moving inventory and write-downs of inventory to reflect net realizable
      value, (ii) increased revenues, and (iii) higher inbound freight costs. As
      a
      result of the changes in sales and cost of goods sold, gross profit for 2004
      of
      approximately $4.9 million decreased 7.5% from $5.3 million for 2003, and gross
      profit as a percentage of net sales decreased to 13.8% for 2004, compared with
      21.3% for 2003.





**Selling,
      General and Administrative Expenses**





Selling, **** general
      and administrative expenses **** increased
      87.3% to approximately $13.6 million in 2004 from approximately $7.3 million
      in
      2003, as follows.





*Sales
      and Marketing.* **** Sales
      and
      marketing expenses increased 80.6% to approximately $6.5 million in 2004 from
      approximately $3.6 million in 2003. The increase was primarily due to increased
      commissions, salaries and travel-related expenses. Contributing to the increase
      in salaries and travel-related expenses was approximately $925,000 relating
      to
      the formation of our Enterprise Solutions Group during 2004, which focused
      on
      providing fully-integrated security products solutions to the Professional
      Channel.





*General
      and Administrative.* **** General
      and administrative expenses increased 91.9% to approximately $7.1 million in
      2004 from approximately $3.7 million in 2003. The increase was primarily due
      to
      (i) increased salaries and wages associated with additional hires, (ii)
      increased administrative, accounting, finance and legal costs associated with
      being a public company following our merger in February 2004, as well as (iii)
      costs related to our Enterprise Solutions Group and expansion into the
      integrated security solutions market. Also included in general and
      administrative expenses for 2004 is approximately $400,000 of costs associated
      with personnel terminations during the year.




**Interest
      Expense**




Interest
      expense for 2004 increased 203% to approximately $691,000 from approximately
      $228,000 in 2003. The increase was primarily related to increased borrowing
      and
      the amortization of increased loan origination fees during 2004 as a result
      of
      our May 2004 debt financing with Laurus Master Fund, described
      below.




**Discontinued
      Operations**




Net
      revenues from our discontinued Retail Channel operations were approximately
      $30.7 million for the year ended December 31, 2004 compared with approximately
      $31.3 million in 2003. Income from discontinued operations of approximately
      $1.2
      million (net of $700,000 of income taxes) for the year ended December 31, 2004
      compares to income from discontinued operations of approximately $2.3 million
      (net of $1.6 million of income taxes) for the prior year ended December 31,
      2003. These operating results do not include any allocation of corporate
      overhead. Revenues from discontinued operations for the year ended December
      31,
      2004 decreased approximately $600,000, or 1.9%, to $30.7 million, compared
      to
      $31.3 million for the year ended December 31, 2003. Gross margin decreased
      to
      7.3% for the year 2004 compared to 12.6% for 2003. Contributing to the decrease
      in margins were charges of approximately $1.6 million in connection with
      reserves established for slow moving inventory and write-downs of inventory
      to
      reflect net realizable value.





**Income
      Tax Expense (Benefit)**




The
      provision for federal, state and local income tax benefit was approximately
      $413,000 for 2004 (comprised of approximately $1.1 million benefit from
      continuing operations and approximately $600,000 provision from discontinued
      operations), **** as
      compared to income tax expenses of approximately $536,000 for 2003 (comprised
      of
      approximately $1.1 million benefit from continuing operations and approximately
      $1.6 million provision from discontinued operations). The tax benefit for 2004
      has been reduced by approximately $2.2 million, the amount of a deferred tax
      valuation allowance. We established the allowance because, in light of our
      history, including our losses following our merger in February 2004, there
      is
      uncertainty under generally accepted accounting principles as to whether we
      will
      have future income against which we can offset our losses for 2004 to reduce
      our
      tax expense in future periods.


22


Prior
      to
      May 23, 2003, GVI Security, Inc. was taxed under the provisions of Sub Chapter
      S
      of the Internal Revenue Code. As a Sub Chapter S corporation, GVI Security,
      Inc.
      did not provide for or pay any Federal or certain corporate or state income
      taxes on its taxable income for the period from January 1, 2003 until May 2003.
      In May 2003, GVI Security, Inc. lost its Sub Chapter S corporation status,
      and
      accordingly a provision was made for the payment of income taxes based on the
      prorated taxable income of GVI Security, Inc. for 2003.




**Net
      Loss**




As
      a
      result of the items discussed above, net loss for 2004 was approximately $7.2
      million, compared with net income of approximately $1.3 million for
      2003.





**Liquidity
      and Capital Resources**





At
      December 31, 2006, we had cash and equivalents of approximately $225,000,
      working capital (excluding senior debt) of approximately $6.9 million,
      stockholders’ deficiency of $1.4 million, outstanding balances of $1.9 million
      under our term loan with Laurus Master Fund, and outstanding balances of $6.4
      million under our revolving credit facility with Laurus. In comparison, at
      December 31, 2005, we had cash and equivalents of approximately $3.0 million,
      working capital (excluding current portion of senior debt) of approximately
      $13.8 million, an outstanding balance of $3.3 million under the Laurus term
      loan, and outstanding balances under the Laurus revolving credit facility of
      approximately $8.5 million. Additionally, we had borrowing availability of
      approximately $2.2 million at December 31, 2006, with no such availability
      at
      December 31, 2005.




Cash
      decreased from $3.0 million at December 31, 2005 to $225,000 at December 31,
      2006 primarily as a result of (i) cash operating losses of approximately $4.8
      million, (ii) term loan principal and interest payments of $1.7 million, and
      (iii) net working capital revolver payments of $2.1 million. These factors
      were
      partially offset by (i) net private placement proceeds received of $4.9 million
      in 2006, and (ii) cash generated from discontinued operations of approximately
      $506,000, from December 31, 2005 to December 31, 2006.




Our
      credit facility with Laurus Master Funds matures December 31, 2007, Accordingly,
      at December 31, 2006 we have reflected both the remaining senior term note
      balance and working capital revolver as current liabilities. We are currently
      in
      discussions with Laurus, as well as other potential lenders, with regard to
      the
      extension and/or replacement of this credit facility. We believe that we will
      be
      able to obtain additional financing on acceptable or similar terms; however,
      there can be no assurance whether we will be able to do so.





In
      October 2006 and January 2007, as described below, we raised $6,028,000 in
      aggregate gross proceeds from the private placement of common stock and
      convertible notes. We may need to raise additional capital in the future to
      finance our operations; however, there can be no assurance whether we will
      be
      able to do so.




**October
      2006 Private Placement**




On
      October 6, 2006, we completed a $5 million private placement, consisting of
      100
      Units at a price of $50,000 per unit. Each Unit consisted of 25,000 shares
      of
      Common Stock and a 6% Subordinated Secured Convertible Promissory Note
      (“Convertible Notes”) in the principal amount of $45,000 convertible into
      225,000 shares of Common Stock at a conversion price equal to $.20. As a result,
      we issued 2,500,000 shares of Common Stock for $500,000 and Convertible Notes
      in
      the principal amount of $4,500,000 convertible into 22,500,000 shares of the
      Company’s Common Stock. On November 27, 2006, we effected a 50-for-1 reverse
      stock split of the Common Stock, and all of the Convertible Notes (including
      approximately $40,460 of accrued interest) were converted to Common Stock.
      After
      giving effect to the reverse split and the conversion, we had outstanding
      26,392,834 shares of Common Stock, of which 25,202,314 were issued to the
      purchasers of the Units (2,500,000 on the closing of the October 2006 private
      placement and 22,702,314 upon conversion of the Convertible Notes in November
      2006).




As
      part
      of the transaction, we agreed to issue warrants to purchase an aggregate of
      1,875,000 shares of Common Stock at a price of $.20 per share to a director
      and/or his designees as a consulting fee. As a result of this agreement, we
      valued the warrant at fair value, resulting in a charge to earnings during
      the
      year ended December 31,


23




2006
      of
      $46,875. In addition, in accordance with EITF 98-5 we recognized a debt discount
      of $4.5 million associated with the beneficial conversion feature of the
      Convertible Notes.




Approximately
      $3 million of the proceeds of the private placement were immediately used to
      repay past due amounts owed Samsung for security products previously purchased
      by us, and approximately $108,000 was paid to a consulting group owned and
      controlled by our former Chairman of the Board. The balance of the net proceeds
      from the private placement have used primarily for working capital and to pay
      expenses incurred in connection with the private placement.




**January
      2007 Private Placement**




On
      January 22, 2007, we completed a private placement of 1,713,334 shares of Common
      Stock at a price of $0.60 per share for aggregate gross consideration of
      $1,028,000. The proceeds from the private placement will be used for working
      capital and general corporate purposes. Because the shares were sold directly
      by
      us to the purchasers in the placement, we did not pay any placement agent fees
      or commissions in connection with the private placement.




**Laurus
      Credit Facility**




On
      May
      27, 2004, we closed a $15 million convertible debt financing with Laurus Master
      Fund, Ltd. under which we were provided with a $5 million term loan and a $10
      million revolving credit facility. At closing, we borrowed $5 million under
      the
      term loan and $10 million under the revolving credit facility, and used
      $10,016,000 of the proceeds to repay in full the indebtedness outstanding under
      the prior revolving credit agreement with Comerica Bank. Additional proceeds
      of
      the financing were used to increase working capital, pay closing fees to Laurus
      in the aggregate amount of $617,500, and pay a finder's fee in the amount of
      $800,000. As part of the transaction, Laurus was also issued a seven-year
      warrant to purchase 18,800 shares of Common Stock at a price of $175.00 per
      share. We also issued a similar warrant to purchase 1,880 shares of Common
      Stock
      to the finder. Borrowings under the Laurus financing are secured by all of
      our
      assets. At December 31, 2006, $1.9 million in principal was outstanding under
      the Term Loan and $6.4 million in principal was outstanding under the revolving
      credit facility. The agreements with Laurus prohibit the payment of dividends
      on
      the Company’s Common Stock, and contain other customary affirmative and negative
      covenants.




The
      term
      loan is evidenced by a Secured Term Note and bears interest at a rate per annum
      equal to the prime rate (as reported in the Wall Street Journal), plus two
      percent, subject to a floor of six percent. Interest on the term loan is payable
      monthly.




Prior
      to
      the October 2006 amendment described below, the interest rate under the Term
      Note was subject to downward adjustment at the end of each month so that if
      at
      the end of the applicable month we had registered the shares of Common Stock
      underlying the Term Note with the SEC, interest payable on the Term Note would
      be adjusted downward by 200 basis points (two percent) for each incremental
      25
      percent increase in the market price of the Common Stock, at the end of the
      month, in excess of the conversion price under the Term Note.




Amounts
      outstanding under the Term Note were initially convertible into Common Stock
      at
      Laurus's option. In addition, subject to (i) having an effective registration
      statement with respect to the shares of Common Stock underlying the Term Note,
      and (ii) limitations based on trading volume of the Common Stock, originally
      scheduled principal and interest payments under the Term Note were made in
      shares of Common Stock valued at the conversion price. In addition prepayments
      under the Term Note were subject to a premium in the amount of 20% of the
      principal being prepaid.




Borrowings
      under the revolving credit facility bear interest at a rate per annum equal
      to
      the prime rate plus two percent. In addition, prior to the October 2006
      amendment described below, the interest rate under the revolving credit facility
      was subject to downward adjustment at the end of each month in the same manner
      as provided for under the Term Note. The revolving credit facility terminates,
      and borrowings thereunder become due, on December 31, 2007.


24


Amounts
      outstanding under the revolving credit facility were also initially convertible
      to Common Stock at Laurus's option. To the extent the Company repays loans
      outstanding under the revolving credit facility, the Company can reborrow or
      make additional borrowings under the revolving credit facility, provided that
      aggregate loans outstanding under the revolving credit facility at any time
      may
      not exceed the lesser of $10 million or a borrowing base equal to the sum of
      83.7% of "eligible accounts" plus 60% of "eligible inventory" (with borrowings
      based on eligible inventory limited to $3.5 million). Eligible accounts are
      generally gross accounts receivable less foreign receivables and domestic
      receivables over 90 days from invoice date. Eligible inventory is substantially
      all finished goods inventory.




Pursuant
      to an amendment, dated as of May 26, 2006, (i) payments of principal due to
      Laurus for the months of June 2006 through December 2006 under the Term Note
      were reduced from $190,000 per month to $100,000 per month, (ii) the final
      payment of principal due to Laurus under the Term Note on May 27, 2007 was
      correspondingly increased from $435,000 to $1,065,000, and (iii) the exercise
      price of warrants previously issued to Laurus to purchase an aggregate of 26,800
      shares of the Company’s Common Stock was reduced from $175.00 to $30.00.
      Pursuant to a further Amendment, dated as of June 22, 2006, the conversion
      price
      of $300,000 of principal under the Term Note was reduced to $7.50 from $95.50,
      and Laurus converted such amount of principal into 2,000,000 shares of Common
      Stock. The principal so converted was applied to the payments of principal
      that
      would otherwise have been due under the Term Note for the months of July, August
      and September 2006. As a result of the reduction in the exercise price of the
      warrants, we recorded an interest charge of approximately $76,000.




On
      October 4, 2006, in connection with the private placement referred to above,
      we
      entered into an Omnibus Amendment and Consent with Laurus, pursuant to which
      Laurus consented to the issuance of the Convertible Notes in the private
      placement. In addition, Laurus agreed to further amendments to the revolving
      credit facility and term loan under which (i) the ability of Laurus to convert
      the revolving credit facility and term loan into Common Stock was eliminated;
      (ii) the maturity date of both the revolving credit facility and Term Note
      was
      extended from May 24, 2007 until December 31, 2007; (iii) prepayment penalties
      with respect to both the revolving credit facility and Term Note were
      eliminated; and (iv) monthly principal payments of $152,000 are due under the
      Term Note for the months of January 2007 through December 2007.




We
      will
      not be able to repay our obligations to Laurus at maturity unless we receive
      replacement financing or extend our current financing. There can be no assurance
      that we will be able to obtain such financing.




**December
      2004 Private Placement**




On
      December 27, 2004, we completed a private placement of approximately 452,400
      (post-split) shares of Common Stock for aggregate gross consideration of $33.9
      million. C.E. Unterberg, Towbin LLC acted as the financial advisor for us in
      the
      private placement and was paid a cash fee equal to seven percent of the gross
      proceeds from the private placement, plus its legal costs and expenses. Net
      cash
      proceeds were approximately $31.5 million, after compensation to the financial
      advisor and other costs of the placement.





Approximately
      $4.7 million of the proceeds were used to repay borrowings from Laurus Master
      Fund under the receivables facility, and $1.15 million of the proceeds were
      used
      to repay notes issued in an October 2004 bridge financing. The holders of
      $600,000 in principal amount of these notes reinvested such amount in the
      private placement. We used an additional $10 million of the net proceeds to
      repurchase 133,333 (post-split) shares of Common Stock from William A.
      Teitelbaum, a stockholder of the Company, pursuant to a Settlement Agreement
      between us and Mr. Teitelbaum entered into in October 2004. The balance of
      the
      net proceeds was used primarily for working capital and general corporate
      purposes.





**Going
      Concern Considerations**




As
      a
      result of our losses from operations and limited capital resources, our
      independent auditors have included an explanatory paragraph in their report
      on
      the accompanying financial statements indicating there is substantial doubt
      about our ability to continue as a going concern. The financial statements
      do
      not include any adjustments that might result from the outcome of this
      uncertainty. During
      the years ended December 31, 2006, 2005 and 2004, we experienced negative cash
      flow and operating losses, as well as losses from discontinued operations,
      which have
      resulted in a significant reduction in our cash balances. These factors raise
      substantial doubt


25




about
      our
      ability to continue as a going concern. If we are not successful in improving
      our operating results in the near term we may need to raise additional capital
      to finance our operations and sustain our business model. We may not be able
      to
      obtain additional financing on acceptable terms, or at all. In addition, any
      financing we obtain in the future may result in dilution to our existing
      stockholders.





**Contractual
      Obligations and Commitments**





A
      summary
      of our contractual obligations as of December 31, 2006 is as follows:




**Payments
                  Due by Period (in thousands)****2007**
              
              **2008**
              
              **2009**
              
              **2010**
              
              **Thereafter**Long-Term
                  Debt Obligations
              
              $
              8,291
              
              $
              0
              
              $
              0
              
              $
              0
              
              $
              0Capital
                  Lease Obligations
              
              
              77
              
              
              62
              
              
              0
              
              
              0
              
              
              0Operating
                  Lease Obligations
              
              
              308
              
              
              308
              
              
              231
              
              
              0
              
              
              0Samsung
                  Purchase Commitment
              
              
              27,000
              
              
              —
              
              
              —
              
              
              —
              
              
              —Total
              
              $
              35,676
              
              $
              370
              
              $
              231
              
              $
              0
              
              $
              0




**Off-Balance
      Sheet Arrangements**




We
      do not
      have any off-balance sheet transactions, arrangements or obligations (including
      contingent obligations) that would have a material effect on our financial
      results.




**Item
      7A. Quantitative and Qualitative Disclosures about Market
      Risk.**




**Quantitative**




Foreign
      Currency Exchange Risk





Our
      results of operations and cash flows are not subject in any material
      respect **** to
      fluctuations due to changes in foreign currency exchange rates. We do not
      currently have any foreign currency hedging contracts in place, nor did we
      enter
      into any such contracts during the years ended December 31, 2006, 2005 and
      2004.
      To date, exchange rate fluctuations have had little impact on our operating
      results and cash flows.





Interest
      Rate Sensitivity





As
      disclosed above, our loans with Laurus bear interest at a fluctuating rate
      of
      interest related to the “prime” rate in effect from time to time. Accordingly,
      increases in the prime rate will increase our interest expense under our
      agreements with Laurus. We do not use interest rate hedging contracts to manage
      our exposure to changes in interest rates.





**Item
      8. Financial Statements and Supplementary Data.**




The
      Financial Statements and Notes thereto can be found beginning on page F-1,
      "Index to Financial Statements," at the end of this Form 10-K.


26




**Item
      9. Changes in and Disagreements with Accountants on Accounting and Financial
      Disclosure.**




Not
      Applicable.




**Item
      9A. Controls and Procedures.**




Our
      management has evaluated, with the participation of our Chief Executive Officer
      and Chief Financial Officer, the effectiveness of our disclosure controls and
      procedures as of the end of the period covered by this report. Based on that
      evaluation, our Chief Executive Officer and Chief Financial Officer have
      concluded that our disclosure controls and procedures were effective as of
      the
      end of the period covered by this report.




Our
      management, including our Chief Executive and Chief Financial Officer, does
      not
      expect that our disclosure controls and procedures or internal control over
      financial reporting will prevent all errors and all fraud. A control system,
      no
      matter how well conceived and operated, can provide only reasonable, not
      absolute, assurance that the objectives of the system are met and cannot detect
      all deviations.  Because of the inherent limitations in all control
      systems, no evaluation of control can provide absolute assurance that all
      control issues and instances of fraud or deviations, if any, within the Company
      have been detected. While we believe that our disclosure controls and procedures
      and our internal control over financial reporting have been effective, in light
      of the foregoing, we intend to continue to examine and refine our disclosure
      controls and procedures and our internal control over financial reporting to
      monitor ongoing developments in this area.




There
      were no significant changes in our internal control over financial reporting
      subsequent to our evaluation of our internal control over financial reporting
      that could materially affect or are reasonably likely to materially affect
      our
      internal control over financial reporting.




**Item
      9B. Other Information.**




Not
      Applicable.




**PART
      III**




**Item
      10** **.
      Directors, Executive Officers and Corporate Governance of the
      Registrant.**




The
      following table sets forth our directors and executive officers, their ages
      and
      the positions they hold:




**Name**
            
            **Age**
            
            **Position**David
                Weiner
            
            50
            
            Chairman
                of the Board of DirectorsSteven
                E. Walin
            
            51
            
            Chief
                Executive Officer and DirectorJoseph
                Restivo
            
            53
            
            Chief
                Financial Officer and DirectorCraig
                Ellins1,2,3
            
            54
            
            DirectorGary
                Freeman1,2,3
            
            39
            
            DirectorMoshe
                Zarmi1,2,3
            
            69
            
            Director





1
            Member
                of the Audit Committee


2
            Member
                of the Compensation Committee


3
            Member
                of the Governance Committee





DAVID
      WEINER has served as one of our directors since October 4, 2006, and was
      previously a director of ours from February 17, 2004 until January 4, 2005.
      Mr.
      Weiner is the President of W-Net, Inc., an investment and consulting firm he
      founded in 1998. From December 2002 to April 2003 Mr. Weiner was Co-President
      for Trestle Holding Inc., a provider of digital imaging and telemedicine
      products. In 1993, Mr. Weiner joined K-tel, a music retailer, as Vice President
      of Corporate Development. He advanced to the position of President in 1996,
      which he held until he left to form W-Net in 1998.


