**UNITED
STATES**


**SECURITIES
AND EXCHANGE COMMISSION**


**WASHINGTON,
D** . **C** . **20549**




****


**FORM
10-KSB**


**ANNUAL
REPORT PURSUANT TO SECTION 13 OR 15(d)**


**OF
THE SECURITIES EXCHANGE ACT OF 1934**


**FOR
THE FISCAL YEAR ENDED DECEMBER 31, 2004**


**COMMISSION
FILE NUMBER 000-21295**










**GVI
Security Solutions, Inc.**


(Name of
Small 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**










Check
whether the issuer: (1) 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




Check if
there is no disclosure of delinquent filers in response to Item 405 of
Regulation S-B contained herein, and no disclosure will 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-KSB.  ̈




The
issuer had revenues of $66,206,000 for its fiscal year ended December 31,
2004.





The
aggregate market value of the voting and non-voting common equity held by
non-affiliates of the registrant as of March 22, 2005 was approximately
$60,910,059. The number of shares outstanding of the registrant’s Common Stock
as of March 31, 2005 was 49,047,949.




Transitional
Small Business Disclosure Format:  ̈ Yes  þ No




**Documents
Incorporated By Reference**


Portions
of the Registrant's Proxy Statement for the 2005 Annual Meeting of Stockholders,
which is to be filed subsequent to the date hereof, are incorporated by
reference into Part III of this Annual Report on Form 10-KSB.






















**GVI
SECURITY SOLUTIONS, INC** .


**2004
FORM 10-KSB ANNUAL REPORT**


**TABLE
OF CONTENTS**






PagePART I
    3Item 1. Business.
    3Item 2. Properties.
    18Item 3.
      Legal Proceedings.
    18Item 4. Submission of Matters to a Vote of Security
      Holders.
    18PART
      II
    18Item 5. Market for Registrant’s Common Equity and Related
      Stockholder Matters.
    18Item 6. Management’s Discussion and Analysis of Plan of
      Operation.
    19Item 7. Financial Statements.
    26Item 8. Changes in and Disagreements With Accountants on Accounting
      and Financial Disclosure.
    26Item
      8A. Controls and Procedures
    26Item 8B. Other Information
    26PART
      III
    26Item 9. Directors and Executive Officers of the
      Registrant.
    26Item
      10. Executive Compensation.
    26Item
      11. Security Ownership of Certain Beneficial Owners and Management and
      Related Stockholder Matters.
    26Item 12. Certain Relationships and Related
Transactions.
    27Item 13. Exhibits and Reports on Form 8-K.
    27Item 14. Principal Accountant Fees and Services.
    30


















**CAUTIONARY
NOTE REGARDING FORWARD-LOOKING STATEMENTS**




*This
annual report on Form 10-KSB 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.**




General




Through
our subsidiaries, we provide complete video surveillance and security solutions incorporating
a complete line of video surveillance, access control and detection systems to
the homeland security, professional, business-to-business and retail market
segments . We provide a
strong combination of closed
circuit televisions ( CCTVs),
digital video recorders (DVRs), access control, Rapid Access
Portals, software
systems and networking products that
enhance life safety for both government agencies and the private sector. We are
the exclusive distributor of video surveillance and security products for
Samsung Electronics in North, Central and South America to professional end
users, installers and resellers, and a major national retailer. Our full
service Enterprise Solutions Group provides turnkey solutions and integrated
security systems for various government, homeland security, and Fortune 500
companies.




Our
customers include distributors and system integrators that specialize in video
surveillance and security products and services, government agencies and private
sector businesses, as well as retail outlets such as warehouse clubs,
mass-market retailers and specialty electronics stores. Our technology is
available to the United States Government through a General Services
Administration (GSA) contract.




On
December 1, 2004, we acquired Rapor, Inc. in a merger in which we issued to
Rapor’s former stockholders an aggregate of 2,707,852 shares of our Common Stock
and seven-year warrants to purchase an aggregate of 1,353,925 shares of our
Common Stock at an exercise price of $3.04 per share. In connection with the
closing of the merger, we also paid approximately $184,000 in cash, and issued
98,007 shares of Common Stock, in satisfaction of secured obligations of Rapor.
Rapor designs and manufactures high security building access portals. Rapor's
patented Fast Trac TM Rapid
Access Portal is intended for use in new, high security installations, and can
also be integrated with existing access control and surveillance systems.




We
operate sales and distribution centers in Dallas, Texas, New Britain,
Connecticut, Mexico City, Mexico, Sao Paulo, Brazil and Bogota,
Colombia.




Corporate
History




We were
incorporated in Delaware in August 1996 as Thinking Tools, Inc. Following our
organization, we succeeded by merger to the business of Thinking Tools, Inc., a
California corporation engaged in developing and marketing business simulation
software. Changes in market conditions and lack of demand for our software
products had an adverse effect on our business, results of operations and
financial condition, and in April, 1999, we eliminated substantially all of our
operations and terminated substantially all of our personnel.






3




On March
7, 2000, through a newly-formed and wholly-owned subsidiary, StartFree.com,
Inc., we acquired the business and substantially all of the assets and certain
of the liabilities of Tritium Network, Inc., an Internet software and service
provider. StartFree was not able to generate sufficient revenues to support its
operations, which we discontinued in December, 2000.




From the
time we discontinued Startfree’s operations 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.




Electronic
Security Systems Industry




The
worldwide market for security products and services is estimated at
approximately $120 billion. 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. The world market is
expected to continue to grow at an annual rate in excess of 10% with the primary
components of this growth being electronic integrated security systems. We
believe that access control and video surveillance products represent the
largest components of a typical integrated security system.




Access
control systems, which include turnstiles and mantraps, may utilize traditional
card readers but are increasingly becoming more sophisticated, incorporating
biometrics (such as iris scan, retina scan, and fingerprint and facial
recognition capabilities), and badging systems for visitor control and asset
tracking.




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 “total solutions” for our customers and partners by
providing a range of products and engineering services designed to meet the
specific needs of the end user. From our simple pre-packaged suites of
easy-to-install security solutions to our range of products that can be fully
integrated into a comprehensive security solution, our goal is to provide our
customers with excellent service and superior technology at competitive prices.




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, access control and detection product areas, with
a focus on increasing sales of our products in the Professional Channel, which
typically generates higher gross margins than Retail Channel sales. Further, we
intend to grow our business by expanding and diversifying our distribution
channels and capitalizing on domestic and international expansion opportunities.






4




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 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 “best of breed” integrated security products. We offer a range of
video surveillance and security systems to our retail and professional
customers, from simple four camera observation systems that include monitors and
recording devices suitable for homes and small businesses to more sophisticated
products that can be used on a stand-alone basis or that can be integrated into
a larger more sophisticated security system. Through Rapor, we also design and
manufacture high security building access portals (controlled door systems, with
substance detection options) for use in high security installations. These
portals can also be integrated with existing access control and surveillance
systems.




We serve
the import, support, marketing, inventory, warranty and distribution needs of
our customers.




*Professional
Products*




Our
objective is to provide complete security solutions for our professional
customers, by providing a suite of fully-integrated products that is
complemented by the extensive knowledge and expertise of our dedicated
Enterprise Solutions Group. Our Enterprise Solutions Group works closely with
our professional customers to assist them in submitting bids for projects,
designing security systems and developing the specifications for a project. Our
Enterprise Solutions Group also provides end-to-end project management,
including oversight of installation and implementation of the security systems,
and after-sale service and support.




We sell
the following products separately and as part of our fully integrated suite of
video surveillance and integrated security solutions:




·
    access
      control




·
    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






5




·
    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




·
    digital
      watchdog ATM/point of service transaction verification
      software




·
    standalone
      digital recorders




·
    video
      transmission equipment




·
    digital
      processors (quads and multiplexers), switchers and video management
      systems




·
    digital
      video recording software




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, or in the case of our access portals, in Connecticut.




*Consumer
Products*




As the
cost of CCTV products decline, small businesses and homeowners in increasing
numbers are installing security surveillance systems to replace or supplement
conventional alarm systems. The consumer products market consists of end users
who purchase systems and install them on their own. Our consumer products
include a broad range of pre-packaged CCTV security solutions. Our CCTV
solutions range from simple four camera observation systems with monitor and
recording devices, to more sophisticated systems that rely on switching with
many cameras and monitoring points. Our CCTV products offered to consumers
through the retail channel include options such as black and white or color
monitors and varying camera counts. Our CCTV products address the typical
acquisition, transmission, viewing, storage and retrieval of video images needs
of the consumer, and encompass the integration of all the standard components
necessary to supply a complete security solution to an end user.