27


STEVEN
      WALIN has been our Chief Executive Officer since March 6, 2006, and has served
      as a director of ours since March 28, 2006. Mr. Walin has over 20 years of
      experience in the security industry. Most recently, from April 2003 until his
      appointment as our Chief Executive Officer, Mr. Walin served as the President
      of
      GE Security Enterprise Solutions, a division of General Electric Company that
      provides security solutions, including video monitoring, intrusion and access
      control systems. Prior to his employment with GE, from July 2001, Mr. Walin
      served as the Senior Vice President - North America Security for the Security
      Systems Division of Siemens Building Technologies. Prior to that, Mr. Walin
      had
      been the President and Chief Operating Officer of Securities Technology Group,
      Inc. until it was acquired by Siemens in July 2001.




JOSEPH
      RESTIVO has been our Chief Financial Officer since March 2006 and a director
      since October 4, 2006. Prior to his employment with us, since January 2003,
      Mr.
      Restivo was an independent business consultant providing services in the areas
      of financial and business planning, turnaround assistance and operational
      management support. Prior to that time, from January 2000 until January 2002,
      Mr. Restivo served as the Vice President, North American Services and Business
      Development, for the Security Systems Division of Siemens Building Technologies.
      In addition, from 1990 until 1999, Mr. Restivo held numerous positions with
      Casi-Rusco (subsequently acquired by General Electric), a developer and
      manufacturer of large-scale access control systems, including Chief Financial
      Officer and Chief Operating Officer.




GARY
      FREEMAN has served as one of our directors since October 4, 2006. Mr. Freeman
      is
      currently a Partner in Bandari, Beach, Lim & Cleland’s Audit and Accounting
      services division. In conjunction with various consulting engagements, Mr.
      Freeman has assumed interim senior level management roles at numerous public
      and
      private companies during his career, including Co-President and Chief Financial
      Officer of Trestle Holdings Inc., Chief Financial Officer of Silvergraph
      International and Chief Financial Officer of Galorath Incorporated. Mr. Freeman
      is currently a member of the Board of Directors of Blue Holdings and serves
      as
      its Audit Committee Chairman. Mr. Freeman’s previous experience includes ten
      years with BDO Seidman, LLP, including two years as an Audit Partner.




CRAIG
      ELLINS has served as one of our directors since October 4, 2006. Mr. Ellins
      is
      the founder, Chairman and Chief Executive Officer of DigitalFX International,
      Inc. a digital communication company. Mr. Ellins has more than 20 years of
      experience in television direct marketing and Internet communications and has
      provided strategic planning services to companies such as K-tel International,
      Fingerhut Corporation, Guthy-Renker, Simitar Entertainment, and Stamina
      Products.




MOSHE
      ZARMI has served as one of our directors since October 4, 2006, and previously
      served as one of our directors from January 1998 until June 27, 2006. Mr. Zarmi
      was also our President and Chief Executive Officer from January 1998 until
      February 2004. Mr. Zarmi has 30 years experience, primarily in high technology
      industries. From February 1993 to January 1997, Mr. Zarmi was the Chief
      Executive Officer of Geotest, a leading Automated Test Equipment company based
      in Southern California. His extensive business experience includes a tenure
      at
      Israel Aircraft Industries, where he held various positions in finance and
      administration, as well as head of US marketing and sales.




**Audit
      Committee Financial Expert**




The
      Board
      of Directors has determined that Gary Freeman is an “audit committee financial
      expert,” as such term is defined in Item 401(h) of Regulation S-K, and is
      independent as defined in rule 4200(a)(15) of the listing standards of the
      National Association of Securities Dealers.




**Section
      16(a) Beneficial Ownership Reporting Compliance**




The
      members of our Board of Directors, our executive officers and persons who hold
      more than 10% of our outstanding Common Stock are subject to the reporting
      requirements of Section 16(a) of the Exchange Act, which requires them to file
      reports with respect to their ownership of our Common Stock and their
      transactions in such Common Stock. Based solely upon a review of Forms 3 and
      4
      and amendments furnished to the Company by such persons subject to the reporting
      requirements of Section 16(a) of the Exchange Act, except for a late filing
      of a
      Form 4 by Europa International, we believe that all reporting requirements
      under
      Section 16(a) for the 2006 fiscal year


28




were
      met
      in a timely manner by our directors, executive officers and beneficial owners
      of
      more than 10% of our Common Stock.




**Code
      of Conduct**




The
      Company maintains a Code of Business Conduct and Ethics that is applicable
      to
      all of our employees, including our Chief Executive Officer and Chief Financial
      Officer, and our directors. The Code of Conduct, which satisfies the
      requirements of a “code of ethics” under applicable SEC rules, contains written
      standards that are designed to deter wrongdoing and to promote honest and
      ethical conduct, including the ethical handling of actual or apparent conflicts
      of interest; full, fair, accurate, timely and understandable public disclosures
      and communications, including financial reporting; compliance with applicable
      laws, rules and regulations; prompt internal reporting of violations of the
      code; and accountability for adherence to the code.




**Item
                11.**
            **Executive
                Compensation**




*Compensation
      Discussion and Analysis*




***General***




Our
      compensation arrangements with those persons who served as our executive
      officers for all or part of 2006 reflect the individual circumstances
      surrounding the applicable executive officer’s hiring or appointment, as
      reflected in the employment agreements we entered into with those persons,
      and
      with respect to the person who previously served as our chief executive officer
      and chief financial officer, the separation agreement we entered into with
      him.
      The foregoing information is intended to provide context for the discussion
      that
      follows regarding our existing compensation arrangements with those persons
      who
      served as our executive officers for all or part of 2006.




The
      compensation committee of the board of directors is responsible for implementing
      and administering our benefit and compensation plans and programs. All of the
      members of our compensation committee are independent directors who were
      appointed to our board in October 2006. Our compensation committee consists
      of
      Craig Ellins, Gary Freeman and Moshe Zarmi.




***Principal
      Components of Compensation of Our Executive Officers***




The
      principal components of the compensation we have historically paid to our
      executive officers have consisted of:




·
            base
                salary;




·
            signing
                bonuses, paid in cash;




·
            operating
                bonuses, and




·
            equity
                compensation, generally in the form of stock options.




***Allocation
      and Objectives of Compensation***




The
      compensation committee of our board of directors has not established any
      policies or guidelines with respect to the mix of base salary, bonus, cash
      incentive compensation and equity awards to be paid or awarded to our executive
      officers. In general, the compensation committee implements policies and
      negotiates employment agreements designed to attract, retain and motivate
      individuals with the skills and experience necessary for us to achieve our
      business objectives. Compensation is established based on the scope of the
      executive’s responsibilities, taking into account competitive market
      compensation paid by other companies for similar positions.


29




***Base
      Salary***




*Our
      Chief Executive Officer*




We
      appointed Steven Walin as our chief executive officer in February 2006 following
      the negotiation of an employment agreement with him. The terms of Mr. Walin’s
      employment agreement were negotiated by our former Chairman of the Board, in
      consultation with our directors at that time, based on prevailing market
      conditions and available data on the compensation of executives in similar
      positions with comparable companies.





Mr. Walin’s
      employment agreement with us provides for an initial base salary of $375,000
      per
      year, with the base salary being subject to an annual increase in the discretion
      of our board.




*Our
      Chief Financial Officer*




Following
      our hiring of Mr. Walin, in March 2006, we negotiated an employment agreement
      with Joseph Restivo to serve as our Chief Financial Officer. Mr. Restivo’s
      agreement is similar in form to our agreement with Mr. Walin, and the
      negotiations with respect to Mr. Restivo’s agreement were based in part on the
      final terms of our agreement with Mr. Walin, as well as prevailing market
      conditions and available data on the compensation of executives in similar
      positions with comparable companies.




Mr. Restivo’s
      employment agreement with us provides for an initial base salary of $200,000
      per
      year, with the base salary being subject to an annual increase in the discretion
      of our board.




*Our
      former Chief Executive Officer and Chief Financial Officer*




Nazzareno
      Paciotti was appointed our Chief Executive Officer and Chief Financial Officer
      in February 2004 in connection with our reverse merger with GVI Security Inc.
      In
      connection with such appointment, Mr. Paciotti entered into a one-year
      employment agreement with us. In January 2005, we entered into a three-year
      employment agreement with Mr. Paciotti, similar in form to the original
      agreement we entered into with him, and reflective of negotiations between
      Mr.
      Paciotti and the persons serving on our compensation committee at that
      time.




During
      our fiscal year ended December 31, 2006, pursuant to the terms of his employment
      agreement with us, Mr. Paciotti was paid a base salary of $300,000 per year
      until the time of his departure in March 2006. In connection with his departure,
      we negotiated a Mutual Separation Agreement with Mr. Paciotti, the terms of
      which are described below under “Separation Agreement with Nazzareno Paciotti.”




***Bonus
      Compensation***




We
      have
      not historically paid any bonuses to our executive officers. However, during
      2006 we paid Mr. Walin a signing bonus of $100,000 and a guaranteed bonus of
      $140,625, both as required by the specific terms of Mr. Walin’s employment
      agreement with us. Pursuant to their employment agreements, each of Mr. Walin
      and Mr. Restivo are eligible to receive an annual cash bonus of up to 50% of
      their respective base salaries based on the achievement of annual performance
      targets approved by our board. We believe that the establishment of performance
      criteria will adequately reflect the quantitative performance of our executive
      officers.




***Equity
      Compensation***




Our
      board
      of directors’ historical practice has been to grant equity-based awards to
      attract, retain, motivate and reward our employees, particularly our executive
      officers, and to encourage their ownership of an equity interest in us and
      align
      management’s performance objectives with the interests of our stockholders. Our
      Amended and Restated 2004 Long Term Incentive Plan, which is administrated
      by
      our compensation committee, authorizes us to grant options to purchase shares
      to
      our employees, directors and consultants. Stock options are generally granted
      at
      the commencement of employment, and as described below, following other
      circumstances to meet retention or performance objectives. Generally, stock
      options granted by us have an exercise price equal to the fair market value
      on
      the grant date, vest over time based on continued employment, and expire ten
      years after the grant date.




Pursuant
      to their employment agreements with us, upon his appointment as our Chief
      Executive Officer, Mr. Walin was granted an option to purchase 60,000 shares
      of
      common stock at exercise prices ranging from $15.00


30




to
      $40.00, and Mr. Restivo was granted an option to purchase 15,000 shares of
      common stock at exercise prices ranging from $6.00 to $39.00. The employment
      agreements with each of Mr. Walin and Mr. Restivo provided them with the right
      to be issued additional options based on the number of shares sold by us on
      our
      next offering of securities within two-years following the date of their initial
      employment.




In
      connection with our October 2006 private placement, we negotiated amendments
      to
      the employment agreements with each of Mr. Walin and Mr. Restivo under which
      each of them were granted an option to purchase 1,881,795 shares of common
      stock
      with an exercise price of $0.20 per share (the price per share paid in
      connection with that private placement). The options granted to Mr. Walin and
      Mr. Restivo were intended to provide them with beneficial ownership,
      collectively, of approximately 10% of our common stock after giving effect
      to
      the October 2006 private placement. Pursuant to these amendments to their
      employment agreements, Mr. Walin and Mr. Restivo forfeited the options
      previously granted to them under their employment agreements as well as the
      additional options they would have otherwise been entitled to in connection
      with
      the sale of our securities.




We
      do not
      have any program, plan or practice that requires us to grant equity-based awards
      on specified dates and we have not made grants of such awards that were timed
      to
      precede or follow the release or withholding of material non-public information.
      It is possible that we will establish programs or policies regarding the timing
      of equity-based awards in the future. Authority to make equity-based awards
      to
      executive officers rests with our compensation committee.




***Severance
      and Change of Control Payments***




We
      believe that companies should provide reasonable severance benefits to
      employees, recognizing that it may be difficult for them to find comparable
      employment within a short period of time. We also believe it prudent that we
      disentangle ourselves from employees whose employment terminates as soon as
      practicable.  As provided in greater detail below under “Employment
      Agreement with Chief Executive Officer” and “Employment Agreement with Chief
      Financial Officer,” the employment agreements with Mr. Walin and Mr. Restivo
      contain provisions providing for payments following their termination by us
      without cause or for good reason, with increased payments and acceleration
      of
      option vesting in the event such termination follows a change of control.




In
      addition, in connection with his departure, we negotiated a Mutual Separation
      Agreement with Mr. Paciotti under which he was entitled to receive severance
      payments equal to one year of his annual base salary of $300,000, payable in
      12
      equal monthly installments. In addition, Mr. Paciotti was to continue to receive
      medical benefits until January 24, 2008. In consideration of such payments,
      Mr.
      Paciotti agreed to release us in full from any and all claims and to continue
      to
      be bound by the confidentiality and non-solicitation terms of his employment
      agreement. In September 2006, in consideration of a cash payment of $85,926,
      Mr.
      Paciotti agreed to the termination of our remaining obligations under the Mutual
      Separation Agreement. Prior to such payment, we had approximately $194,000
      of
      remaining cash severance obligations to Mr. Paciotti.




***Other
      Benefits***




We
      believe that establishing competitive benefit packages for our employees is
      an
      important factor in attracting and retaining highly qualified personnel.
      Executive officers are eligible to participate in all of our employee benefit
      plans, such as medical, dental, and our 401(k) plan, in each case on the same
      basis as other employees. We do not currently provide a matching contribution
      under our 401(k) plan nor do we offer retirement benefits.




***Perquisites***




Pursuant
      to their respective employment agreements, Mr. Walin receives a car allowance
      of
      $1,500 per month, and Mr. Restivo receives a car allowance of $1,000 per month.
      In addition, under the terms of their employment agreements with us, we are
      obligated to reimburse Mr. Walin and Mr. Restivo for all reasonable travel,
      entertainment and other expenses incurred by them in connection with the
      performance of their duties and obligations under their respective
      agreements.


31




*Summary
      Compensation Table*




The
      following table shows for the fiscal year ended December 31, 2006, compensation
      awarded to or paid to, or earned by, Steven Walin, our Chief Executive Officer;
      Joseph Restivo, our Chief Financial Officer; and Nazzareno Paciotti, who was
      our
      Chief Executive Officer and Chief Financial Officer during 2006 and departed
      from the Company on March 28, 2006 (the “Named Executive
      Officers”).




**Summary
      Compensation Table for Fiscal 2006**




Name
                and Principal Position
            Year
            Salary
              ($)
            Bonus
              ($)
            Option
                Awards (2)
              ($)
            All
                Other
              Compensation
                ($)
            Total
                ($)Steven
                Walin
              Chief
                Executive Officer
            2006
            $315,859
            $240,625
                (1)
            $259,445
                (3)
            $15,231
                (6)
            $831,160Joseph
                Restivo Chief Financial Officer
            2006
            $159,351
            —
            $50,684
                (4)
            $9,692
                (6)
            $219,727Nazzareno
                Paciotti
              Former
                Chief Executive Officer and Chief Financial Officer
            2006
            $259,791
                (7)
            —
            $4,000
                (5)
            —
            $263,791




(1)
            Consists
                of a signing bonus of $100,000 and a guaranteed bonus of $140,625
                for the
                first year of employment, both as required by the specific terms
                of Mr.
                Walin’s Employment Agreement.




(2)
            The
                value of option awards granted to the Named Executive Officers has
                been
                estimated pursuant to SFAS No. 123(R) based on our expense during
                2006 for
                the options described in the footnotes below, except that for purposes
                of
                this table, we have assumed that none of the options will be forfeited.
                The Named Executive Officers will not realize the estimated value
                of these
                awards in cash until these awards are vested and exercised or sold.
                For
                information regarding our valuation of option awards, see “Stock-Based
                Compensation” in Note 1 of our financial statements for the year ended
                December 31, 2006.




(3)
            Represents
                2006 expense with respect to options to purchase 60,000 shares of
                common
                stock granted March 6, 2006, with exercise prices of $15.00 to $40.00
                per
                share, and options to purchase 1,881,795 shares of common stock granted
                October 4, 2006, with an exercise price of $0.20 per share, after
                giving
                effect to the cancellation of the option granted March 6, 2006, which
                was
                forfeited in connection with the grant in October 4, 2006.




(4)
            Represents
                2006 expense with respect to options to purchase 15,000 shares of
                common
                stock granted March 28, 2006, with exercise prices of $8.00 to $39.00
                per
                share, and options to purchase 1,881,795 shares of common stock granted
                October 4, 2006, with an exercise price of $0.20 per share, after
                giving
                effect to the cancellation of the option granted March 28, 2006,
                which was
                forfeited in connection with the grant in October 4, 2006.




(5)
            Represents
                2006 expense with respect to options to purchase 7,500 share of common
                stock granted January 6, 2005, with an exercise price of $75.00 per
                share,
                and options to purchase 5,000 shares of common stock granted February
                17,
                2004, with an exercise price of $130.00 per share.




(6)
            Consists
                of a car allowance of $1,500 per month for Mr. Walin and $1,000 per
                month
                for Mr. Restivo.




(7)
            Includes
                approximately $192,000 of severance
                payments.




32




*Grants
      of Plan-Based Awards*




The
      following table shows for the fiscal year ended December 31, 2006, certain
      information regarding grants of awards under our Amended and Restated 2004
      Long
      Term Incentive Plan to our Named Executive Officers. All
      share
      and per share amounts in the table below give effect to the 1-for-50 reverse
      stock split effected in November 2006.




**Grants
      of Plan-Based Awards in Fiscal 2006**




Name
            Grant
                Date
            All
                Other Option Awards: Number of Securities Underlying Options
              (#)
            Exercise
                or Base
              Price
                of Option Awards
              ($/Sh)
            Closing
                Price of Common Stock on Grant Date (if lower than Exercise
                Price)
              ($/Sh)
            Grant
                Date Fair Value of Stock and Option Awards
              ($)Steven
                Walin
            October
                4, 2006 (1)
            1,881,795
            $.20
            $1.98
            $56,454March
                6, 2006 (2)
            60,000
            $15.00
                to $40.00
            —
            $300,000Joseph
                Restivo
            October
                4, 2006 (1)
            1,881,795
            $.20
            $1.98
            $56,454March
                28, 2006 (2)
            15,000
            $8.00
                to $39.00
            —
            $54,750Nazzareno
                Paciotti
            —
            —
            —
            —
            —





(1)
            These
                options were granted under our 2004 Long-Term Incentive Plan concurrently
                with our October 2006 private placement, and the exercise price of
                these
                options is equal to the price per share paid by investors in that
                private
                placement. These options vested immediately as to 25% of the shares
                subject to the option grant, and become exercisable as to the remaining
                option shares in equal monthly installments over the 36-month period
                following the grant date.





(2)
            These
                options were granted pursuant to the employment agreements of Mr.
                Walin
                and Mr. Restivo, respectively, and as described above in “Compensation
                Discussion and Analysis,” these options were forfeited in connection with
                the October 4, 2006 option grants.





*Outstanding
      Equity Awards at Fiscal Year-End*




The
      following table shows for the fiscal year ended December 31, 2006, certain
      information regarding outstanding equity awards at fiscal year end for the
      Named
      Executive Officers .




**Outstanding
      Equity Awards At December 31, 2006**




Option
                AwardsName
            Number
                of
              Securities
                Underlying Unexercised Options
              (#)
              Exercisable
            Number
                of Securities Underlying
              Unexercised
                Options
              (#)
              Unexercisable
            Option
                Exercise Price
              ($)
            Option
                Expiration DateSteven
                Walin
            548,857
            1,332,938
            $.20
            October
                4, 2016Joseph
                Restivo
            548,857
            1,332,938
            $.20
            October
                4, 2016Nazzareno
                Paciotti (1)
            —
            —
            —
            —





(1)
            Pursuant
                to a Mutual Separation Agreement described below, all options previously
                held by Mr. Paciotti expired on December 31,
                2006.




33




*Option
      Exercises and Stock Vested*




None
      of
      our Named Executive Officers exercised stock options or vested with respect
      to
      stock awards during our fiscal year ended December 31, 2006.




*Pension
      Benefits*




None
      of
      our Named Executive Officers participate in or have account balances in
      qualified or non-qualified defined benefit plans sponsored by us.




*Nonqualified
      Deferred Compensation*




None
      of
      our Named Executive Officers participate in or have account balances in
      non-qualified defined contribution plans or other deferred compensation plans
      maintained by us.





**Employment
      Contracts; Termination of Employment and Change-in-Control
      Arrangements**




***Employment
      Agreement with Chief Executive Officer***




We
      have
      entered into an Employment Agreement, dated as of February 9, 2006, with Steven
      Walin, our Chief Executive Officer. The Employment Agreement is for a three-year
      term of employment which commenced March 6, 2006. Pursuant
      to the Employment Agreement, Mr. Walin received a $100,000 signing bonus and
      receives an annual base salary of $375,000.




Pursuant
      to his Employment Agreement, Mr. Walin was also paid a guaranteed bonus equal
      to
      50% of his base salary ($140,625) for the first nine months of his service
      to
      us, and is entitled to receive an annual bonus of up to 50% of his base salary
      based on the achievement of annual performance targets approved of by our board
      of directors, for subsequent years.




In
      addition, pursuant to the Employment Agreement, in the event that Mr. Walin’s
      employment is terminated by us without “Cause” or by Mr. Walin for “Good Reason”
(as such terms are defined in the Employment Agreement), Mr. Walin will be
      entitled to:




·
            payment
                of all accrued but unpaid base salary, his signing bonus (to the
                extent
                then unpaid), and unpaid annual bonus with respect to any completed
                fiscal
                year;




·
            payment
                of his base salary and continued medical benefits for 12 months;
                provided,
                that if such termination occurs after a “Change in Control” Mr. Walin will
                instead be entitled to a payment equal to 200% of his base salary
                and
                continued medical benefits for 24
                months;




·
            pro-rated
                bonus for the year in which the termination occurs, payable following
                such
                fiscal year to the extent he would have otherwise been entitled to
                such
                bonus; and




·
            provided
                at least six months has expired since the last vesting of an option
                grant,
                a pro rata vesting of his option shares which are scheduled to vest
                on the
                next vesting date; provided, that if such termination occurs after
                a
                “Change in Control” or after the first anniversary of Mr. Walin’s
                employment with us, all of the unvested options will immediately
                vest.




If
      Mr.
      Walin’s employment is terminated as a result of his death or disability, we will
      pay him his accrued but unpaid base salary, unpaid signing bonus, and unpaid
      annual bonus with respect to any completed fiscal year, and a pro-rated portion
      of any bonus he would have otherwise been entitled for the fiscal year in which
      the termination occurs.




Mr.
      Walin
      is prohibited under the Employment Agreement from using or disclosing any of
      our
      proprietary information, competing with us, hiring any of our employees or
      consultants and soliciting any of our customers or suppliers to reduce or cease
      business with us.


34


On
      October 4, 2006, we entered into an amendment to our Employment Agreement with
      Mr. Walin under which we issued him an option to purchase 1,881,795 shares
      of
      our Common Stock at an exercise price of $.20 per share (such number of shares
      and exercise price after giving effect to our subsequent reverse stock split)
      vesting over a three-year period. Pursuant to the amendment, Mr. Walin forfeited
      all stock options previously granted to him under his employment agreement
      as
      well as the right to be issued additional stock options upon the closing of
      a
      private placement of our securities. In addition, we amended the definition
      of
“Cause” for termination purposes to include our incurrence of a net loss, as
      defined in the amendment, in the quarter ending June 30, 2007.




***Employment
      Agreement with Chief Financial Officer***




We
      have
      entered into an Employment Agreement, dated as of March 28, 2006, with Joseph
      Restivo, our Chief Financial Officer. The
      Employment Agreement is for a three-year term and provides Mr. Restivo with
      an
      annual base salary of $200,000, and an annual bonus of up to 50% of his base
      salary based on the achievement of annual performance targets approved of by
      our
      board of directors.




In
      addition, pursuant to the Employment Agreement, in the event that Mr. Restivo’s
      employment is terminated by us without “Cause” or by Mr. Restivo for “Good
      Reason” (as such terms are defined in the Employment Agreement), Mr. Restivo
      will be entitled to:




·
            payment
                of all accrued but unpaid base salary and unpaid annual bonus with
                respect
                to any completed fiscal year;




·
            payment
                of his base salary and continued medical benefits for 12 months;
                provided,
                that if such termination occurs after a “Change in Control” Mr. Restivo
                will instead be entitled to a payment equal to 200% of his base salary
                and
                continued medical benefits for 24
                months;




·
            pro-rated
                bonus for the year in which the termination occurs, payable following
                such
                fiscal year to the extent he would have otherwise been entitled to
                such
                bonus; and




·
            provided
                at least six months has expired since the last vesting of his option
                grant, a pro rata vesting of his option shares which are scheduled
                to vest
                on the next vesting date; provided, that if such termination occurs
                after
                a “Change in Control” or after the first anniversary of Mr. Restivo’s
                employment with us, all of the unvested options will immediately
                vest.




If
      Mr.
      Restivo’s employment is terminated as a result of his death or disability, we
      will pay him his accrued but unpaid base salary and unpaid annual bonus with
      respect to any completed fiscal year, and a pro-rated portion of any bonus
      he
      would have otherwise been entitled for the fiscal year in which the termination
      occurs.




Mr.
      Restivo is prohibited under the Employment Agreement from using or disclosing
      any of our proprietary information, competing with us, hiring any of our
      employees or consultants and soliciting any of our customers or suppliers to
      reduce or cease business with us.




On
      October 4, 2006, we entered into an amendment to our Employment Agreement with
      Mr. Restivo under which we issued him an option to purchase 1,881,795 shares
      of
      our Common Stock at an exercise price of $.20 per share (such number of shares
      and exercise price after giving effect to our subsequent reverse stock split)
      vesting over a three-year period. Pursuant to the amendment, Mr. Restivo
      forfeited all stock options previously granted to him under his employment
      agreement as well as the right to be issued additional stock options upon the
      closing of a private placement of our securities. In addition, we amended the
      definition of “Cause” for termination purposes to include our incurrence of a
      net loss, as defined in the amendment, in the quarter ending June 30, 2007.




***Separation
      Agreement with Nazzareno Paciotti***




On
      March
      28, 2006 we entered into a Mutual Separation Agreement with Nazzareno Paciotti,
      who was our Chief Financial Officer from February 2004 until such date, and
      who
      was our Chief Executive Officer from February 2004 until March 6, 2006. Pursuant
      to the Mutual Separation Agreement, the parties mutually agreed to


35




the
      termination of Mr. Paciotti’s employment with us and to his resignation as a
      director and officer of GVI Security Solutions, Inc. and its subsidiaries.
      Mr.
      Paciotti was entitled to receive severance payments equal to one year of his
      annual base salary of $300,000, payable in 12 equal monthly installments. In
      addition, Mr. Paciotti will continue to receive medical benefits until January
      24, 2008. Mr. Paciotti agreed to release us in full from any and all claims
      and
      to continue to be bound by the confidentiality and non-solicitation terms of
      his
      employment agreement. In September 2006, in consideration of a cash payment
      of
      $8 5,926,
      Mr. Paciotti agreed to the termination of our remaining obligations under the Mutual
      Separation Agreement. Prior to such payment, we had approximately $194,000
      of
      remaining cash severance obligations to Mr. Paciotti.




***Director
      Compensation***




*Non-employee
      Directors*




On
      December 6, 2006, our Board of Directors approved compensation arrangements
      for
      non-employee directors under which, commencing January 2007, each of our
      non-employee directors will be entitled to receive a monthly cash payment of
      $2,500. David Weiner and Craig Ellins have waived their current rights to
      receive these payments. Accordingly, these monthly payments will initially
      be
      made only to Gary Freeman and Moshe Zarmi. Our directors are also reimbursed
      for
      actual out-of-pocket expenses incurred by them in connection with their
      attendance at meetings of the Board of Directors.




From
      August 2005 through June 2006, our non-employee directors received a monthly
      payment of $2,000 in cash. In addition, in October 2005, we adopted a
      Non-Employee Directors’ Stock Plan and authorized 400,000 shares of Common Stock
      for issuance thereunder. Under the Non-Employee Directors’ Stock Plan, each
      non-employee director was awarded shares of our Common Stock with an aggregate
      fair market value of $1,000 as of the 15 th day of
      each month. The shares authorized for issuance under the Non-Employee Directors’
Stock Plan were exhausted in August 2006.




*Former
      Chairman Compensation*




Howard
      Safir was our Chairman of the Board from February 17, 2004 until October 4,
      2006. Under an agreement dated as of February 17, 2004 with November Group,
      Ltd., of which Mr. Safir is a principal, November Group agreed to provide us
      with advice, consultation and assistance over a term of three years ending
      February 17, 2007 for a fee of $600,000, payable in equal monthly installments
      over the term of the agreement. Upon the closing of our October 2006 private
      placement, which constituted a change in control under the agreement, we paid
      the remaining fee owed to the November Group in the amount of approximately $108,000 .




The
      following table shows for the fiscal year ended December 31, 2006 certain
      information with respect to the compensation of all non-employee directors
      of
      the Company.




**Director
      Compensation for Fiscal 2006**




Name
            Fees
                Earned or
              Paid
                in
              Cash
              ($)
            Stock
              Awards
              ($)
            Option
              Awards
              ($)
                (1)
            All
                Other
              Compensation
              ($)
            Total
              ($)Richard
                Berman (2)
            $12,000
            $7,903
            $1,312
                (3)
            —
            $
                21,215Victor
                DeMarines (2)
            $4,000
            $3,903
            —
            —
            $
                7,903




36




Name
              Fees
                  Earned or
                Paid
                  in
                Cash
                ($)
              Stock
                Awards
                ($)
              Option
                Awards
                ($)
                  (1)
              All
                  Other
                Compensation
                ($)
              Total
                ($)Craig
                  Ellins
              —
              —
              $
                  56 (4)
              —
              $
                  56Gary
                  Freeman
              —
              —
              $
                  56 (4)
              —
              $
                  56Bruce
                  Galloway (2)
              $12,000
              $6,000
              $1,312
                  (3)
              —
              $
                  19,312John
                  Gutfreund (2)
              $12,000
              $7,903
              —
              —
              $
                  19,903Asa
                  Hutchinson (2)
              $12,000
              $7,903
              —
              —
              $
                  19,903Kenneth
                  Minihan (2)
              $4,000
              $3,903
              —
              —
              $
                  7,903Joseph
                  Rosetti (2)
              $12,000
              $7,903
              $1,162
                  (5)
              —
              $
                  21,065Howard
                  Safir (2)
              —
              —
              $3,883
                  (6)
              $241,673
                  (8)
              $245,556David
                  Weiner
              —
              —
              —
              —
              --Moshe
                  Zarmi
              $12,000
              $6,000
              $701
                  (7)
              
              $
                  18,701


(1)
            The
                value of option awards granted to directors has been estimated pursuant
                to
                SFAS No. 123(R) based on our expense during 2006 for the options
                described
                in the footnotes below, except that for purposes of this table, we
                have
                assumed that none of the options will be forfeited. The directors
                will not
                realize the estimated value of these awards in cash until these awards
                are
                vested and exercised or sold. For information regarding our valuation
                of
                option awards, see “Stock-Based Compensation” in Note 1 of our financial
                statements for the year ended December 31,
                2006.




(2)
            Not
                currently a director of the
                Company.




(3)
            Represents
                2006 expense with respect to options to purchase 950 shares of common
                stock granted January 6, 2005, with an exercise price of $75.00 per
                share,
                and options to purchase 6,000 shares of common stock granted February
                17,
                2004, with an exercise price of $130.00 per share.




(4)
            Represents
                2006 expense with respect to options to purchase 10,000 shares of
                common
                stock granted October 20, 2006, with an exercise price of $0.20 per
                share.




(5)
            Represents
                2006 expense with respect to options to purchase 950 shares of common
                stock granted January 6, 2005, with an exercise price of $75.00 per
                share,
                and options to purchase 5,000 shares of common stock granted February
                17,
                2004, with an exercise price of $130.00 per share.




(6)
            Represents
                2006 expense with respect to options to purchase 5,500 shares of
                common
                stock granted January 6, 2005, with an exercise price of $75.00 per
                share,
                and options to purchase 10,000 shares of common stock granted February
                17,
                2004, with an exercise price of $130.00 per share.




(7)
            Represents
                2006 expense with respect to options to purchase 10,000 shares of
                common
                stock granted October 20, 2006, with an exercise price of $0.20 per
                share,
                options to purchase 450 shares of common stock granted January 6,
                2005,
                with an exercise price of $75.00 per share, and options to purchase
                3,000
                shares of common stock granted February 17, 2004, with an exercise
                price
                of $130.00 per share.




(8)
            Paid
                to November Group, Ltd. pursuant to the agreement dated February
                17, 2004,
                as described above.







**Stock
      Option Plan**




In
      March
      2004, our stockholders approved our 2004 Long-Term Incentive Plan, reserving
      118,798 (after


37




giving
      effect to a subsequent one-for-65 reverse split) shares of our Common Stock
      for
      issuance thereunder. Pursuant to amendments to the Plan approved by our
      stockholders, and after giving effect to our recent one-for-50 reverse split,
      we
      are authorized to issue up to 5,900,000 shares of Common Stock under the Plan.
      The Plan provides for the grant of options and other awards to our employees,
      officers, directors and consultants. The Plan authorizes the Board of Directors
      to issue incentive stock options (“ISOs”) as defined in Section 422(b) of the
      Internal Revenue Code of 1986, as amended, stock options that do not conform
      to
      the requirements of that Code section (“Non-ISOs”), stock appreciation rights
      (“SARs”), restricted stock, stock awards and other stock based awards. Directors
      who are not employees of the Company may only be granted Non-ISOs.




The
      Plan
      is administered by the Compensation Committee of the Board of Directors. The
      Compensation Committee has the authority to select those employees, officers,
      directors and consultants whose performance it determines significantly promotes
      the Company’s success to receive discretionary awards under the Plan, grant the
      awards, interpret and determine all questions of policy with respect thereto
      and
      adopt rules, regulations, agreements and instruments deemed necessary for its
      proper administration.




**COMPENSATION
      COMMITTEE REPORT**





The
      Compensation Committee has reviewed and discussed the Compensation Discussion
      and Analysis with management. Based upon such review, the related discussions
      and such other matters deemed relevant and appropriate by the Compensation
      Committee, the Compensation Committee has recommended to the Board of Directors
      that the Compensation Discussion and Analysis be included in this Annual Report
      on Form 10-K.





Craig
      Ellins


Gary
      Freeman


Moshe
      Zarmi




**Compensation
      Committee Interlocks and Insider Participation**




The
      Compensation Committee consists of Messrs.  Ellins, Freeman and Zarmi, all
      of whom are independent non-management directors. Other than Mr. Zarmi, who
      was
      our President and Chief Executive Officer from January 1998 until February
      2004,
      none of the Compensation Committee members has served as an officer or employee
      of ours, and none of our executive officers has served as a member of a
      compensation committee or board of directors of any other entity, which has
      an
      executive officer serving as a member of our Board of Directors.




**Item
      12. Security Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters.**




The
      following table sets forth as of March 26, 2007, certain information known
      to us
      with respect to the beneficial ownership of Common Stock by (i) each person
      who
      is known by us to own of record or beneficially more than 5% of the outstanding
      Common Stock, (ii) each of our directors executive officers, and (iii) all
      of
      our directors and executive officers as a group. Unless otherwise indicated,
      each of the stockholders can be reached at the Company’s principal executive
      offices located at 2801 Trade Center Drive, Suite 120, Carrollton, Texas
      75007.


38




**SHARES
                BENEFICIALLY OWNED****1****Number**
            
            **Percent
                (%)*****Beneficial
                Owners of more than 5% of Common Stock (other than directors and
                executive
                officers)***Steven
                Kolow2
              *PO
                Box 5360*
              *Wayland,
                MA 01778*
            
            
            5,345,623
            
            
            18.8
            %Europa
                International, Inc.3
            
            
            3,557,303
            
            
            12.4
            %Fred
                Knoll4
            
            
            3,565,445
            
            
            12.4
            %HG
                Investments, LLC
              *7030
                Hayvenhurst Ave.*
              *Van
                Nuys, CA 91406*
            
            
            2,770,342
            
            
            9.9
            %Paul
                & Beth Guez Living Trust
              *972
                Palisades Beach Road*
              *Santa
                Monica, CA 90403*
            
            
            1,720,536
            
            
            6.1
            %Richard
                Kall5
              *9000
                Players Club Drive*
              *Las
                Vegas, NV 89134*
            
            
            2,595,342
            
            
            9.2
            %***Directors
                and Executive Officers***David
                Weiner6
            
            
            2,611,649
            
            
            9.1
            %Craig
                Ellins7
            
            
            87,083
            
            
            *Gary
                Freeman7
            
            
            3,750
            
            
            *Moshe
                Zarmi8
            
            
            4,641
            
            
            *Joseph
                Restivo9
            
            
            792,486
            
            
            2.8
            %Steven
                Walin9
            
            
            809,153
            
            
            2.8
            %***All
                directors and executive officers as a group (six persons)*10**
            
            
            4,308,354
            
            
            14.4
            %





*
            Less
                than 1%.





1
            Gives
                effect to the shares of Common Stock issuable upon the exercise of
                all
                options exercisable within 60 days of March 23, 2007 and other rights
                beneficially owned by the indicated stockholders on that date. Beneficial
                ownership is determined in accordance with the rules of the Securities
                and
                Exchange Commission and includes voting and investment power with
                respect
                to shares. Unless otherwise indicated, the persons named in the table
                have
                sole voting and sole investment control with respect to all shares
                beneficially owned. Percentage ownership is calculated based on 28,106,168
                shares of the Common Stock outstanding as of March 23, 2007. All
                information is based upon information furnished by the persons listed,
                contained in filings made by them with the SEC or otherwise available
                to
                the Company.




2
            Includes
                324,938 shares of Common Stock issuable upon exercise of warrants.




3
            Includes
                650,063 shares of Common Stock issuable upon exercise of warrants.
                Europa’s address is P.O. Box 146, Road Town, Tortola, British Virgin
                Islands. Fred Knoll is the principal of Knoll Capital Management,
                L.P.,
                which manages Europa’s investments.




4
            Includes
                (i) 3,557,303 shares of Common Stock beneficially owned by Europa;
                (ii)
                1,475 shares of Common Stock beneficially owned by Thinking Technologies,
                L.P., and (iii) warrants to purchase 6,667 shares of Common Stock
                held by
                Knoll Capital Fund II. Fred Knoll is the principal of Knoll Capital
                Management, L.P., which is the general partner of Thinking Technologies,
                L.P., and the investment




39




manager
      of Knoll Capital Fund II and Europa. Mr. Knoll’s address is c/o Knoll Capital
      Management, L.P. 666 5 th Avenue
      Suite 3702, New York, New York 10102.




5
            Includes
                75,000 shares of Common Stock issuable upon exercise of a
                warrant.




6
            Includes
                (i) 20,020 shares of Common Stock owned by Woodman Management Corporation,
                of which David Weiner is the sole shareholder, (ii) 568,688 shares
                of
                Common Stock issuable upon exercise of a warrant, and (iii) warrants
                to
                purchase 6,667 shares of Common Stock held by W-Net, Inc., of which
                Mr.
                Weiner is the sole shareholder.





7
            Includes
                3,750 shares of Common Stock issuable upon exercise of
                options.





8
            Consists
                of shares of Common Stock issuable upon exercise of options.





9
            Includes
                666,469 shares of Common Stock issuable upon exercise of options.





10
            Includes
                Messrs. Weiner, Ellins, Freeman, Zarmi, Walin, and
                Restivo.




**Item
      13. Certain Relationships and Related Transactions** **,
      and Director Independence.**




On
      October 6, 2006, we completed a $5 million private placement, consisting of
      100
      Units at a price of $50,000 per unit. Each of Steve Walin, our Chief Executive
      Officer, and Joseph Restivo, our Chief Financial Officer, purchased one-half
      of
      a Unit in the private placement. Each Unit consisted of 25,000 shares of Common
      Stock and a 6% Subordinated Secured Convertible Promissory Note in the principal
      amount of $45,000, convertible into 225,000 shares of Common Stock at a
      conversion price equal to $.20. On November 27, 2006, we effected a 50-for-1
      reverse stock split of the Common Stock, and all of the Convertible Notes
      (including approximately $40,460 of accrued interest) were converted to Common
      Stock. After giving effect to the reverse split and the conversion, we have
      outstanding 26,392,834 shares of Common Stock, of which 25,202,314 were issued
      to the purchasers of the Units (2,500,000 on the closing of the October 2006
      private placement and 22,702,314 upon conversion of the Convertible Notes in
      November 2006).




W-Net,
      Inc. acted a consultant to us in connection with the private placement and
      in
      consideration thereof, we issued to W-Net’s designees warrants to purchase
      1,875,000 shares of Common Stock at a price of $.20 per share. David Weiner
      is
      the principal of W-Net, and is also the managing member of GVI Investment
      Company LLC, which was the lead investor in the private placement. In connection
      with the private placement, Mr. Weiner was appointed to our Board of
      Directors.