*Access
Portals*




Rapor's
patented Fast Trac TM Rapid
Access Portal units are intended for use in new, high security installations,
and can also be seamlessly integrated with existing access control and
surveillance systems. The Fast Trac TM unit
controls access to secure areas through bi-folding doors with infrared sensors
that can open or remain open for authorized personnel, and close or remain
closed when necessary to prevent unauthorized access. We believe that the Fast
Trac TM portal
offers reliable security while allowing a more efficient flow of traffic than
competing portal designs such as turnstiles, mantraps and revolving doors.
Screening and monitoring functions can be added to the portal in a modular form
to include a variety of metal and drug detection options. To date, Rapor’s Fast
Trac TM portal
has been installed in airports, manufacturing facilities and office
buildings.




*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
offer customer support to both our retail and our professional customers. We
operate customer support centers in Dallas, Texas, New Britain, Connecticut,
Mexico City, Mexico, Sao Paulo, Brazil, and Bogota, Colombia and also utilize a
number of independent service providers in the other territories that we
service.






6




Distribution
and Marketing




We
believe that our dual distribution channels enable us to reach a broad range of
potential customers with products and services targeted to meet their needs and
to increase our exposure across the market. We believe that we provide our
customers with functional solutions with superior performance at competitive
prices across both of our distribution channels.




*Professional
Channel.* We
offer a wide range of products and services through local, regional and national
system integrators and distributors who resell our products to professional
security providers. System integrators, on their own, or with the assistance of
our Enterprise Solutions Group utilize our products to develop and install a
fully integrated security suite for end users. Our Enterprise Solutions Group
will engineer and deliver integrated security solutions to end users including
airports, sea ports, military installments, high security federal installations,
Fortune 500 companies, casino, gaming and institutional end users. For the years
ended December 31, 2004 and 2003, 55% and 44%, respectively, of our revenues
were generated through sales in our Professional Channel.




We also
utilize regional sales executives who often support sales across all of our
product and service offerings. We use a combination of our internal sales force
and independent representatives to sell our products to dealers and systems
integrators.




*Retail
Channel.* We
also offer our products and services through warehouse clubs, mass-market
retailers and specialty electronics stores including Sam’s Club, Costco,
CompUSA, Wal-Mart, Fry’s Electronics and J & R Music & Computer World.
Through retailers we offer a pre-packaged suite of easy-to-install CCTV systems
that are suitable for homes and small businesses. We also maintain a technical
support hotline for all of our retail customers. For the years ended December
31, 2004 and 2003, approximately 45% and 56%, respectively, of our revenues were
generated through sales in our Retail Channel. Sales through our distributor to
a major national retailer comprised approximately 98% and 96%, respectively, of
these retail sales for the years ended December 31, 2004 and 2003. Our agreement
with Samsung to distribute its products to this retailer expires December 31,
2005.




*Alliance
Agreement with ESI* . 
The products we distribute to the Retail Channel are distributed by us pursuant
to an alliance with E&S International Enterprises, Inc. (ESI), a distributor
of consumer electronics and appliances, under a new agreement we entered into
with ESI in October 2004. Under this agreement, ESI is our exclusive distributor
to retailers of consumer security products purchased by us from manufacturers.
ESI purchases these products from us at an initial price equal to 108% of the
base cost to us, subject to downward adjustment if ESI’s gross margins fall
below certain specified levels. We are responsible for all warranty obligations
with respect to these products, including servicing and supporting such
products. In addition, ESI is obligated to pay us an amount in respect of
consumer security products it purchases from other distributors, initially equal
to 8% of the base cost of such products, so as minimize any incentive ESI may
have to purchase these products other than through us. The agreement is for an
initial term of three years and will automatically renew for one-year periods
unless ESI provides notice to us at least 90-days prior to the then end of the
term of its intention not to renew, subject to early termination rights of
ESI.




In
connection with our entering this agreement, we agreed to issue ESI warrants to
purchase 3,000,000 shares of our Common Stock at a price of $1.50 per share. In
addition, ESI may be issued up to an additional 3,000,000 shares of our Common
Stock upon attaining certain goals provided for in the agreement.






7




Competition




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 merchandising, price, quality, product performance, ease of integration and
customer service and support.




*Competition
in the Professional Sector*




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 professional customers with superior levels of customer service
and by giving them the flexibility to choose between purchasing our products
separately or utilizing the expertise and knowledge of our Enterprise Solutions
Group to design and implement a fully integrated customized security suite for
their end users using our products. Our main competitors in the professional
sector are Pelco and Panasonic.