The
      purchasers in the private placement consisted of a group of accredited investors
      led by GVI Investment Company, LLC, a Nevada limited liability company formed
      for the purpose of participating in the private placement. GVI Investment
      Company, LLC, which purchased $2.5 **** million
      of the Units is managed by David Weiner. In January 2007, GVI Investment Company
      LLC transferred to its members the 12,601,712 shares of Common Stock it acquired
      in connection with its investment in the private placement. Included in such
      transfers was the transfer of 2,016,274 shares of Common Stock to Mr. Weiner,
      who through GVI Investment Company LLC invested $400,000 in the private
      placement.




In
      connection with the private placement, and effective immediately following
      its
      closing, our existing directors at that time, other than Steven Walin our Chief
      Executive Officer, resigned, and David Weiner, Craig Ellins, Gary Freeman,
      Moshe
      Zarmi and Joseph Restivo, our Chief Financial Officer, were appointed to our
      Board of Directors.




On
      January 22, 2007, we completed a private placement of 1,713,334 shares of Common
      Stock at a price of $0.60 per share for aggregate gross consideration of
      $1,028,000. The purchasers in the private placement included Craig Ellins,
      a
      director of ours who purchased 83,333 shares of Common Stock, and Steve Walin,
      our Chief Executive Officer, who purchased 16,667 shares of Common
      Stock.




40




***Director
      Independence***




All
      members of our Board of Directors, other than our Chairman of the Board, David
      Weiner, our Chief Executive Officer, Steven Walin, and our Chief Financial
      Officer, Joseph Restivo, are independent under the standards set forth in Nasdaq
      Marketplace Rule 4200(a)(15). In addition, each member of our Compensation
      and
      Governance Committees is independent under Nasdaq Marketplace Rule 4200(a)(15)
      and each member of our Audit Committee is independent under the standards set
      forth in Nasdaq Marketplace Rules 4350(d)(2)(A)(i) and (ii).




**Item
      14. Principal Accountant Fees and Services.**




The
      following table presents fees for professional audit services rendered by
      Mercadien for the audit of the Company’s annual financial statements for the
      years ended December 31, 2006, 2005 and 2004, and fees billed for other services
      rendered by Mercadien during those years.




**2006**
            
            **2005**
            
            **2004**Audit
                fees(1)
            
            $
            194,271
            
            $
            253,690
            
            $
            216,244Audit
                related fees
            
            
            —
            
            
            —
            
            
            —Tax
                fees
            
            
            11,930
            
            $
            15,487
            
            $
            3,136All
                other fees(2)
            
            
            28,429
            
            $
            14,291
            
            $
            40,220Total
                fees
            
            $
            234,630
            
            $
            283,470
            
            $
            259,600





(1)
            Includes
                fees paid for professional services rendered in connection with the
                audit
                of annual financial statements and the review of quarterly financial
                statements.




(2)
            Consists
                primarily of fees paid in connection with review of the Company’s
                financial statements in the Company’s Registration Statement on Form SB-2,
                Current Reports on Form 8-K, and related due
                diligence.




**Pre-Approval
      Policies and Procedures**




The
      Audit
      Committee pre-approves all auditing services and permitted non-audit services
      (including the fees and terms thereof) to be performed for us by our independent
      auditor, subject to the de minimis exceptions for non-audit services described
      in Section 10A(i)(1)(B) of the Securities Exchange Act of 1934, as amended.
      The
      Audit Committee approved all such services prior to the auditor’s engagement for
      such services during the year ended December 31, 2006.




41




**PART
      IV**




**Item
      15. Exhibits, Financial Statement Schedules.** ****




The
      following documents are filed as part of this report:




**Exhibit**
              **Number**
            
            **Exhibit
                Title**2.1
            
            Agreement
                and Plan of Merger, dated as of February 19, 2004, by and among Thinking
                Tools, Inc., GVI Security, Inc., and GVI Security Acquisition Corp.
                *2.2
            
            Agreement
                and Plan of Merger, dated as of June 30, 2004, by and among GVI Security
                Solutions, Inc., Rapor, Inc., and Rapor Acquisition
                Corp.####3.1
            
            Certificate
                of Incorporation and Amendments of GVI Security Solutions,
                Inc.**3.2
            
            Amended
                and Restated By-Laws of GVI Security Solutions, Inc.****4.1‡
            
            2004
                Long-Term Stock Incentive Plan #4.2
            
            Registration
                Rights Agreement, dated as of February 19, 2004, by and among the
                Registrant and the stockholders of the Registrant party
                thereto.*4.3
            
            Registration
                Rights Agreement, dated as of July, 2004, by and among the GVI Security
                Solutions, Inc. and the former stockholders of
                Rapor.####4.4
            
            Form
                of Subscription Agreement for Units purchased by investors in October
                2004
                Bridge Financing+4.5
            
            Form
                of Warrant issued to investors in October 2004 Bridge
                Financing+4.6
            
            Security
                Purchase Agreement, dated as of December 21, 2004, by and among GVI
                Security Solutions, Inc. and the Purchasers listed on Schedule A
                thereto.+++4.7
            
            Form
                of Subscription Agreement to purchase Units consisting of 6% Subordinated
                Secured Convertible Promissory Note and shares of Common Stock, dated
                October __, 2006††4.8
            
            Form
                of Warrant to purchase Common Stock issued to designees of W-Net,
                Inc.
                dated October __, 2006 ††4.9
            
            Registration
                Rights Agreement, dated May 27, 2004, by and between GVI Security
                Solutions, Inc. and Laurus Master Fund, Ltd. ##4.10
            
            Form
                of Subscription Agreement to purchase Common Stock in connection
                with the
                January 2007 Private Placement (Incorporated by reference to the
                exhibit
                to Registrant’s Current Report on Form 8-K, as filed with the SEC on June
                23, 2007.)4.16
            
            Employment
                Agreement, dated as of January 31, 2006, between GVI Security Solutions,
                Inc. and Steven E. Walin †††10.1
            
            Distributorship
                Agreement dated as of October 2, 2006 between GVI Security Inc. and
                Samsung Electronics Co., Ltd.. ††




42




10.2‡
            
            Executive
                Employment Agreement, dated as of January 24, 2005, by and between
                the
                Registrant and Nazzareno E. Paciotti (Incorporated by reference to
                the
                similarly described exhibit previously filed as an exhibit to Registration
                Statement on Form SB-2 (Registration No. 33-122314))10.3‡
            
            Consulting
                Agreement, dated as of February 17, 2004, by and between the Registrant
                and November Group, Ltd. #10.4
            
            Commercial
                Industrial Lease Agreement, effective as of April 1, 2004, between,
                CSHV
                Texas Industrial, L.P., as Landlord, and GVI Security, Inc., as Tenant
                ***10.5
            
            Settlement
                Agreement and General Release, dated as of October 13, 2004, between
                the
                Registrant, GVI Security, Inc., William A. Teitelbaum and Alarmax
                Distributors, Inc. ***10.6
            
            Mutual
                Separation Agreement, dated as of September 30, 2004, by and among
                GVI
                Security, Inc., GVI Security Solutions, Inc. and Thomas Wade.
                ####10.7
            
            Alliance
                Agreement dated May 5, 2005 between GVI Security Solutions, Inc.
                and SSC,
                Inc†++10.8‡
            
            GVI
                Security Solutions, Inc. Nonemployee Directors’ Stock Plan
                ####10.9‡
            
            Employment
                Agreement, dated as of January 31, 2006, between GVI Security Solutions,
                Inc. and Steven E. Walin †10.10‡
            
            Employment
                Agreement, dated as of March 28, 2006, between GVI Security Solutions,
                Inc. and Joseph Restivo. ****10.11‡
            
            Mutual
                Separation Agreement, dated as of March 28, 2006, between GVI Security
                Solutions, Inc. and Nazzareno Paciotti.****10.12‡
            
            Omnibus
                Amendment and Consent betweenGVI
                Security Solutions, Inc., andLaurus
                Master Fund Ltd.dated October 3, 2006††10.13
            
            Amended
                and Restated Securities Purchase Agreement, by and between GVI Security
                Solutions, Inc. and Laurus Master Fund, Ltd., dated May 27, 2004,
                and
                amended and restated as of October 4, 2006††10.14
            
            Amended
                and Restated Secured Term Note, made by GVI Security Solutions, Inc.
                to
                Laurus Master Fund, Ltd. dated May 27, 2004, and amended and restated
                as
                of October 4, 2006††10.15
            
            Common
                Stock Purchase Warrant, dated May 27, 2004, issued to Laurus Master
                Fund,
                Ltd. ##10.16
            
            Amended
                and Restated Security Agreement, by and between GVI Security Solutions,
                Inc. and Laurus Master Fund, Ltd., dated May 27, 2004, and amended
                and
                restated as of October 4, 2006††10.17
            
            Amended
                and Restated Secured Minimum Borrowing Note, made by GVI Security
                Solutions, Inc. to Laurus Master Fund, Ltd. dated May 27, 2004, and
                amended and restated as of October 4, 2006††10.18
            
            Amended
                and Restated Revolving Note, made by GVI Security Solutions, Inc.
                to
                Laurus Master Fund, Ltd. dated May 27, 2004, and amended and restated
                as
                of October 4, 2006††10.19
            
            Subsidiary
                Guarantee, dated May 27, 2004, by GVI Security, Inc. in favor of
                Laurus
                Master Fund, Ltd. ##10.20
            
            Stock
                Pledge Agreement, dated May 27, 2004, by and among GVI Security Solutions,
                Inc. and Laurus Master Fund, Ltd.
                ##




43




10.21‡
            
            Amendment
                to Employment Agreement between GVI Security Solutions, Inc. and
                Steven
                Walin dated as of October 4, 2006††10.22‡
            
            Amendment
                to Employment Agreement between GVI Security Solutions, Inc. and
                Joseph
                Restivo dated as of October 4, 2006††10.23
            
            Amendment,
                dated as of June 22, 2006, between GVI Security Solutions, Inc. and
                Laurus
                Master Fund, Ltd. (Incorporated by reference to the similarly described
                exhibit previously filed as an exhibit to Registrant’s Current Report on
                Form 8-K, as filed with the SEC on June 22, 2006.)10.24
            
            Amendment,
                dated as of May 26, 2006, between GVI Security Solutions, Inc. and
                Laurus
                Master Fund, Ltd. (Incorporated by reference to the similarly described
                exhibit previously filed as an exhibit to Registrant’s Current Report on
                Form 8-K, as filed with the SEC on June 5, 2006.)21
            
            Subsidiaries
                of the Registrant (Incorporated by reference to the similarly described
                exhibit previously filed as an exhibit to Registration Statement
                on Form
                SB-2 (Registration No. 33-122314)).31.1
            
            Certification
                of Joseph Restivo, Chief Financial Officer of the Registrant, pursuant
                to
                Rules 13a-14(a) and 15(d)-14(a) of the Securities Exchange Act of
                193431.2
            
            Certification
                of Steven Walin, Chief Executive Officer of the Registrant, pursuant
                to
                Rules 13a-14(a) and 15(d)-14(a) of the Securities Exchange Act of
                193432.1
            
            Certification
                of Joseph Restivo, Chief Financial Officer of the Registrant, pursuant
                to
                Rules 13a-14(b) and 15(d)-14(b) of the Securities Exchange Act of
                193432.2
            
            Certification
                of Steven Walin, Chief Executive Officer of the Registrant, pursuant
                to
                Rules 13a-14(b) and 15(d)-14(b) of the Securities Exchange Act of
                1934





*
            Incorporated
                by reference to the similarly described exhibit previously filed
                as an
                exhibit to Registrant’s Current Report on Form 8-K, as filed with the SEC
                on February 27, 2004.





**
            Incorporated
                by reference to the similarly described exhibit previously filed
                as an
                exhibit to Registrant’s Quarterly Report on Form 10-QSB for the quarter
                ended March 31, 2004, filed with the Securities and Exchange Commission
                on
                May 24, 2004.





***
            Incorporated
                by reference to the similarly described exhibit previously filed
                as an
                exhibit to our Registration Statement on Form SB-2 (Registration
                No.
                33-11321).




****
            Incorporated
                by reference to the similarly described exhibit previously filed
                as an
                exhibit to Registrant’s Annual Report on Form 10-KSB for the year ended
                December 31, 2005, filed with the Securities and Exchange Commission
                on
                March 31, 2006.





#
            Incorporated
                by reference to the similarly described exhibit previously filed
                as an
                exhibit to Registrant’s Annual Report on Form 10-KSB for the year ended
                December 31, 2004, filed with the Securities and Exchange Commission
                on
                April 14, 2004.





##
            Incorporated
                by reference to the similarly described exhibit previously filed
                as an
                exhibit to Registrant’s Current Report on Form 8-K, as filed with the SEC
                on June 7, 2004.





###
            Incorporated
                by reference to the similarly described exhibit previously filed
                as an
                exhibit to Registrant’s Current Report on Form 8-K, as filed with the SEC
                on June 8, 2004.





####
            Incorporated
                by reference to the similarly described exhibit previously filed
                as an
                exhibit to Registrant’s Current Report on Form 8-K, as filed with the SEC
                on October 19, 2004.




44




+
            Incorporated
                by reference to the similarly described exhibit previously filed
                as an
                exhibit to Registrant’s Current Report on Form 8-K, as filed with the SEC
                on December 13, 2004.





++
            Incorporated
                by reference to the similarly described exhibit previously filed
                as an
                exhibit to Registrant’s Current Report on Form 8-K, as filed with the SEC
                on June 10, 2005.





+++
            Incorporated
                by reference to the similarly described exhibit previously filed
                as an
                exhibit to Registrant’s Current Report on Form 8-K, as filed with the SEC
                on December 30, 2004.





++++
            Incorporated
                by reference to the similarly described exhibit previously filed
                as an
                exhibit to Registrant’s Current Report on Form 8-K, as filed with the SEC
                on October 24, 2005..





†
            Incorporated
                by reference to the similarly described exhibit previously filed
                as an
                exhibit to Registrant’s Current Report on Form 8-K, as filed with the SEC
                on January 21, 2006.




††
            Incorporated
                by reference to the similarly described exhibit previously filed
                as an
                exhibit to Registrant’s Current Report on Form 8-K, as filed with the SEC
                on October 5, 2006.




‡
            Indicates
                a management contract or compensatory plan or
                arrangement.




45




**SIGNATURES**





In
      accordance with Section 13 or 15(d) of the Exchange Act, GVI Security Solutions,
      Inc. has caused this report to be signed on its behalf by the undersigned,
      thereunto duly authorized, in the city of Carrolton, State of Texas, on March
      29, 2007.




**GVI
      SECURITY SOLUTIONS, INC.**


(Registrant)




By: /s/
      Steven Walin


Steven
      Walin


Chief
      Executive Officer






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 and on the dates indicated.




**Signature**
            
            **Title**
            
            **Date**/s/
                Steven Walin
            
            Chief
                Executive Officer (Principal Executive Officer) and
                Director
            
            March
                29, 2007Steven
              Walin/s/
                Joseph Restivo
            
            Chief
                Financial Officer (Principal Accounting and Financial Officer) and
                Director
            
            March
                29, 2007Joseph
              Restivo/s/
                David Weiner
            
            Chairman
                of the Board of Directors
            
            March
                29, 2007David
              Weiner/s/
                Craig Ellins
            
            Director
            
            March
                29, 2007Craig
              Ellins/s/
                Gary Freeman
            
            Director
            
            March
                29, 2007Gary
              Freeman/s/
                Moshe Zarmi
            
            Director
            
            March
                29, 2007Moshe
              Zarmi






46




FINANCIAL
      STATEMENTS




PageReports
                of Independent Registered Public Accounting Firms
            F-2Consolidated
                Balance Sheets as of December 31, 2006 and 2005
            F-4Consolidated
                Statements of Operations for the fiscal years ended December 31,
                2006,
                2005 and 2004
            F-5Consolidated
                Statements of Stockholders’ Equity (Deficiency) for fiscal years ended
                December 31, 2006, 2005 and 2004
            F-6Consolidated
                Statements of Cash Flows for the years ended December 31, 2006, 2005
                and
                2004
            F-7Notes
                to Consolidated Financial Statements
            F-9




F-1




**Report
      of Independent Registered Public Accounting Firm**





To
      the
      Board of Directors and Stockholders


GVI
      Security Solutions, Inc.


Carrollton,
      Texas





We
      have
      audited the consolidated balance sheet of GVI Security Solutions, Inc. and
      Subsidiaries as of December 31, 2006 and the related consolidated statements
      of
      operations, stockholders’ equity deficiency and cash flows for the year then
      ended. These consolidated financial statements are the responsibility of the
      Company's management. Our responsibility is to express an opinion on these
      consolidated financial statements based on our audit.





We
      conducted our audit in accordance with the standards of the Public Company
      Accounting Oversight Board (United States). Those standards require that we
      plan
      and perform the audit to obtain reasonable assurance about whether the
      consolidated financial statements are free of material misstatement. An audit
      includes examining, on a test basis, evidence supporting the amounts and
      disclosures in the consolidated financial statements. An audit also includes
      assessing the accounting principles used and significant estimates made by
      management, as well as evaluating the overall consolidated financial statement
      presentation. We believe that our audit provides a reasonable basis for our
      opinion.





In
      our
      opinion, the consolidated financial statements referred to above present fairly,
      in all material respects, the consolidated financial position of GVI Security
      Solutions, Inc. and Subsidiaries as of December 31, 2006 and the results of
      their operations and their cash flows for the year then ended, in conformity
      with U.S. generally accepted accounting principles.





The
      accompanying consolidated financial statements have been prepared assuming
      that
      the Company will continue as a going concern. As discussed in Note 1 to the
      financial statements, the Company has suffered recurring losses and negative
      cash flows from operating activities, which have resulted in a negative working
      capital and a stockholders' equity deficiency. These factors raise substantial
      doubt about the Company's ability to continue as a going concern. Management's
      plans in regard to these matters are also described in Note 1. The consolidated
      financial statements do not include any adjustments that might result from
      the
      outcome of this uncertainty.





As
      discussed in Note 1 to the consolidated financial statements, effective January
      1, 2006 the Company adopted Statement of Financial Accounting Standard ("SFAS"),
      "Share-Based Payment" ("SFAS 123(R)") which requires companies to estimate
      the
      fair value of share-based payment awards on the date of grant using an
      option-pricing model.











Weinberg
      & Company, P.A.


Los
      Angeles, California


March
      27,
      2007




F-2




**Report
      of Independent Registered Public Accounting Firm**





To
      the
      Board of Directors and Stockholders


GVI
      Security Solutions, Inc.


Carrollton,
      Texas





We
      have
      audited the balance sheet of GVI Security Solutions, Inc. and Subsidiaries
      as of
      December 31, 2005, and the related statements of operations, stockholders’
equity and cash flows for each of the two years then ended. These financial
      statements are the responsibility of the Company's management. Our
      responsibility is to express an opinion on these financial statements based
      on
      our 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 audit to obtain reasonable assurance about whether the financial
      statements are free of material misstatement. An audit includes examining,
      on a
      test basis, evidence supporting the amounts and disclosures in the financial
      statements. An audit also includes assessing the accounting principles used
      and
      significant estimates made by management, as well as evaluating the overall
      financial statement presentation. We believe that our audits provide a
      reasonable basis for our opinion.





In
      our
      opinion, the financial statements referred to above present fairly, in all
      material respects, the financial position of GVI Security Solutions, Inc. and
      Subsidiaries as of December 31, 2005, and the results of their operations and
      their cash flows for each of the two years then ended, in conformity with U.S.
      generally accepted accounting principles.





The
      accompanying financial statements have been prepared assuming that the Company
      will continue as a going concern. As discussed in Note 1 to the financial
      statements, the Company has suffered recurring losses and negative cash flows
      from operating activities, which have resulted in a significant reduction in
      cash. These factors raise substantial doubt about the Company's ability to
      continue as a going concern. Management's plans in regard to these matters
      are
      also described in Note 1. The financial statements do not include any
      adjustments that might result from the outcome of this uncertainty.











Mercadien,
      P.C., Certified Public Accountants


Hamilton,
      New Jersey





March
      30,
      2006




F-3




**GVI
      Security Solutions, Inc.**


**Consolidated
      Balance Sheet**


**December
      31, 2006 and 2005**


(In
                thousands, except share and per share
                amounts)





2006
            
            2005**ASSETS:**Current
                AssetsCash
                and equivalents
            
            $
            225
            
            $
            2,981Accounts
                receivable, net of allowances for doubtfulaccounts
                of $558 and $317, respectively
            
            
            7,881
            
            
            7,688Inventory,
                net
            
            
            6,416
            
            
            7,127Refundable
                income tax receivable
            
            
            -
            
            
            643Prepaid
                and other current assets
            
            
            1,324
            
            
            1,221Current
                assets of discontinued operations
            
            
            -
            
            
            2,850Total
                Current Assets
            
            
            15,846
            
            
            22,510Property
                and Equipment, net
            
            
            384
            
            
            748Deferred
                loan origination fee, net
            
            
            209
            
            
            809Goodwill
            
            
            -
            
            
            544Intangibles,
                net
            
            
            -
            
            
            532Other
                assets
            
            
            33
            
            
            83Total
                Assets
            
            $
            16,472
            
            $
            25,226**LIABILITIES
                AND STOCKHOLDERS' EQUITY (DEFICIENCY):**Current
                LiabilitiesAccounts
                payable
            
            $
            7,059
            
            $
            7,036Accrued
                expenses
            
            
            2,023
            
            
            1,490Revolving
                credit facility, current
            
            
            6,366
            
            
            -Capitalized
                lease obligations, current
            
            
            77
            
            
            118Senior
                term note, current
            
            
            1,925
            
            
            2,080Liabilities
                of discontinued operations
            
            
            400
            
            
            70Total
                Current Liabilities
            
            
            17,850
            
            
            10,794Capital
                lease obligations, net of current portion
            
            
            62
            
            
            139Revolving
                credit facility
            
            
            -
            
            
            8,495Senior
                term note, net of current portion
            
            
            -
            
            
            1,195Total
                Liabilities
            
            
            17,912
            
            
            20,623Commitments
                and ContingenciesStockholders'
                Equity (Deficiency)Preferred
                stock, undesignated, $.001 par value, 3,000,000 shares authorized,
                none
                issued or outstanding
            
            
            -
            
            
            -Common
                stock, $.001 par value, 200,000,000 shares authorized, 26,292,830
                issued
                and outstanding at December 31, 2006 and 1,005,160 shares issued
                and
                outstanding at December 31, 2005
            
            
            26
            
            
            1Additional
                paid-in capital
            
            
            33,309
            
            
            22,886Accumulated
                deficit
            
            
            (34,775
            )
            
            (18,284
            )Total
                Stockholders' Equity (Deficiency)
            
            
            (1,440
            )
            
            4,603Total
                Liabilities and Stockholders' Equity (Deficiency)
            
            $
            16,472
            
            $
            25,226


The
      Notes
      to Consolidated Financial Statements are an integral part of these
      statements




F-4


**GVI
      Security Solutions, Inc.**


**Consolidated
      Statements of Operations**


**Years
      Ended December 31, 2006, 2005 and 2004**


(In
      thousands, except per share amounts)




2006
            
            2005
            
            2004Revenues
            
            $
            43,973
            
            $
            40,782
            
            $
            35,761Cost
                of Revenues
            
            
            37,389
            
            
            34,814
            
            
            30,834Gross
                Profit
            
            
            6,584
            
            
            5,968
            
            
            4,927Selling,
                General and Administrative Expenses
            
            
            13,494
            
            
            15,156
            
            
            13,602Impairment
                of goodwill and other intangible assets
            
            
            977
            
            
            -
            
            
            -Other
            
            
            -
            
            
            200
            
            
            156Loss
                from operations
            
            
            (7,887
            )
            
            (9,388
            )
            
            (8,831
            )Interest
                Expense
            
            
            5,916
            
            
            1,266
            
            
            691Loss
                from continuing operations before income taxes and income (loss)
                from
                discontinued operations
            
            
            (13,803
            )
            
            (10,654
            )
            
            (9,522
            )Income
                Tax Expense (Benefit)
            
            
            14
            
            
            83
            
            
            (1,108
            )Loss
                from continuing operations before income (loss) from discontinued
                operations
            
            
            (13,817
            )
            
            (10,737
            )
            
            (8,414
            )Income
                (loss) from discontinued operations, net of taxes
            
            
            (2,674
            )
            
            (2,283
            )
            
            1,236Net
                loss
            
            $
            (16,491
            )
            $
            (13,020
            )
            $
            (7,178
            )Basic
                and diluted loss per shareContinuing
                operations
            
            $
            (3.74
            )
            $
            (10.71
            )
            $
            (13.96
            )Discontinued
                operations
            
            $
            (0.72
            )
            $
            (2.28
            )
            $
            2.05Net
                loss per share (basic and diluted)
            
            $
            (4.46
            )
            $
            (12.99
            )
            $
            (11.91
            )Shares
                Used in Calculation of Net Loss per share
            
            
            3,693,955
            
            
            1,002541
            
            
            602,696




The
      Notes
      to Condensed Consolidated Financial Statements are an integral part of these
      statements




F-5


**GVI
      Security Solutions, Inc.**


**Consolidated
      Statements of Stockholders’ Equity (Deficiency)**


**For
      the Years Ended December 31, 2006, 2005 and 2004**




Common
                    Stock
                
                Preferred
                    A
                
                Preferred
                    B
                
                Preferred
                    D
                
                Preferred
                    EAdditional
                
                RetainedPaid-in-
                
                EarningsShares
                
                Amount
                
                Shares
                
                Amount
                
                Shares
                
                Amount
                
                Shares
                
                Amount
                
                Shares
                
                Amount
                
                Capital
                
                (Deficit)
                
                TOTALBalance,
                    December 31, 2003
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                1,000,000
                
                $
                1
                
                $
                574
                
                $
                1,914
                
                $
                2,489(Predecessor
                    business)Thinking
                    Tools Capitalization
                
                
                3,141
                
                $
                -
                
                
                1,148,799
                
                $
                1
                
                
                200
                
                
                -
                
                
                10,000
                
                $
                -
                
                
                
                
                
                
                
                
                20,790
                
                
                (22,611
                )
                
                (1,820
                )Eliminate
                    Thinking Tools toRecapitalize
                    GVI
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                (21,094
                )
                
                22,611
                
                
                1,517Conversion
                    to Common Stock
                
                
                884
                
                
                -
                
                
                (1,148,799
                )
                
                (1
                )
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                1
                
                
                
                
                
                -Conversion
                    to Common Stock
                
                
                23,760
                
                
                -
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                (10,000
                )
                
                -
                
                
                
                
                
                
                
                
                -
                
                
                
                
                
                -Conversion
                    to Common Stock
                
                
                564,292
                
                
                1
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                (1,000,000
                )
                
                (1
                )
                
                -
                
                
                
                
                
                -Warrants
                    Issued
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                212
                
                
                
                
                
                212Shares
                    Issued
                
                
                13,000
                
                
                -
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                156
                
                
                
                
                
                156Acquisition
                    of Rapor
                
                
                56,117
                
                
                -
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                673
                
                
                
                
                
                673Private
                    Placement
                
                
                452,399
                
                
                -
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                31,477
                
                
                
                
                
                31,477Stock
                    Repurchase
                
                
                (133,333
                )
                
                -
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                (10,000
                )
                
                
                
                
                (10,000
                )Net
                    Loss
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                (7,178
                )
                
                (7,178
                )Balance,
                    December 31, 2004
                
                
                980,260
                
                
                1
                
                
                -
                
                
                -
                
                
                200
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                22,789
                
                
                (5,264
                )
                
                17,526Laurus
                    Principal Payment Conversion
                
                
                700
                
                
                -
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                67
                
                
                
                
                
                67Conversion
                      Series B Preferred to Common
                
                
                -
                
                
                
                
                
                
                
                
                
                
                
                (200
                )Restricted
                    Stock Issued to Directors
                
                
                2,644
                
                
                -
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                30
                
                
                
                
                
                30Stock
                    Options Exercised
                
                
                39,500
                
                
                -
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                629
                
                
                
                
                
                629Stock
                    Exchanged for Options
                
                
                (17,944
                )
                
                -
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                (629
                )
                
                
                
                
                (629
                )Net
                    Loss
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                (13,020
                )
                
                (13,020
                )Balance.
                    December 31, 2005
                
                
                1,005,160
                
                
                1
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                -
                
                
                22,886
                
                
                (18,284
                )
                
                4,603Laurus
                    Principal Payment Conversion
                
                
                40,000
                
                
                -
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                320
                
                
                
                
                
                320Fair
                      value of Restricted Stock Issued to Directors
                
                
                5,356
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                52
                
                
                
                
                
                52Fair
                    value of Shares Issued to RetailAgent
                    under Alliance Agreement
                
                
                15,000
                
                
                -
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                158
                
                
                
                
                
                158Beneficial
                      Conversion from LaurusModification
                      of Warrant Exercise Price
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                76
                
                
                
                
                
                76Private
                    Placement Proceeds, net
                
                
                2,500,000
                
                
                3
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                397
                
                
                
                
                
                400Beneficial
                      Conversion Feature resulting from issuance of convertible
                      notes
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                4,500
                
                
                
                
                
                4,500Subordinated
                    Debt Conversion
                
                
                22,500,000
                
                
                22
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                4,478
                
                
                
                
                
                4,500Fair
                    value of warrant issued to director
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                47
                
                
                
                
                
                47Issuance
                      of common stock for interest on convertible debt
                
                
                202,314
                
                
                -
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                40
                
                
                
                
                
                40Fair
                      value of common stock issued for services
                
                
                25,000
                
                
                -
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                23
                
                
                
                
                
                23Fair
                    value of vested options
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                332
                
                
                
                
                
                332Net
                    Loss
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                (16,491
                )
                
                (16,491
                )Balance,
                    December 31, 2006
                
                
                26,292,830
                
                $
                26
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                $
                33,309
                
                
                ($34,775
                )
                
                ($1,440
                )
  The
        Notes
        to Consolidated Financial Statements are an integral part of these
        statements


F-6


**GVI
      Security Solutions, Inc.**


**Condensed
      Consolidated Statements of Cash Flows**


**Years
      Ended December 31, 2006, 2005 and 2004**


(In
      thousands, except per share amounts)





2006
            
            2005
            
            2004Cash
                Flows Used In Operating ActivitiesNet
                Loss
            
            $
            (16,491
            )
            $
            (13,020
            )
            $
            (7,178
            )Adjustments
                to reconcile Net Loss to Net Cash Used In
              Operating
                Activities:Loss
                (Income) from discontinued operations, net of tax
            
            
            2,674
            
            
            2,283
            
            
            (1,236
            )Depreciation
                and amortization from continuing operations
            
            
            455
            
            
            1,148
            
            
            846Deferred
                tax liability
            
            
            -
            
            
            -
            
            
            213Loss
                on retirement of assets
            
            
            50
            
            
            -
            
            
            -Write-down
                of investment
            
            
            -
            
            
            200
            
            
            -Impairment
                of goodwill and intangible assets
            
            
            977
            
            
            -
            
            
            -Beneficial
                conversion discount on convertible debt
            
            
            4,500
            
            
            -
            
            
            -Amortization
                of deferred loan origination fee
            
            
            647
            
            
            600
            
            
            312Fair
                value of shares issued for interest
            
            
            40
            
            
            -
            
            
            -Compensation
                costs and expenses for stock and options issued
            
            
            661
            
            
            30
            
            
            189Changes
                in Assets and LiabilitiesAccounts
                receivable, net
            
            
            (193
            )
            
            734
            
            
            (1,894
            )Inventory
            
            
            711
            
            
            2,419
            
            
            (2,215
            )Refundable
                income tax receivable
            
            
            643
            
            
            -
            
            
            (1,099
            )Prepaids
                and other current assets
            
            
            (103
            )
            
            477
            
            
            199Other
                assets
            
            
            -
            
            
            -
            
            
            (34
            )Accounts
                payable
            
            
            23
            
            
            (3,712
            )
            
            4,964Accrued
                expenses
            
            
            533
            
            
            (512
            )
            
            822Net
                cash used in operating activities from continuing
                operations
            
            
            (4,873
            )
            
            (9,353
            )
            
            (6,111
            )Net
                cash provided by (used in) operating activitiesof
                discontinued operations
            
            
            506
            
            
            (1,986
            )
            
            155Net
                cash provided by (used in) operating activities
            
            
            (4,367
            )
            
            (11,339
            )
            
            (5,956
            )Cash
                Flows Provided By (Used In) Investing ActivitiesPurchase
                of property and equipment
            
            
            (42
            )
            
            (430
            )
            
            (1,420
            )Purchase
                of Rapor assets
            
            
            -
            
            
            -
            
            
            (288
            )Purchase
                of investment
            
            
            -
            
            
            -
            
            
            (250
            )Proceeds
                from sale of investment
            
            
            50
            
            
            -
            
            
            -Net
                cash provided by (used in) Investing activities
            
            
            8
            
            
            (430
            )
            
            (1,958
            )Cash
                Flows Provided By (Used In) Financing ActivitiesIssuance
                of common stock
            
            
            400
            
            
            -
            
            
            31,476Issuance
                of convertible notes
            
            
            4,500
            
            
            -
            
            
            -Net
                proceeds from (repayments of) revolving credit facility
            
            
            (2,129
            )
            
            2,880
            
            
            3,465Principal
                payments of Senior term note
            
            
            (1,050
            )
            
            (1,358
            )
            
            (908
            )Repayment
                of prior line of credit
            
            
            -
            
            
            -
            
            
            (5,304
            )Principal
                payments of capitalized lease obligations
            
            
            (118
            )
            
            (170
            )
            
            (126
            )Restricted
                cash
            
            
            -
            
            
            -
            
            
            (10,000
            )Loan
                origination costs
            
            
            -
            
            
            -
            
            
            (1,604
            )Net
                Cash Provided by Financing Activities
            
            
            1,603
            
            
            1,352
            
            
            21,243Net
                Increase (Decrease) in Cash
            
            
            (2,756
            )
            
            (10,417
            )
            
            13,329Cash,
                Beginning of Period
            
            
            2,981
            
            
            13,398
            
            
            69Cash,
                End of Period
            
            $
            225
            
            $
            2,981
            
            $
            13,398**SUPPLEMENTARY
                CASH FLOW INFORMATION**Cash
                paid for interest
            
            $
            878
            
            $
            429
            
            $
            356Cash
                paid for income taxes
            
            
            14
            
            
            110
            
            
            468




F-7




**SUPPLEMENTAL
                SCHEDULE OF NONCASH INVESTING AND**
              **FINANCING
                ACTIVITIES**Debt
                principal payment converted to common stock
            
            $
            300
            
            $
            67
            
            $
            -Conversion
                of debt to common stock
            
            
            4,500
            
            
            -
            
            
            -Liabilities
                assumed in acquisition and Recapitalization
            
            
            -
            
            
            -
            
            
            1,821Capital
                lease equipment acquisitions
            
            
            -
            
            
            -
            
            
            501Conversion
                of related party note/loan and interest
            
            
            -
            
            
            -
            
            
            1,517Loan
                origination fee compensation cost for warrant issued
            
            
            47
            
            
            -
            
            
            112Rapor
                assets, net of liabilities assumed
            
            
            -
            
            
            -
            
            
            741Restricted
                cash to satisfy stock repurchase obligation
            
            
            -
            
            
            -
            
            
            10,000




The
      Notes
      to Condensed Consolidated Financial Statements are an integral part of these
      statements




F-8




**GVI
      Security Solutions, Inc.**


**Notes
      to Consolidated Financial Statements**


**For
      the years ended December 31, 2006, 2005 and 2004**





**NOTE
      1 ~ SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**





**Organization**





GVI
      Security Solutions, Inc. (the “Company” and/or “GVI”) was incorporated in August
      1996 as Thinking Tools, Inc. and was originally engaged in the software
      development business. From December 18, 2000 until February 20, 2004, Thinking
      Tools, Inc. had no active business. On February 20, 2004, pursuant to an
      Agreement and Plan of Merger, Thinking Tools, Inc. acquired all of the stock
      of
      GVI Security, Inc. in a merger, and the business of GVI Security, Inc. became
      the business of Thinking Tools, Inc. For accounting purposes, because the
      Company had become a shell company, GVI Security, Inc. was treated as the
      acquiror in the merger, which was treated as a recapitalization of GVI Security,
      Inc., and the pre-merger financial statements of GVI Security, Inc. became
      the
      Company’s historical financial statements. The 2003 stockholders’ equity of the
      Company was retroactively restated for the equivalent number of shares of
      Thinking Tools, Inc. received by GVI Security, Inc. in the reverse merger,
      with
      the difference between the par value of Thinking Tools, Inc. preferred stock
      and
      GVI Security, Inc.’s common stock recorded as paid in capital. In the merger,
      230,000 shares of GVI Security, Inc.’s Common Stock was converted to 1,000,000
      shares of Thinking Tools, Inc. Series E Preferred Stock. The Series E Preferred
      Stock was initially convertible into 36,678,958 shares of Thinking Tools, Inc.
      common stock, and ultimately converted into 564,292 shares of common stock
      of
      the Company as a result of the one-for-65 reverse split effected on April 12,
      2004 (on which date Thinking Tools, Inc. changed its name to GVI Security
      Solutions, Inc.) after giving effect to the one-for-50 reverse split effected
      on
      November 28, 2006 as a result of the Company’s 2006 Private Placement
      transaction. See Note 14 for further discussion of the Company’s 2004
      Recapitalization, and Note 8 for 2006 Private Placement transaction.





On
      December 1, 2004, the Company acquired all of the capital stock of Rapor, Inc.
      in a merger in which the Company issued to Rapor’s former stockholders an
      aggregate of 54 shares of common stock and seven-year warrants to purchase
      an
      aggregate of 27,079 shares of common stock at an exercise price of $152 per
      share. In connection with the closing of the merger, the Company also paid
      approximately $184,000 in cash, and issued 1,960 shares of common stock, in
      satisfaction of secured obligations of Rapor. Rapor designs and manufactures
      high security building access portals.





All
      share
      and per share amounts herein have been given retroactive effect to the 1-for-65
      reverse stock split of the Company’s common stock effected in April 2004, as
      well as to the 1-for-50 reverse stock split effected November 2006. . See
      Note
      16 for further discussion of the Company’s 2004 Recapitalization, and Note 8 for
      2006 Private Placement transaction.





**Nature
      of Business**





The
      Company provides video surveillance security solutions that are deployed in
      the
      commercial and homeland security market segments. Products are sold primarily
      to
      distributors and system integrators that specialize in providing security
      products and services to these business segments.





**Principles
      of Consolidation**





The
      accompanying consolidated financial statements include the accounts of GVI
      Security Solutions, Inc., and its wholly-owned subsidiaries GVI Security, Inc.
      and Rapor, Inc. All material intercompany transactions, balances and profits
      have been eliminated.





**Reclassifications**





Certain
      reclassifications have been made to the 2005 and 2004 financial statements
      for
      consistency purposes, including both income statement reclassifications of
      certain revenue and expense amounts relating to the years ended December 31,
      2005 and 2004, as well as balance sheet reclassifications relating to the year
      ended December 31, 2005. Income statement reclassifications include (1)
      classification of net freight billed to customers as a reduction
      of costs of revenue, and (2) classification of certain warehousing, technical
      support and assembly expenses as costs of revenue. The balance sheet
      reclassification relates to recharacterization of third party controlled cash
      lockbox balances as other current assets at December 31, 2006.




F-9




**Going
      Concern Considerations**





The
      accompanying financial statements have been presented in accordance with
      generally accepted accounting principles , which assumes the continuity of
      the
      Company as a going concern. During the years ended December 31, 2006, 2005
      and
      2004, the Company suffered
      net losses of $16,5 million, $13.0 million and $7.8 million, respectively.
      In
      addition the Company utilized net cash from operations of $4,872,000 during
      the
      year ended December 31, 2006, and had a working capital deficit of $2,004,000
      and a stockholders’ deficiency of $1,440,000 as of December 31,
      2006. These
      factors raise substantial doubt about the Company’s ability to continue as a
      going concern.





In
      October 2006, the Company raised $5 million in gross proceeds in a private
      placement of common stock and convertible notes. The Company may need to raise
      additional capital in the future to finance its operations, and management
      can
      not provide assurance that the Company will be successful in this effort. At
      December 31, 2006, the Company had cash and cash equivalents of approximately
      $225,000, a working capital deficit of approximately $2.0 million, a
      stockholders’ deficiency of $1.4 million, an outstanding balance of $1.9 million
      under the Laurus Term Loan, and an outstanding revolving credit loan balance
      from Laurus of approximately $6.4 million, with an additional $2.2 million
      available for borrowing under such facility.





The
      Company’s operating results in 2007 will be dependent upon its ability to
      continue to provide quality products and services in sufficient volume at
      attractive prices and maintain customer loyalty. The Company will continue
      to
      implement measures to reduce operating costs, including sales and marketing
      expenses, support and other general and administrative expenses. Depending
      upon
      the Company’s ability to increase its revenues and effectively manage its
      working capital requirements, as well as the timing and rate of revenue growth
      and management’s ability to control costs, the Company may require additional
      equity or debt borrowings to finance its operations, working capital
      requirements or capital expenditure needs. There can be no assurance that such
      additional financing will be available, or if available, that such financing
      can
      be obtained on terms satisfactory to the Company. If the Company is not able
      to
      raise additional funds, it may be required to limit its operations which could
      have an adverse effect on its financial position, results of operations and
      cash
      flow. The financial statements do not include any adjustments that might result
      from the outcome of this uncertainty.