*Competition
in the Retail Sector*




The
market for video surveillance and security systems components is highly
competitive and includes a wide range of electronics companies, each proficient
at supplying a certain component of a CCTV, but only a few of these companies
have developed a pre-packaged integrated security system. At this time, we
believe our main competitor in this sector is Strategic Vista, which sells
products under the Lorex and Sylvania brands. We believe that we have
distinguished ourselves in the retail market by the quality of our merchandising
and the range of features our products offer relative to their
prices.




*Competition
for Portals*




A number
of companies provide a wide range of access control products, such as optical
turnstiles, mechanical turnstiles and mantraps, which compete with our access
portals. We believe that our patented Fast Trac TM Rapid
Access Portal, which can remain open for authorized personnel, allows a more
efficient flow of traffic than competing portal designs and
products.




Strategic
Relationships




We are
party to a Distribution Agreement with Samsung Electronics pursuant to which
Samsung has given us the exclusive right to sell, market, lease, license and
distribute Samsung security products throughout North, Central and South
America, until December 31, 2005 with respect to sales made to two particular
national retailers and one particular regional retailer, and until August 30,
2009 with respect to sales made to professional users and installers. The
Distribution Agreement requires us to purchase minimum amounts of products for
distribution to the professional sector as set forth below:






8




Calendar
      Year
    Volume
      Requirement2005
    $22
      Million2006
    $28
      Million2007
    $35
      Million2008
    $43
      Million2009
    $52
      Million





In the
event we fail to purchase the minimum amounts required above, Samsung may
immediately terminate the Distribution Agreement. If we breach any other
provision of the Distribution Agreement, Samsung may terminate the Distribution
Agreement upon 180 days notice if we fail to cure the breach during the 180-day
period following such notice. Under the Distribution Agreement, we retain the
right to develop and/or independently sell and market security products which
are similar to or competitive with Samsung’s products and to enter into similar
distribution agreements with third parties in the event Samsung does not provide
us with similar products to distribute at comparable prices.




For the
years ended December 31, 2004 and 2003, 68% and 74%, respectively, of our total
revenues, and all of our revenues from sales in the Retail Channel, were
attributable to products manufactured by Samsung. 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, 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.




The
products we purchase from Samsung for sale in the Retail Channel are distributed
under our alliance with ESI described above. 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.




Intellectual
Property




Rapor is
the owner of patent number 5,845,692 issued on December 8, 1998. The patent
describes Rapor’s Fast Trac TM portal
as a *Rapid
Access Portal* that
utilizes a rapid access door system which allows authorized individuals passage
through the doors and blocks the entry of unauthorized individuals, rerouting
them to unsecured areas. We also have several pending trademark applications for
“GVI” in connection with the products we sell.




Employees




As of
December 31, 2004, we had approximately 54 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.







9





**RISK
FACTORS**




**Risks
Related to Our Industry and Our Business**




*Any
investment in our Common Stock involves a high degree of risk. You should
consider carefully the risks described below, together with the other
information contained in this report. If any of the following events actually
occurs, our business, financial condition and results of operations may suffer
materially. As a result, the market price of our Common Stock could decline, and
you could lose all or part of your investment in our Common
Stock.*




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





We
distribute Samsung Electronics surveillance and security products in North,
Central and South America under an agreement that expires on December 31, 2005
with respect to sales made by us to retailers, and August 30, 2009 with respect
to sales made by us to professional users and installers. For the years ended
December 31, 2004 and 2003, 68% and 74%, respectively, of our total revenues,
and all of our revenues from sales in the Retail Channel, were attributable to
products manufactured by Samsung. Samsung has the right to terminate the
Distribution Agreement in the event we fail to purchase the minimum amount of
products required to be purchased by us in a given calendar year as provided in
the Distribution Agreement. Although we have relationships with other
manufacturers and believe we could purchase similar products from alternative
sources, we currently derive a substantial amount of our total revenues, and all
of our revenues from sales in the Retail Channel, from the sale of Samsung
products. 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, 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. ****





**WE
HAVE EXPERIENCED RECENT OPERATING LOSSES AND MAY INCUR ADDITIONAL OPERATING
LOSSES IN THE FUTURE.**





We
incurred a net loss of approximately $7 million for the year ended December 31,
2004. The net loss is primarily attributable to the following:





·
    A
      sales concession of approximately $800,000 we granted in the fourth
      quarter to a large retailer as a result of the retailer’s difficulty in
      selling our products.