**Discontinued
      Operations**





In
      the
      first quarter of 2006, the Company’s board approved a plan to discontinue its
      Retail Channel business. This business is accounted for as discontinued
      operations and, accordingly, its operations are segregated in the accompanying
      financial statements. In connection with the discontinuance of the Retail
      Channel business for the years ended December 31, 2006 and 2005, the Company
      wrote down assets identified with the retail business by approximately $2.3
      million and $2.9 million, respectively, to net realizable value. The write
      down
      to net realizable value was based on management’s best estimates of the amounts
      expected to be realized on the disposition of all related assets and liabilities
      held for disposition from the discontinued operations. The results of the
      discontinued operations do not include any allocation of corporate overhead
      during the periods presented.





On
      September 13, 2006, the Company entered into an agreement with its former
      distributor to the retail channel, whereby the Company transferred to this
      distributor substantially all of its remaining retail inventory in exchange
      for
      the termination of the parties’ respective remaining obligations under its
      previous alliance agreement. The Company has written off all remaining net
      assets associated with the Retail Channel business, and has accrued a reserve
      of
      $400,000 for estimated remaining obligations associated with completing the
      termination of this business channel.





**Revenue
      Recognition**





The
      Company’s primary source of revenue is from sales of its products. The Company
      recognizes revenue when the sales process is deemed complete and associated
      revenue has been earned. The Company’s policy is to recognize revenue when
      products have been shipped, risk of loss and title to the product transfers
      to
      the customer, the selling price is fixed and determinable and collectibility
      is
      reasonably assured. Net sales is comprised of gross revenue less expected
      returns, trade discounts and customer allowances, which include costs associated
      with off-invoice mark downs and other price reductions, as well as trade
      promotions. Related incentive costs are recognized at the later of the date
      on
      which the Company recognizes the related revenue or the date on which the
      Company offers the incentive.




F-10




The
      Company allows customers to return defective products when they meet certain
      established criteria as outlined in its sales terms and conditions. It is the
      Company’s practice to regularly review and revise, when deemed necessary, its
      estimates of sales returns, which are based primarily on actual historical
      return rates. The Company records estimated sales returns as reductions to
      sales, cost of sales, and accounts receivable and an increase to inventory.
      Returned products which are recorded as inventory are valued based upon the
      amount the Company expects to realize upon its subsequent disposition. The
      Company considers the physical condition and marketability of the returned
      products as major factors in estimating realizable value. Actual returns, as
      well as realized values on returned products, may differ significantly, either
      favorably or unfavorably, from Company estimates if factors such as customer
      inventory levels or competitive conditions differ from estimates and
      expectations and, in the case of actual returns, if economic conditions differ
      significantly from Company estimates and expectations.





At
      the
      time revenue is recognized, the Company also records reductions to revenue
      for
      customer incentive programs in accordance with the provisions of Emerging Issue
      Task Force (EITF) Issue No. 01-09, “Accounting for Consideration Given from a
      Vendor to a Customer (Including a Reseller of the Vendor’s Products).” Such
      incentive programs include cash and volume discounts, price protection,
      promotional, cooperative and other advertising allowances. For those incentives
      that require the estimation of sales volumes or redemption rates, such as for
      volume rebates, the Company uses historical experience and internal and customer
      data to estimate the sales incentive at the time the revenue is recognized.
      In
      the event that the actual results of these items differ from the estimates,
      adjustment to the sales incentive accruals would be recorded.




**Accounts
      Receivable**




Trade
      receivables are presented on the balance sheet as outstanding principal adjusted
      for any charge offs. The Company maintains an allowance for doubtful receivables
      based primarily on historical loss experience. Additional amounts are provided
      through charges to income, as management feels necessary, after evaluation
      of
      receivables and current economic conditions. Amounts which are considered to
      be
      uncollectible are charged off and recoveries of amounts previously charged
      off
      are credited to the allowance upon recovery.




**Inventory**





Inventory
      is stated at the lower of cost (first-in, first-out method) or market and
      consists of goods held for resale and parts used for repair work. Reserves
      are
      recorded for slow-moving, obsolete, nonsaleable or unusable items based upon
      a
      product-level review, in order to reflect inventory balances at their net
      realizable value. Inventory reserve balances at December 31, 2006 and 2005
      were
      approximately $2,541,000 and $1,300,000, respectively.





**Long-Lived
      Assets**




The
      Company adopted the provisions of FASB Statement No. 144, “Accounting for the
      Impairment or Disposal of Long Lived Assets “ effective January 1, 2005. 
When impairment indicators are present, the Company reviews the carrying value
      of its assets in determining the ultimate recoverability of their unamortized
      values using analyses of future undiscounted cash flows expected to be generated
      by the assets.  If such assets are considered impaired, the impairment
      recognized is measured by the amount by which the carrying amount of the asset
      exceeded its fair value.  Assets to be disposed of are reported at the
      lower of the carrying amount or fair value, less cost to sell.




**Goodwill
      and Intangible Assets**




The
      Company adopted the provisions of FASB Statement No. 142, “Goodwill and Other
      Intangible Assets,” (SFAS 142) effective January 1, 2005. SFAS No. 142 requires
      that goodwill and intangible assets with indefinite useful lives no longer
      be
      amortized, but instead be tested for impairment using the guidance for measuring
      impairment set forth in this statement.





During
      the year ended December 31, 2006, management concluded that the Rapor product
      line no longer fit the Company’s existing distribution channels and market
      strategy and, accordingly, recorded impairment costs of approximately
      $977,000 resulting from the write-off of goodwill of approximately $544,000,
      and
      the write-off of the remaining net book value of the trademark and technology
      associated with Rapor products totaling approximately $433,000, as prescribed
      under SFAS 142. No such impairment expense was recorded for the years ending
      December 31, 2005 and 2004.




F-11




**Property
      and Equipment**





Property
      and equipment is stated at cost net of depreciation and amortization.
      Depreciation and amortization are provided for on the straight-line method
      over
      the estimated useful lives of the respective assets. Maintenance and repairs
      are
      charged to expense as incurred; major renewals and betterments are capitalized.
      When assets are fully depreciated, or otherwise disposed of, the related cost
      and accumulated depreciation are removed from the accounts and any gain or
      loss
      on disposition is credited or charged to income.





**Shipping
      and Handling Costs**





Shipping
      and handling costs related to product sales and fulfillment are expensed as
      incurred and included in cost of goods sold. Shipping and handling costs related
      to purchases are included in the cost of inventory, and charged to cost of
      goods
      sold when sold to customers.





**Advertising**





Advertising
      costs are expensed as incurred. Certain advertising costs, which included
      various promotional incentives and trade show participation, for the years
      ended
      December 31, 2006, 2005 and 2004 were reimbursed by Samsung in the form of
      marketing incentives and partial reimbursement for trade show participation.
      Advertising costs during the years ended December 31, 2006, 2005 and 2004 were
      $815,000, $1,495,000 and $893,000, respectively.





**Income
      Taxes**





Income
      taxes consist of taxes currently payable plus deferred taxes related primarily
      to differences between the basis of property and equipment, inventory, and
      accounts receivable for financial and income tax reporting. Deferred taxes
      represent the future tax return consequences of those differences, which will
      be
      taxable or deductible when the assets and liabilities are recovered or
      settled.





Deferred
      tax liabilities and assets are classified as current or noncurrent based on
      the
      classification of the related asset or liability for financial reporting, or
      according to the expected reversal date of temporary differences not related
      to
      an asset or liability for financial reporting. Also, a valuation allowance
      is
      used, if necessary, to reduce deferred tax assets by the amount of any tax
      benefits that are not expected to be realized in the future based on available
      evidence.





Income
      tax expense for the years ended December 31, 2006 and 2005 primarily relate
      to
      state and local franchise taxes that are due to various states and
      municipalities in which the Company is licensed and transacts
      business.





**Stock-Based
      Compensation**




In
      December 2004, the Financial Accounting Standards Board (“FASB”) issued
      Statement of Financial Accounting Standards 123R, “Share-Based Payment” (“SFAS
      123R”). This statement requires that the cost resulting from all share-based
      payment transactions be recognized in the financial statements. This statement
      establishes fair value as the measurement objective in accounting for
      share-based payment arrangements and requires all entities to apply a fair-value
      based measurement method in accounting for share-based payment transactions
      with
      employees except for equity instruments held by employee share ownership plans.
      Effective January 1, 2006, the Company adopted the fair value recognition
      provisions of SFAS 123R, using the modified prospective method. Under this
      method, the provisions of SFAS 123R apply to all awards granted or modified
      after the date of adoption and all previously granted awards not yet vested
      as
      of the date of adoption. Prior periods have not been restated.




F-12




Prior
      to
      the January 1, 2006 adoption of SFAS 123R, the Company accounted for
      stock-based compensation using the intrinsic value method prescribed in
      Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for
      Stock Issued to Employees” and related interpretations. Accordingly, no
      compensation expense had been recognized for stock options since all options
      granted had an exercise price equal to the market price on the date of grant.
      As
      permitted by SFAS 123, “Accounting for Stock-Based Compensation,” stock-based
      compensation was included as a pro forma disclosure in the notes to the
      consolidated financial statements.





The
      following table illustrates the effect on operating results and per share
      information had the Company accounted for share-based compensation in accordance
      with SFAS 123 for the years ended December 31, 2005 and 2004:


**($
                  in thousands, except per share amounts)**2005
              
              2004Net
                  Income (Loss), as reported
              
              $
              (13,020
              )
              $
              (7,178
              )Stock-based
                  employee compensation expense,
                net
                  of related tax effects
              
              
              (188
              )
              
              (104
              )Net
                  Income (Loss), pro forma
              
              $
              (13,208
              )
              $
              (7,282
              )Net
                  income (loss) per share:Basic
                  as Reported
              
              $
              (12.99
              )
              $
              (11.91
              )Basic
                  pro forma
              
              $
              (13.17
              )
              $
              (12.08
              )Diluted
                  as reported
              
              $
              (12.99
              )
              $
              (11.91
              )Diluted
                  pro forma
              
              $
              (13.17
              )
              $
              (12.08
              )




The
      weighted average fair value of options granted during 2006, 2005 and 2004 was
      $0.09, $1.75 and $2.94, respectively. The fair value of each option on the
      date
      of grant was estimated using the Black-Scholes option pricing model with the
      following weighted average assumptions:





2005
            
            2004Risk
                free rate of return
            
            3.5%
            
            3.5%Option
                lives in years
            
            
            3.0
            
            
            3.0Annual
                volatility of stock price
            
            
            74
            %
            
            74
            %Dividend
                yield
            
            
            --
            %
            
            --
            %




**Net
      Income (Loss) Per Share**




Statement
      of Financial Accounting Standards (SFAS) No. 128 "Earnings Per Share" requires
      presentation of basic earnings per share (“Basic EPS”) and diluted earnings per
      share (“Diluted EPS”). Basic earnings (loss) per share is computed by dividing
      income (loss) available to common stockholders by the weighted average number
      of
      common shares outstanding during the period. Diluted earnings per share gives
      effect to all dilutive potential common shares outstanding during the period.
      These potentially dilutive securities are not included in the calculation of
      loss per share for the years ended December 31, 2006, 2005 and 2004 because
      the
      company incurred a loss during such periods and thus their effect would have
      been anti-dilutive. Accordingly, basic and diluted loss per share is the same
      for years ended December 31, 2006, 2005 and 2004. At December 31, 2006, 2005
      and
      2004 potentially dilutive securities consisted of outstanding warrants and
      stock
      options to acquire an aggregate of 7,508,519, 251,161 and 237,411 shares,
      respectively.





**Credit
      Risk Concentration**




At
      December 31, 2006, 2005 and 2004, three customers accounted for $17.7 million
      (40%), $17.3 million (42%) and $16.8 million (47%), respectively, of the
      Company’s continuing sales, and these customers’ receivable balances for the
      years ended December 31, 2006, 2005 and 2004 totaled approximately $4,663,000
      (50%), $3,982,000 (39%) and $4,861,000 (46%), respectively, of accounts
      receivable.




F-13




International
      sales accounted for approximately 38%, 33% and 22% of the Company's sales during
      the years ended December 31, 2006, 2005 and 2004, respectively. Geographically,
      Mexico has become one of our major growth areas. During the year ended December
      31, 2006, Mexico accounted for 10.4% of our total sales.





The
      Company performs ongoing credit evaluations of its customers and generally
      requires no collateral from them. ****





**Fair
      Value of Financial Instruments**





The
      following methods and assumptions were used to estimate the fair value of each
      class of financial instruments for which it is practicable to estimate that
      value:





·
            Cash,
                accounts receivable, accounts payable and accrued expenses - The
                carrying
                amount approximates fair value because of the short maturity of those
                instruments.





·
            Notes
                payable and capitalized lease obligations - Based on the borrowing
                rates
                currently available to the Corporation for bank loans with similar
                terms
                and average maturities, the fair value of long-term debt approximates
                the
                carrying value shown on our balance sheet.





**Use
      of Estimates**





The
      preparation of financial statements in conformity with generally accepted
      accounting principles requires management to make estimates and assumptions
      that
      affect the reported amounts of assets and liabilities and disclosures of
      contingent assets and liabilities at the date of the financial statements and
      the reported amounts of revenues and expenses during the reporting period.
      Actual results could differ from those estimates. Significant estimates include
      those that relate to the valuation of inventory, accounts receivable, certain
      accruals and liabilities and the useful lives of property and
      equipment.





**Recent
      Accounting Pronouncements**





In
      June
      2006, the Financial Accounting Standards Board (“FASB”) issued FIN 48,
      "Accounting for Uncertainty in Income Taxes--an interpretation of FASB Statement
      No. 109," which seeks to reduce the diversity in practice associated with the
      accounting and reporting for uncertainty in income tax positions. This
      Interpretation prescribes a comprehensive model for the financial statement
      recognition, measurement, presentation and disclosure of uncertain tax positions
      taken or expected to be taken in an income tax return. FIN 48 presents a
      two-step process for evaluating a tax position. The first step is to determine
      whether it is more-likely-than-not that a tax position will be sustained upon
      examination, based on the technical merits of the position. The second step
      is
      to measure the benefit to be recorded from tax positions that meet the
      more-likely-than-not recognition threshold, by determining the largest amount
      of
      tax benefit that is greater than 50 percent likely of being realized upon
      ultimate settlement, and recognizing that amount in the financial statements.
      FIN 48 is effective for fiscal years beginning after December 15, 2006. The
      Company does not believe the adoption of FIN 48 will have a material on its
      consolidated results of operations, financial position, or cash
      flows.





In
      September 2006, the FASB issued SFAS No. 157, "Fair Value Measurements," which
      provides enhanced guidance for using fair value to measure assets and
      liabilities. SFAS No. 157 provides a common definition of fair value and
      establishes a framework to make the measurement of fair value in generally
      accepted accounting principles more consistent and comparable. SFAS No. 157
      also
      requires expanded disclosures to provide information about the extent to which
      fair value is used to measure assets and liabilities, the methods and
      assumptions used to measure fair value, and the effect of fair value measures
      on
      earnings. SFAS No. 157 is effective for financial statements issued in fiscal
      years beginning after November 15, 2007 and to interim periods within those
      fiscal years. The Company does not believe the adoption of SFAS No. 157 will
      have a material on its consolidated results of operations, financial position,
      or cash flows





In
      September 2006, the Securities and Exchange Commission issued Staff Accounting
      Bulletin ("SAB") No. 108, "Considering the Effects of Prior Year Misstatements
      when Quantifying Misstatements in Current Year Financial Statements". SAB No.
      108 was issued in order to eliminate the diversity in practice surrounding
      how
      public companies quantify financial statement misstatements. SAB No. 108
      requires that registrants quantify errors using both
      a
      balance sheet (iron curtain) approach and an income statement (rollover)
      approach then evaluate whether either approach results in a misstated amount
      that, when all relevant quantitative and qualitative factors are considered,
      is
      material. SAB No. 108 is effective for fiscal years ending after November 15,
      2006. The Company has adopted the bulletin during 2006. The adoption did not
      have a material effect on its consolidated results of operations, financial
      position, or cash flows.




F-14




**NOTE
      2 ~ ACCOUNTS RECEIVABLE**





Accounts
      receivable, net, at December 31, 2006 and 2005 consists of trade receivables
      from customers, less allowances for doubtful accounts, estimated future returns
      and customer rebates and credits.





The
      Company maintains an allowance for doubtful accounts receivables based primarily
      on historical loss experience. Additional amounts are provided through charges
      to income, as management feels necessary, after evaluation of receivables and
      current economic conditions. Amounts which are considered to be uncollectible
      are charged off and recoveries of amounts previously charged off are credited
      to
      the allowance upon recovery.





Allowance
      for doubtful accounts activity during the years ended December 31, 2006 and
      2005
      was as follows:




2006
            
            2005Beginning
                balance
            
            $
            317
            
            $
            250Bad
                debt provisions
            
            
            817
            
            
            186Account
                write-offs
            
            
            (635
            )
            
            (119
            )Recoveries
            
            
            59
            
            
            -Ending
                Balance
            
            $
            558
            
            $
            317




**NOTE
      3 ~ PROPERTY AND EQUIPMENT**





Property
      and equipment at December 31, 2006 and 2005 consists of the
      following:





Useful
                Lives
              in
                Years
            
            2006
            
            2005Furniture
                and fixtures
            
            
            5-7
            
            $
            483
            
            $
            517Office
                and warehouse equipment
            
            
            2-7
            
            
            201
            
            
            245Leasehold
                improvements
            
            
            2-7
            
            
            168
            
            
            163Computer
                equipment and software
            
            
            3-5
            
            
            676
            
            
            662Demo
                and sample equipment
            
            
            1-2
            
            
            -
            
            
            9701,528
            
            
            2,557Accumulated
                Depreciation
            
            
            
            
            
            (1,144
            )
            
            (970
            )$
            384
            
            $
            748





**NOTE
      4 ~ LAURUS CREDIT FACILITY**





On
      May
      27, 2004, the Company closed a $15 million convertible debt financing with
      Laurus under which the Company was provided with a $5 million term loan and
      a
      $10 million revolving credit facility. At closing, the Company borrowed $5
      million under the term loan and $10 million under the revolving credit facility,
      and used $10,016,000 of the proceeds to repay in full the indebtedness
      outstanding under the prior revolving credit agreement with Comerica Bank.
      Additional proceeds of the financing were used to increase working capital,
      pay
      closing fees to Laurus in the aggregate amount of $617,500, and pay a finder's
      fee in the amount of $800,000. As part of the transaction, Laurus was also
      issued a seven-year warrant to purchase 18,800 shares of Common Stock at a
      price
      of $175 per share The Company also issued a similar warrant to purchase 1,880
      shares of Common Stock to the finder. These warrants were valued at $112,000
      using a Black-Scholes pricing model. The assumptions used in the model were
      (i)
      risk free interest rate of 6%, (ii) expected life of 7 years, (iii) expected
      volatility of 70% and (iv) no anticipated
      dividends. Borrowings under the Laurus financing are secured by all assets
      of
      the Company. At December 31, 2006, $1.9 million in principal was outstanding
      under the Term Loan and $6.4 million in principal was outstanding under the
      revolving credit facility. The agreements with Laurus prohibit the payment
      of
      dividends on the Company’s Common Stock, and contain other customary affirmative
      and negative covenants.




F-15





The
      loan
      documents with Laurus required the Company’s Common Stock to be quoted on the
      NASD Over the Counter Bulletin Board by July 27, 2004, which date was extended
      to September 27, 2004 and further extended to December 31, 2004. In
      consideration for extending the deadlines, the Company issued Laurus additional
      seven-year warrants to purchase an aggregate of 8,000 shares of Common Stock
      at
      a price of $175 per share. The fair value of these warrants at date of issue
      was
      determined to be approximately $20,000 using a Black-Scholes pricing model,
      and
      were charged to expense during the year ended December 31, 2004. The assumptions
      used in the model were (i) risk free interest rate of 6%, (ii) expected life
      of
      7 years, (iii) expected volatility of 70% and (iv) no anticipated dividends.
      The
      Company’s Common Stock began being quoted on the NASD Over the Counter Bulletin
      Board on December 13, 2004.




The
      term
      loan is evidenced by a Secured Convertible Term Note (“Term Note”) and bears
      interest at a rate per annum equal to the prime rate (as reported in the Wall
      Street Journal), plus two percent, subject to a floor of six percent. Interest
      on the term loan is payable monthly.




Prior
      to
      the October 2006 amendment described below, the interest rate under the Term
      Note was subject to downward adjustment at the end of each month so that if
      at
      the end of the applicable month the Company had registered the shares of Common
      Stock underlying the Term Note with the SEC, interest payable on the Term Note
      would be adjusted downward by 200 basis points (two percent) for each
      incremental 25 percent increase in the market price of the Common Stock, at
      the
      end of the month, in excess of the conversion price under the Term Note.




Amounts
      outstanding under the Term Note were initially convertible into Common Stock
      at
      Laurus's option at a conversion price initially equal to $135.00 per share.
      As
      the market price of the stock at the date of the modification was significantly
      below the conversion price, there was no financial statement impact of the
      modification of the conversion price. In December 2004 the conversion price
      was
      reduced to $95.50 under the terms of the anti-dilution feature of the Term
      Note.
      In addition, subject to (i) having an effective registration statement with
      respect to the shares of Common Stock underlying the Term Note, and (ii)
      limitations based on trading volume of the Common Stock, originally scheduled
      principal and interest payments under the Term Note were made in shares of
      Common Stock valued at the conversion price. In addition, prepayments under
      the
      Term Note were subject to a premium in the amount of 20% of the principal being
      prepaid.





Borrowings
      under the revolving credit facility bear interest at a rate per annum equal
      to
      the prime rate plus two percent. In addition, prior to the October 2006
      amendment described below, the interest rate under the revolving credit facility
      was previously subject to downward adjustment at the end of each month in the
      same manner as provided for under the Term Note. The revolving credit facility
      terminates, and borrowings thereunder become due, on December 31,
      2007.





Amounts
      outstanding under the revolving credit facility were initially convertible
      to
      Common Stock at Laurus's option at a conversion price initially equal to $169.00
      per share. In December 2004 the conversion price was reduced to $111.00 under
      the terms of the anti-dilution feature of the facility. As the market price
      of
      the stock at the date of the modification was significantly below the conversion
      price, there was no financial statement impact of the modification of the
      conversion price. To the extent the Company repays loans outstanding under
      the
      revolving credit facility and/or Laurus converts loans under the revolving
      credit facility into Common Stock, the Company could reborrow or make additional
      borrowings under the revolving credit facility, provided that aggregate loans
      outstanding under the revolving credit facility at any time may not exceed
      the
      lesser of $10 million or a borrowing base equal to the sum of 83.7% of "eligible
      accounts" plus 60% of "eligible inventory" (with borrowings based on eligible
      inventory limited to $3.5 million). Eligible accounts are generally gross
      accounts receivable less foreign receivables and domestic receivables over
      90
      days from invoice date. Eligible inventory is substantially all finished goods
      inventory.





Pursuant
      to an amendment, dated as of May 26, 2006, between the Company and Laurus,
      (i)
      payments of principal due to Laurus for the months of June 2006 through December
      2006 under the Term Note were reduced from $190,000 per month to $100,000 per
      month, (ii) the final payment of principal due to Laurus under the Term Note on
      May
      27, 2007 was correspondingly increased from $435,000 to $1,065,000, and (iii)
      the exercise price of warrants previously issued to Laurus to purchase an
      aggregate of 26,800 shares of the Company’s Common Stock was reduced from
      $175.00 to $30.00. Pursuant to a further Amendment, dated as of June 22, 2006,
      the conversion price of $300,000 of principal under the Term Note was reduced
      to
      $7.50 from $95.50, and Laurus converted such amount of principal into 40,000
      shares of the Company’s Common Stock. The principal so converted was applied to
      the payments of principal that would otherwise have been due under the Term
      Note
      for the months of July, August and September 2006. As a result of the reduction
      in the exercise price of the warrants, the Company recorded an interest charge
      of approximately $76,000 in the second quarter of 2006. In addition, the Company
      also recorded a charge of approximately $20,000 from the reduction of the
      conversion price of $300,000 of convertible term debt principal in June 2006.




F-16




On
      October 4, 2006, in connection with the private placement referred to in Note
      8,
      the Company entered into an Omnibus Amendment and Consent with Laurus, pursuant
      to which Laurus consented to the issuance of the Convertible Notes in the
      private placement. In addition, Laurus agreed to further amendments to the
      Company’s revolving credit facility and term loan agreements under which (i) the
      ability of Laurus to convert the Company’s revolving credit facility and term
      loan into Common Stock was eliminated; (ii) the maturity date of both the
      revolving credit facility and Term Note was extended from May 24, 2007 until
      December 31, 2007; (iii) prepayment penalties with respect to both the revolving
      credit facility and Term Note were eliminated; and (iv) monthly principal
      payments of $152,000 are due under the Term Note for the months of January
      2007
      through November 2007, with the final payment in December 2007 of $252,000.





Accordingly,
      after giving effect to the amendments above, the remaining amortizing payments
      of principal on the Term Note are $152,083 per month January 2007 through
      November 2007 and a final payment of $252,083 on December 2007.





**NOTE
      5** **~** **LOAN
      ORIGINATION FEES**





The
      Company incurred and capitalized origination and finders fees associated with
      the Laurus credit facility of approximately $1.8 million. These fees are
      amortized into interest expense using the effective interest method over the
      initial term of the loan of three years. Included in the capitalized origination
      fees is compensation of approximately $112,000 relating to the issuance of
      warrants to purchase 20,680 shares of the Company’s Common Stock. These fees
      will be fully amortized in May 2007.





As
      noted
      in Note 8, in conjunction with its private placement transaction in October
      2006
      the Company recorded loan origination fees of approximately $47,000 to reflect
      the fair value of a warrant to purchase 1,875,000 shares of Common Stock issued
      to a shareholder for consulting services in connection with the private
      placement transaction. These non-cash expenses were initially amortized into
      interest expense using the effective interest method over the term of the
      underlying subordinated convertible notes of three years. In November 2006,
      the
      private placement investors exercised the conversion feature of the subordinated
      convertible notes, at which time the remaining unamortized balance of the
      related loan origination fees were immediately charged to income.





**NOTE
      6** **~** **CAPITALIZED
      LEASES**





The
      Company has entered into separate capital lease obligations in conjunction
      with
      the acquisition of warehouse racking and office furniture. These assets have
      original capitalized values of $519,000, and have payment terms ranging from
      48
      to 60 months.





Future
      minimum lease payments under noncancelable capital lease obligations at December
      31, 2006 were as follows:




2007
            
            $
            832008
            
            
            532009
            
            
            12Total
                payments
            
            
            148Less
                amounts relating to interest
            
            
            8Total
                capital lease obligations
            
            
            140Less
                current portion
            
            
            77Capital
                lease obligations, noncurrent
            
            $
            63






F-17


**NOTE
        7 ~ INCOME TAXES**
 
 The
        Company’s provision for income taxes consists of the
        following:


2006
            
            2005
            
            2004CurrentFederal
            
            $
            -
            
            $
            -
            
            $
            (647
            )State
            
            
            14
            
            
            83
            
            
            2214
            
            
            83
            
            
            (625
            )DeferredFederal
            
            
            -
            
            
            -
            
            
            212State
            
            
            -
            
            
            -
            
            
            --
            
            
            -
            
            
            212Total
            
            $
            14
            
            $
            83
            
            $
            (413
            )





The
      2004
      provision includes a benefit of $1.1 million relating to continuing operations,
      which is partially offset by $695,000 expense charge relating to discontinued
      operations.





Deferred
      taxes are provided for the differences in the tax and accounting basis of assets
      and liabilities as follows ($ in thousands):





2006
            
            2005Current
                deferred taxesAccounts
                receivable allowances
            
            $
            546
            
            $
            352Other
            
            
            0
            
            
            28Inventory
                reserve
            
            
            864
            
            
            979Uniform
                capitalization of inventory costs
            
            
            74
            
            
            98Net
                operating loss carry-forward
            
            
            7,943
            
            
            5,1699,427
            
            
            6,626Noncurrent
                deferred tax liabilitiesProperty
                and equipment
            
            
            (121
            )
            
            (84
            )Non
                Cash compensation
            
            
            46
            
            
            33(75
            )
            
            (51
            )Less:
                Deferred tax valuation allowance
            
            
            (9,352
            )
            
            6,575Net
            
            $
            -
            
            $
            -





The
      Company's effective tax rate differs from the expected federal income tax rate
      as follows ($ in thousands):





2006
            
            2005
            
            2004Income
                tax at statutory rates (34%)
            
            $
            (5,612
            )
            $
            (4,397
            )
            $
            (2,581
            )State
                income tax expense - net of federal benefit
            
            
            14
            
            
            55
            
            
            15Change
                in deferred tax valuation allowance
            
            
            5,612
            
            
            4,425
            
            
            2,150Other
            
            
            -
            
            
            -
            
            
            3Income
                tax (benefit) provision
            
            $
            14
            
            $
            83
            
            $
            (413
            )





F-18


The
      Company records income taxes using the asset and liability approach, whereby
      deferred tax assets, net of valuation allowances, and liabilities are recorded
      for the future tax consequences of temporary differences between financial
      statement and tax bases of assets and liabilities and for the benefit of net
      operating loss carry forwards.





The
      Company has incurred significant operating losses over the past several fiscal
      years, which has generated net operating loss carry-forwards which may be
      available for future utilization. Internal Revenue Code Section 382 places
      a
      limitation on the utilization of Federal net operating loss and other credit
      carry-forwards when an ownership change, as defined by the tax law, occurs.
      Generally, this occurs when a greater than 50 percentage point change in
      ownership occurs. In October 2006, as a result of the completion of the
      Company’s private placement transaction, the investors in the private placement
      as a group became the beneficial owners of approximately 96% of the Company’s
      outstanding shares, after consideration of the conversion of convertible
      promissory notes issued to those investors in conjunction with the transaction.
      Accordingly, the actual utilization of net operating loss carry-forwards and
      other deferred tax assets for tax purposes may be limited annually under Code
      Section 382 to a percentage of the fair market value of the Company at the
      date
      of this ownership change. As a result, at December 31,
      200 6, the
      Company has a
      net operating loss carry-forward of approximately $27.5 million expiring 2025.
      A
      full valuation allowance has been provided against the deferred tax assets.
      The
      valuation allowance reflects management’s assessment of the uncertainty of the
      Company’s ability to utilize the deferred tax benefits in the
      future.





**NOTE
      8 ~ STOCKHOLDERS’ EQUITY**





***October
      2006 Private Placement***




On
      October 6, 2006, the Company completed a $5 million private placement (excluding
      closing costs of $100,000), consisting of 100 Units at a price of $50,000 per
      unit. Each Unit consisted of 25,000 shares of Common Stock and a 6% Subordinated
      Secured Convertible Promissory Note (“Convertible Notes”) in the principal
      amount of $45,000, convertible into 225,000 shares of Common Stock at a
      conversion price equal to $.20. As a result, the Company issued 2,500,000 shares
      of common stock for $400,000 (net of closing costs of $100,000) and Convertible
      Notes in the aggregate principle amount of $4,500,000 convertible into
      22,500,000 shares of the Company’s common stock. The Company could repay the
      Convertible Notes at maturity through the issuance of common stock, so long
      as
      the market price of the common stock was no less than 150% of the conversion
      price at maturity. The Convertible Notes could not be converted into common
      stock until the Company could amend its certification of incorporation effecting
      a reverse stock split providing for a sufficient number of authorized shares
      of
      common stock to permit such conversion. On November 27, 2006, the Company
      effected a 50-for-1 reverse stock split of the Common Stock, and all of the
      Convertible Notes (including $40,463 of accrued interest) were converted to
      Common Stock.




The
      conversion price of the Convertible Notes was less than the market price of
      the
      Company’s common stock on the date of the issuance of the Convertible Notes. In
      accordance with EITF 98-5 the Company recognized a debt discount of $4.5 million
      associated with the beneficial conversion feature of the Convertible Notes.
      The
      entire debt discount was recognized by the Company on November 27, 2006, the
      date on which the Company’s 50-for-1 reverse split was effected and the Notes
      became ultimately convertible.




As
      part
      of the transaction, the Company agreed to issue warrants to purchase an
      aggregate of 1,875,000 shares of Common Stock at a price of $.20 per share
      to a
      consultant that became a director. As a result of this agreement, the Company
      recorded deferred loan origination fees equal to the fair value of the warrant
      totaling $46,875.




***Other
      Equity Transactions***




During
      the year ended December 31, 2006, the Company issued 40,000 shares of common
      stock to directors valued at $52,000. The shares were valued at the market
      price
      at the date of issuance.




During
      the year ended December 31, 2006, the Company issued 15,000 shares of common
      stock to its former distributor to the retail channel upon achievement of a
      contractual sales milestone. The shares were valued at $157,500, the market
      price at the date of issuance.




F-19




During
      the year ended December 31, 2006, the Company issued 25,000 shares of common
      stock for services valued at $23,250. The shares were valued at the market
      price
      at the date of issuance.





**NOTE
      9** **~** **SIGNIFICANT
      VENDOR AGREEMENT**




The
      Company was party to a product distribution agreement with Samsung Electronics
      Co. Ltd. (“Samsung”) that gave the Company the exclusive right to sell Samsung
      products in the professional channel, as well as the exclusive right to sell
      Samsung products in the retail channel to a major national retailer. The
      exclusive right to sell Samsung products to the major national retailer expired
      on December 31, 2005. In January 2006 Samsung also terminated the remaining
      exclusivity associated with the professional market as a result of the Company’s
      failure to achieve minimum purchase requirements in accordance with the
      distribution agreement. In the first quarter of 2006, Company management elected
      to discontinue its retail business, and no longer sells Samsung retail products.





On
      October 2, 2006, the Company entered into a new Product Distribution Agreement
      (“Agreement”) with Samsung, under which the Company was granted the right to
      distribute Samsung’s complete line of professional video surveillance and
      security products in North, Central and South America (“Territory”) through
      December 31, 2010. Pursuant to the Agreement, Samsung has agreed to a limited
      non-compete in the Territory. The Agreement also provides for minimum annual
      purchase amounts of $21 million and $27 million for the years ending December
      31, 2006 and 2007, respectively, and allows Samsung to terminate the Agreement
      at any time if the Company does not achieve the annual minimum purchase amounts,
      as well as upon the Company’s breach of any of its other obligations thereunder.
      For the year ended December 31, 2006, the Company exceeded its minimum
      purchasing commitment under the agreement. For the year ended December 31,
      2006,
      we purchased approximately $21.3 million under the Distributorship Agreement
      with Samsung.




**NOTE
      10 ~ 401(K) PLAN**





The
      Company has a 401(k) profit-sharing plan covering all of its eligible employees.
      The Plan provides for annual discretionary employer and employee contributions.
      For the years ended December 31, 2006, 2005 and 2004, no annual discretionary
      employer contributions were approved and funded.





**NOTE
      11 ~ COMMITMENTS & CONTINGENCIES**





***General***





Sales
      to
      certain consumers of video surveillance and other security products may be
      subject to sales tax requirements and possible audits by state taxing
      authorities. The Company estimates its sales tax liability and includes that
      amount as an accrued obligation until paid.





The
      Company is also party to other disputes in the normal course of business.
      Management believes the ultimate resolution of such disputes will not have
      a
      material effect on the financial statements.





***Lease
      and Rents***





The
      Company leases warehouse and office space under an operating lease agreement
      which expires on September 30, 2009. Under the terms of the lease, the Company
      paid no rent for six months, and then pays monthly rent of $25,704 for the
      remainder of the sixty-six month lease. The Company records rent on a
      straight-line basis over the life of the lease and records the difference
      between amounts paid and expense recorded as a deferred lease liability.





The
      minimum annual rentals under the non-cancelable lease for the periods subsequent
      to December 31, 2006 are as follows ($ in thousands):





Years
                Ending December 31:
            
            Amount2007
            
            $
            3082008
            
            
            3082009
            
            
            231$
            847







F-20




***Termination
        Agreement with Nazzareno E. Paciotti***
 
 On
        March
        28, 2006, the Company and Nazzareno E. Paciotti, entered into a Mutual
        Separation Agreement whereby the parties mutually agreed to the termination
        of
        Mr. Paciotti’s employment with the Company and to his resignation as a director
        and officer of the Company and its subsidiaries. Under the terms of the Mutual
        Separation Agreement, Mr. Paciotti was entitled to receive severance payments
        equal to one year of his annual base salary of $300,000 payable over 12 months.
        In addition, under the separation agreement, Mr. Paciotti was entitled to
        continue to receive medical benefits through January 24, 2008. The Company
        also
        agreed that Mr. Paciotti’s options to purchase 12,500 shares of Common Stock
        would vest in full and be exercisable in full until December 31, 2006. Mr.
        Paciotti agreed to release the Company in full from any and all claims and
        to
        continue to be bound by the confidentiality and non-solicitation terms of
        his
        employment agreement.


In
      September 2006 the Company entered into an agreement with Mr. Paciotti whereby
      the Company paid Mr. Paciotti a one-time payment of $85,925 in satisfaction
      of
      all remaining obligations under the Mutual Separation Agreement, which resulted
      in total payments under the Mutual Separation Agreement to Mr. Paciotti of
      $206,112. .





***Employment
      Agreements***





The
      Company entered into an Employment Agreement, dated as of February 9, 2006,
      with
      Steven Walin, the Company’s Chief Executive Officer. The Employment Agreement is
      for a three-year term of employment which commenced March 6, 2006. Pursuant
      to the Employment Agreement, Mr. Walin received a $100,000 signing bonus and
      receives an annual base salary of $375,000.




Pursuant
      to his Employment Agreement, Mr. Walin was also paid a guaranteed bonus equal
      to
      50% of his base salary ($140,625) for the first nine months of his service,
      and
      is entitled to receive an annual bonus of up to 50% of his base salary based
      on
      the achievement of annual performance targets approved of by the Company’s board
      of directors, for subsequent years.




In
      addition, pursuant to the Employment Agreement, in the event that Mr. Walin’s
      employment is terminated without “Cause” or by Mr. Walin for “Good Reason” (as
      such terms are defined in the Employment Agreement), Mr. Walin will be entitled
      to:




·
            payment
                of all accrued but unpaid base salary, his signing bonus (to the
                extent
                then unpaid), and unpaid annual bonus with respect to any completed
                fiscal
                year;




·
            payment
                of his base salary and continued medical benefits for 12 months;
                provided,
                that if such termination occurs after a “Change in Control” Mr. Walin will
                instead be entitled to a payment equal to 200% of his base salary
                and
                continued medical benefits for 24
                months;




·
            pro-rated
                bonus for the year in which the termination occurs, payable following
                such
                fiscal year to the extent he would have otherwise been entitled to
                such
                bonus; and




·
            provided
                at least six months has expired since the last vesting of an option
                grant,
                a pro rata vesting of his option shares which are scheduled to vest
                on the
                next vesting date; provided, that if such termination occurs after
                a
                “Change in Control” or after the first anniversary of Mr. Walin’s
                employment, all of the unvested options will immediately
                vest.




If
      Mr.
      Walin’s employment is terminated as a result of his death or disability, the
      Company will pay him his accrued but unpaid base salary, unpaid signing bonus,
      and unpaid annual bonus with respect to any completed fiscal year, and a
      pro-rated portion of any bonus he would have otherwise been entitled for the
      fiscal year in which the termination occurs.




F-21


Mr.
      Walin
      is prohibited under the Employment Agreement from using or disclosing any of
      the
      Company’s proprietary information, competing with the Company, hiring any of the
      Company’s employees or consultants and soliciting any of the Company’s customers
      or suppliers to reduce or cease business with the Company.




In
      addition, the Company also entered into an Employment Agreement, dated as of
      March 28, 2006, with Joseph Restivo, the Company’s Chief Financial Officer. The
      Employment Agreement is for a three-year term and provides Mr. Restivo with
      an
      annual base salary of $200,000, and an annual bonus of up to 50% of his base
      salary based on the achievement of annual performance targets approved of by
      the
      Company’s board of directors.




In
      addition, pursuant to the Employment Agreement, in the event that Mr. Restivo’s
      employment is terminated without “Cause” or by Mr. Restivo for “Good Reason” (as
      such terms are defined in the Employment Agreement), Mr. Restivo will be
      entitled to:




·
            payment
                of all accrued but unpaid base salary and unpaid annual bonus with
                respect
                to any completed fiscal year;




·
            payment
                of his base salary and continued medical benefits for 12 months;
                provided,
                that if such termination occurs after a “Change in Control” Mr. Restivo
                will instead be entitled to a payment equal to 200% of his base salary
                and
                continued medical benefits for 24
                months;




·
            pro-rated
                bonus for the year in which the termination occurs, payable following
                such
                fiscal year to the extent he would have otherwise been entitled to
                such
                bonus; and




·
            provided
                at least six months has expired since the last vesting of his option
                grant, a pro rata vesting of his option shares which are scheduled
                to vest
                on the next vesting date; provided, that if such termination occurs
                after
                a “Change in Control” or after the first anniversary of Mr. Restivo’s
                employment, all of the unvested options will immediately
                vest.




If
      Mr.
      Restivo’s employment is terminated as a result of his death or disability, the
      Company will pay him his accrued but unpaid base salary and unpaid annual bonus
      with respect to any completed fiscal year, and a pro-rated portion of any bonus
      he would have otherwise been entitled for the fiscal year in which the
      termination occurs.




Mr.
      Restivo is prohibited under the Employment Agreement from using or disclosing
      any of the Company’s proprietary information, competing with the Company, hiring
      any of the Company’s employees or consultants and soliciting any of our
      customers or suppliers to reduce or cease business with the Company.




On
      October 4, 2006, in connection with the private placement noted earlier, the
      Company entered into amendments to the employment agreements of both the Chief
      Executive Officer and Chief Financial Officer, by which the Company agreed
      to
      issue to each of the two officers an option to purchase 1,881,795 shares of
      the
      Company’s Common Stock at an exercise price of $.020 per share vesting over a
      three-year period, and have amended the definition of “Cause” for termination
      purposes under each of the employment agreements to include the Company’s
      incurrence of a net loss, as defined in the amendments, in the quarter ending
      June 30, 2007. The new options may not be exercised until such time as the
      Company has available for issuance a sufficient number of unissued shares of
      authorized Common Stock so as to permit such exercise. Pursuant to the
      amendments, the two officers agreed to forfeit all stock options previously
      granted to them under their employment agreements as well as the right to be
      issued additional stock options upon the closing of a private placement of
      the
      Company’s securities.





**NOTE
      12 ~ 2004 STOCK INCENTIVE PLAN**





In
      February 2004, the Company adopted its 2004 Long-Term Stock Plan and reserved
      up
      to 118,798 shares of Common Stock for issuance thereunder. In June 2006 the
      shares available under this Plan increased from 118,798 to 200,000, and in
      October 2006 the shares available were increased under this Plan to
      5,900,000.




F-22




In
      March
      2006, the Company granted to the Chief Executive Officer and Chief Financial
      Officer options to purchase a total of 75,000 shares of Common Stock exercisable
      at $8.00 to $40.00 per share. These options were not granted under a plan.
      In
      October 2006, the Company entered into amendments to the employment agreements
      of both the Chief Executive Officer and Chief Financial Officer, by which the
      Company agreed to issue to each of the two officers an option to purchase
      1,881,795 shares of the Company’s Common Stock at an exercise price of $.20 per
      share vesting over a three-year period. Under the terms of the amendment, the
      two officers agreed to forfeit options to purchase an aggregate of 75,000 shares
      of common stock previously issued to them. In addition, options to purchase
      an
      aggregate of 1,640,000 shares of common stock were made available for
      distribution to other key management members at an exercise price of $.20 per
      share vesting over a three-year period. Additionally, options to purchase an
      aggregate of 30,000 shares of common stock were granted to directors. The
      director options provided for an exercise price of $.20 per share over a 10
      year
      life, and vests over a three-year period.




A
      summary
      of the status and activity of the Company’s stock options is presented below:




Years
                Ended December 31:2006
            
            2005
            
            2004Shares
            
            Weighted
                Ave Exercise Price
            
            Shares
            
            Weighted
                Ave Exercise Price
            
            Shares
            
            Weighted
                Ave Exercise PriceOutstanding
                at January 1:
            
            
            84,435
            
            $
            89.89
            
            
            110,411
            
            $
            80.97
            
            
            482
            
            $
            2,245.54Granted
            
            
            5,508,591
            
            $
            0.56
            
            
            28,350
            
            $
            61.70
            
            
            109,929
            
            $
            71.48Exercised
            
            
            -
            
            
            -
            
            
            (39,500
            )
            $
            16.00
            
            
            -
            
            
            -Forfeited
            
            
            (94,229
            )
            $
            33.42
            
            
            (14,826
            )
            $
            166.43
            
            
            -
            
            
            -Outstanding
                at December 31:
            
            
            5,498,797
            
            $
            1.37
            
            
            84,435
            
            $
            89.89
            
            
            110,411
            
            $
            80.97Options
                Exercisable at December 31:
            
            
            1,411,795
            
            $
            3.80
            
            
            29,786
            
            $
            92.75
            
            
            41,072
            
            $
            76.54




The
      aggregate intrinsic values of outstanding and exercisable shares at December
      31,
      2006 were $0 and $0, respectively.





The
      weighted average fair value of options issued at date of grant using the fair
      value based method during 2006 is estimated at $0.09. The total intrinsic value
      of options exercised during 2006 was $0.




The
      following table summarizes information about stock options outstanding as of
      December 31, 2006:




Outstanding
                Options
            
            Exercisable
                OptionsExercise
                Prices
            
            Shares
                Outstanding at December 31, 2006
            
            Weighted-average
                Remaining Contractual Life
            
            Number
                Outstanding at
              December
                31, 2006$
                0.20
            
            
            5,433,591
            
            
            9.8
                years
            
            
            1,358,39815.93
            
            
            10,280
            
            
            6.6
                years
            
            
            10,28042.50
            
            
            2,000
            
            
            8.3
                years
            
            
            1,00075.00
            
            
            16,300
            
            
            8.0
                years
            
            
            13,366130.00
            
            
            36,500
            
            
            7.1
                years
            
            
            28,625>
                $130.00
            
            
            126
            
            
            2.9
                years
            
            
            1265,498,797
            
            
            9.8
                years
            
            
            1,411,795




There
      were no stock options exercised during the year ended December 31, 2006. The
      Company recognized compensation expense from the vesting of issued stock options
      of approximately $332,000 for the year ended December 31, 2006, and had
      estimated future compensation expense from these stock options of
      approximately $128,000
      at December 31, 2006 which will be recognized over the remaining estimated
      weighted useful life of 34 months.





F-23





**NOTE
      13 ~ WARRANTS**





A
      summary
      of the status and activity of the Company’s outstanding warrants is presented
      below:




Years
                  Ended December 31:2006
              
              2005
              
              2004Shares
              
              Weighted
                  Ave Exercise Price
              
              Shares
              
              Weighted
                  Ave Exercise Price
              
              Shares
              
              Weighted
                  Ave Exercise PriceOutstanding
                  at January 1:
              
              
              134,867
              
              $
              88.07
              
              
              136,193
              
              $
              100.30
              
              
              1,602
              
              $
              1,291.05Issued
              
              
              1,875,000
              
              $
              0.20
              
              
              -
              
              $
              -
              
              
              134,592-
              
              $
              86.13Exercised
              
              
              -
              
              $
              -
              
              
              -
              
              $
              -
              
              
              -
              
              $
              -Expired
              
              
              144
              
              $
              1,625.00
              
              
              1,327
              
              $
              1,343,61
              
              
              -
              
              $
              -Outstanding
                  at December 31:
              
              
              2,009,723
              
              $
              5.98
              
              
              134,867
              
              $
              88.07
              
              
              136,193
              
              $
              100.30




Summary
      of the Company’s outstanding warrants at December 31, 2006 and 2005 are as
      follows:




December
                31, 2006
            
            December
                31, 2005Description
            
            Shares
            
            Approx.
                Remaining Term (Years)
            
            Exercise
                Price
            
            SharesLaurus
                Master Fund
            
            
            26,800
            
            
            4.5
            
            $
            30.00
            
            
            26,800Laurus
                finder’s fee
            
            
            1,880
            
            
            4.4
            
            $
            175.00
            
            
            1,880ESI
            
            
            60,000
            
            
            4.8
            
            $
            75.00
            
            
            60,000Rapor
                shareholders
            
            
            27,079
            
            
            4.9
            
            $
            152.00
            
            
            27,079Oct.
                2004 bridge financing
            
            
            15,333
            
            
            2.8
            
            $
            75.00
            
            
            15,333Consultant
            
            
            3,500
            
            
            2.8
            
            $
            175.00
                - $250.00
            
            
            -Consulting
                fee paid to director
            
            
            1,875,000
            
            
            4.8
            
            $
            0.20
            
            
            -Other
            
            
            131
            
            
            0.9
            
            $
            390.00
            
            
            2752,009,723
            
            
            
            
            
            
            
            
            131,367




**NOTE
      14 ~ RELATED PARTY TRANSACTIONS**




***Settlement
      Agreement with William Teitelbaum***




In
      October 2004 the Company entered into a Settlement Agreement and General Release
      with William A. Teitelbaum, a founder and principal stockholder of the GVI
      Security, Inc., under which Mr. Teitelbaum was issued 13,000 shares of common
      stock and Mr. Teitelbaum released the Company from claims with respect to a
      warrant he alleged had been issued to him by GVI Security, Inc. The value of
      the
      common stock issued under the agreement is recorded as an other operating
      expense of $156,000 for the year ended December 31, 2004. The Settlement
      Agreement required the Company to use a portion of the proceeds it would receive
      in a placement of its securities to repurchase up to $10 million of shares
      of
      common stock held by Mr. Teitelbaum at the purchase price of the securities
      sold
      in the placement. On January 4, 2005 the Company completed the purchase of
      133,333 shares from William A. Teitelbaum for $10 million.




F-24




***Termination
      Agreement with Thomas Wade***


On
      October 19, 2004, the Company, GVI Security Inc. and Thomas Wade, at that time
      the beneficial holder of approximately 14% of Common Stock and the President
      of
      the Company’s subsidiary, entered into a Mutual Separation Agreement whereby the
      parties mutually agreed to the termination of Mr. Wade’s employment with the
      subsidiary. In accordance with Mr. Wade’s employment agreement, Mr. Wade
      received severance payments equal to one year of his annual base salary of
      $350,000. In addition, under the separation agreement, Mr. Wade was entitled
      to
      continue to receive a car allowance of $800 per month, an unconditional expense
      reimbursement of $1,200 per month, and medical benefits, for a period of one
      year. At December 31, 2004, approximately $281,000 for the remaining obligation
      was included in accrued expenses. The Company also agreed that Mr. Wade’s
      options to purchase 39,500 shares of the Company’s Common Stock would vest in
      full. There was no effect on earnings for this acceleration. Mr. Wade agreed
      to
      release the Company in full from any and all claims and to continue to be bound
      by all the terms of his employment agreement.




In
      the
      normal course of business, the Company previously conducted certain transactions
      with a company owned by William Teitelbaum, a principal stockholder. During
      the
      years ended December 31, 2005 and 2004, the Company made sales of $0 and $3,587,
      respectively, to this company. At December 31, 2005, no amounts were due from
      this company.




On
      March
      31, 2004, the Company issued three subordinated convertible notes totaling
      $159,000. Each note bore interest at 10% per annum and was convertible into
      common stock at a price of $255.00 per share. The notes were paid in full with
      accumulated interest on June 29, 2004.




On
      October 29, 2004, in a private placement exempt from registration under the
      Securities Act, the Company sold 23 “Units” for an aggregate purchase price of
      $1,150,000, to a group of five purchasers, all of whom were affiliates of the
      Company. Each Unit consisted of $50,000 principal amount of 12% Subordinated
      Secured Promissory Notes, and the right to be issued warrants to purchase shares
      of common stock. The Notes were repaid in full in accordance with their terms
      in
      December 2004 upon the closing of the private placement. Warrants to purchase
      15,333 shares of common stock were issued to these purchasers in December 2004
      in accordance with the terms of the October 2004 private placement.





Joseph
      Rosetti, one of the Company’s directors, was a director of Rapor prior to the
      merger (See Note 1). Mr. Rosetti was also the direct holder of approximately
      12%
      of Rapor’s outstanding common stock, and a principal partner in a partnership,
      established for the benefit of members of his family, that held approximately
      7.5% of Rapor’s outstanding common stock. In accordance with the terms of the
      merger, as former stockholders of Rapor, Mr. Rosetti was issued 6,921 shares
      of
      common stock and warrants to **** purchase
      2,716 shares of common stock, and the partnership was issued 4,180 shares of
      common stock and warrants to purchase 2,090 shares of common stock. ****





**NOTE
      15 ~ INVESTMENT IN DIGITAL HORIZONS SOLUTIONS, LLC (formerly Bio-AccessID,
      LLC)**





On
      January 20, 2004, pursuant to a Membership Purchase Agreement by and among
      John
      Carter, Ronald DeBerry, GVI Security Solutions, Inc., and Digital Horizons
      Solutions, LLC (formerly Bio-AccessID, LLC)


("Digital
      Horizons"), the Company purchased a 5% membership interest in Bio-Access for
      $250,000. In December 2005 the Company determined the value of this investment
      had been significantly impaired and wrote down the carrying value to $50,000,
      recording a charge to other operating expenses of $200,000 for the year ended
      December 31, 2005. As part of the agreement, the Company had the right to
      acquire up to an additional 21% of Bio-Access over a three-year period after
      certain agreed-upon purchase goals have been attained for a purchase price
      of up
      to an additional $750,030.  As a result of the amount of the Company’s
      purchases from Digital Horizons, the Company’s option to acquire additional
      interest has decreased from 21%
      to
      19%.





In
      June
      2006, the Company sold its rights and interest in Digital Horizons for
      $50,000.





**NOTE
      16 ~ COMPANY RECAPITALIZATION**





On
      February 16, 2004, the Board of Directors and Stockholders of the Company
      authorized new Series D and E Convertible Preferred Stock, each for par value
      of
      $.001 per share. On February 20, 2004, pursuant to an Agreement and Plan of
      Merger (the "Merger Agreement") dated as of February 19, 2004, by and among
      the
      Company (then “Thinking Tools, Inc.”), GVI Security, Inc., and GVI Security
      Acquisition Corp., a newly formed wholly-owned
      subsidiary of the Company, GVI Security, Inc. merged (the “Merger”) with GVI
      Security Acquisition Corp., becoming the Company's wholly-owned subsidiary,
      and
      the stockholders of GVI became stockholders of the Company as described below.
      For accounting purposes, because Thinking Tools, Inc. had become a shell
      company, the Merger was treated as a recapitalization of GVI Security, Inc.




F-25




In
      the
      Merger, the Company issued to the former stockholders of GVI an aggregate of
      1,000,000 shares of the Series E Convertible Preferred Stock ("Series E Stock").
      The shares of Series E Stock were convertible into an aggregate of 564,292
      shares of the Company's common stock, constituting approximately 95.3% of the
      outstanding shares of the Company's common stock outstanding following the
      Merger, assuming the conversion of all other outstanding shares of the Company's
      preferred stock. The shares of Series E Stock were automatically converted
      into
      shares of the Company's common stock when the Company filed the Charter
      Amendment (defined below).





The
      two
      largest stockholders of GVI prior to the Merger were William Teitelbaum, who
      owned approximately 47.8% of GVI's common stock, and GVI Acquisition LLC
      ("Acquisition LLC"), which owned approximately 38.3% of GVI's common stock.
      Acquisition LLC is a California limited liability company, whose sole managers,
      Fred Knoll and David Weiner, were directors of the Company until December 31,
      2004 and January 4, 2005, respectively. The sole members of Acquisition LLC
      are
      (i) a corporation which is wholly-owned by David Weiner, and (ii) Europa
      International, Inc. (“Europa”) an equity fund managed by Knoll Capital
      Management, L.P., of which Mr. Knoll is the principal.





In
      addition, pursuant to the Merger Agreement, certain employees and directors
      of
      GVI were issued options to purchase an aggregate of approximately 56,429 shares
      of the Company's common stock under the 2004 Long-Term Incentive Plan in
      exchange for the cancellation of options to purchase shares of GVI's common
      stock held by such persons prior to the Merger. All of these options have an
      exercise price of $15.93 per share.





Immediately
      prior to the Merger, and as a condition thereto, Europa exchanged a Convertible
      Demand Grid Note issued by the Company in the principal amount of $1,000,000,
      and all other indebtedness of the Company to Europa for 10,000 shares of the
      Series D Convertible Preferred Stock ("Series D Stock") of the Company, which
      shares were convertible into an aggregate of 23,760 shares of common stock.
      The
      shares of Series D Stock automatically converted into shares of the Company's
      common stock when the Company filed the Charter Amendment. Pursuant to its
      obligations under the Merger Agreement, following the Merger, the Company
      obtained the approval of its stockholders to (i) amend the Company's certificate
      of incorporation increasing the authorized shares of the Company's common stock
      to 75,000,000 and effecting a one-for-65 reverse stock split of the common
      stock
      so that the Company would have sufficient shares of unissued common stock to
      permit the conversion of all of the Series D Stock, Series E Stock and all
      other
      convertible securities of the Company (the "Charter Amendment"), (ii) the
      adoption of the Stock Option Plan, and (iii) the change of the Company’s name to
      GVI Security Solutions, Inc. The Company filed a Certificate of Amendment to
      its
      Certificate of Incorporation with the Secretary of State in Delaware giving
      effect to these amendments in April 2004, whereupon all outstanding shares
      of
      Series A Preferred Stock, Series D Preferred Stock and Series E Preferred Stock
      automatically converted into shares of the Company's common stock.





In
      addition, pursuant to amendments to the terms of the Series A Preferred Stock
      approved in January 2004, upon the filing of the Charter Amendment the
      outstanding shares of Series A Preferred Stock converted into an aggregate
      of
      884 shares of the Company’s common stock.





**NOTE
      17 ~** **QUARTERLY
      FINANCIAL INFORMATION (UNAUDITED)**





The
      tables below list the quarterly financial information for the years ended
      December 31, 2006 and 2005:


QUARTERS
                  ENDING:March
                  31
              
              June
                  30
              
              September
                  30
              
              December
                  31:**DECEMBER
                  31, 2006:**Net
                  sales
              
              $
              11,696
              
              $
              11,156
              
              $
              10,067
              
              $
              11,055Gross
                  Profit
              
              
              2,534
              
              
              2,441
              
              
              591
              
              
              1,017Loss
                  from continuing operations before income (loss) from discontinued
                  operations
              
              
              (1,547
              )
              
              (2,198
              )
              
              (3,570
              )
              
              **(a)**(6,501
              )(Loss)
                  income from discontinued operations, net of taxes
              
              
              (962
              )
              
              (2,289
              )
              
              576
              
              
              -Net
                  income (loss)
              
              $
              (2,509
              )
              $
              (4,487
              )
              $
              (2,994
              )
              $
              (6,501
              )Continuing
                  operations
              
              $
              (0.42
              )
              $
              (0.59
              )
              $
              (0.97
              )
              $
              (1.76
              )Discontinued
                  operations
              
              $
              (0.26
              )
              $
              (0.62
              )
              $
              0.16
              
              $
              --Net
                  income (loss) per share
                (basic
                  and diluted)
              
              $
              (0.68
              )
              $
              (1.21
              )
              $
              (0.81
              )
              $
              (1.76
              )
  F-26
  **DECEMBER
                  31, 2005:**Net
                  sales
              
              $
              10,308
              
              $
              9,900
              
              $
              10,936
              
              $
              9,638Gross
                  Profit
              
              
              1,700
              
              
              1,260
              
              
              1,546
              
              
              1,462Loss
                  from continuing operations before income (loss) from discontinued
                  operations
              
              
              (670
              )
              
              (2,807
              )
              
              (2,535
              )
              
              (4,725
              )Income
                  (loss) from discontinued operations, net of taxes
              
              
              1,180
              
              
              (43
              )
              
              (53
              )
              
              **(b)**(3,367
              )Net
                  income (loss)
              
              $
              510
              
              $
              (2,850
              )
              $
              (2,588
              )
              $
              (8,092
              )Continuing
                  operations
              
              $
              (1.07
              )
              $
              (2.81
              )
              $
              (2.53
              )
              $
              (4.71
              )Discontinued
                  operations
              
              $
              1.59
              
              $
              (0.04
              )
              $
              (0.05
              )
              $
              (3.36
              )Net
                  income (loss) per share
                (basic
                  and diluted)
              
              $
              0.52
              
              $
              (2.85
              )
              $
              (2.58
              )
              $
              (8.08
              )




(a)
            The
                2006 fourth quarter loss from continuing operations includes a $4.5
                million charge to reflect the beneficial conversion feature discount
                from
                convertible notes issued in October
                2006




(b)
            The
                2005 fourth quarter loss from discontinued operations includes write-off
                of retail inventory and other assets of approximately $2.9
                million.




**NOTE
      18 ~ SUBSEQUENT EVENTS**





***January
      2007 Private Placement***




On
      January 22, 2007, the Company completed an additional private placement of
      1,713,334 shares of Common Stock at a price of $0.60 per share for aggregate
      gross consideration of $1,028,000. The proceeds from the January private
      placement were used for working capital and general corporate purposes.




***Director
      Stock Option Grants***




On
      February 14, 2007, the Company granted to three directors options to purchase
      an
      aggregate of 100,000 shares of the Company’s common stock. These options provide
      for an exercise price of $.60 per share over a 10 year life. 25% of each
      director’s options vest immediately, with the remaining 75,000 options vesting
      ratably in 12 installments of 6,250 each on the first day of each fiscal quarter
      of the Corporation commencing April 1, 2007.




F-27