·
    The
      establishment of a reserve of approximately $650,000 in the fourth quarter
      in connection with slow-moving inventory.





·
    A
      fourth-quarter write-down of inventory in the amount of approximately
      $800,000 to reflect the net realizable value of that inventory. The
      write-down was primarily attributable to inventory that had been returned
      to us and would be required to be resold as “refurbished”
      products.





·
    Fourth
      quarter costs resulting from our repurchase at a loss of inventory that
      had been sold to distributors for sale to the Retail Channel. We were
      required to repurchase this inventory as a result of entering into an
      exclusive distribution arrangement with ESI with respect to sales to the
      Retail Channel, which arrangement precludes the sale of our products to
      the Retail Channel by distributors other than ESI.






10





·
    Reduced
      sales in the fourth quarter of 2004 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 this product. The
      manufacturer corrected the defect and we were able to continue selling the
      product at the beginning of the first quarter of 2005.





·
    Public
      company costs and increased administrative, accounting, finance and legal
      costs following the merger in February 2004, and costs relating to the
      expansion of our business into the integrated securities solutions
      market.





We may
incur similar costs and write-downs in the future, which together with reduced
sales of higher margin products, acquisition costs and costs associated with the
integration of newly acquired subsidiaries, may contribute to future operating
losses.





**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 OPERATION 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.





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.
During the fourth quarter of 2004, we granted a sales concession of
approximately $800,000 to a major retailer as a result of that retailer’s
difficulty in selling a new product of ours. 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.





11


**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
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 PERFORM THEIR CONTRACTUAL OBLIGATIONS TO US AND
ALTERNATIVE SOURCES ARE NOT AVAILABLE.**





In
addition to Samsung, we have strategic relationships with a number of other
manufacturers for our products. Our success depends in part on whether our
manufacturers fulfill their contractual obligations satisfactorily and in a
timely manner. If any of our manufacturers fail to satisfactorily perform their
contractual obligations, 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 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, 2004
was approximately $10.2 million. The notes and agreements provide for the
following events of default (among others):








12





·
    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,





·
    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.





**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 new personnel. In particular, our success depends on Nazzareno
Paciotti who joined us as our Chief Executive Officer and Chief Financial
Officer in February 2004 and is a party to an employment agreement with us that
expires in January 2008 (subject to renewal provisions provided for in the
employment agreement). 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, AND PRIMARILY
ON A SINGLE RETAILER TO SELL OUR PRODUCTS IN THE RETAIL CHANNEL. DISRUPTION TO
THESE DISTRIBUTION CHANNELS 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, our dealers and
distributors maintain significant levels of our products in their inventories.
If dealers and distributors attempt to reduce their levels of inventory or if
they do not maintain sufficient levels to meet customer demand, our sales could
be negatively impacted. Sales through ESI to a major retailer comprised 98% of
our retail sales for the year ended December 31, 2004. Any reduction in sales to
that retailer could negatively impact our sales. In addition, our exclusive
right to sell Samsung products to that retailer expires on December 31, 2005.








13




Sales of
our products to the Retail Channel are through a single independent distributor,
ESI, with whom we entered into an exclusive arrangement in October 2004. The
agreement with ESI provides for ESI to purchase products from us at a price
equal to 108% of our base cost for such products so long as ESI is able to
generate gross margins from the sale of the products at levels specified in the
agreement. Failure of ESI to generate gross margins at or above the specified
levels may reduce the price at which we are able to sell products to ESI and
could negatively impact our gross margins.





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.





**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. The defect in a product we sell to the
Professional Channel negatively impacted our sales of this product and our gross
margins during the fourth quarter of 2004. The manufacturer of this product
corrected the defect and we were able to continue selling the product during the
first quarter of 2005.




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.





**FAILURE
TO MANAGE OUR GROWTH AND EXPANSION EFFECTIVELY COULD ADVERSELY AFFECT OUR
BUSINESS.**





Our
ability to successfully offer our products and implement our business plan in a
rapidly evolving market requires an effective planning and management process.
We have increased and plan to continue to increase the scope of our operations
domestically and internationally. This growth has placed, and our anticipated
growth in future operations will continue to place, a significant strain on our
management systems and resources. If we are unable to effectively manage our
growth, our business could be adversely affected.






14





**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. In December 2004 we completed the acquisition of
Rapor, Inc. In addition, 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 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.





**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, and in particular, sales of the higher
gross margin products we sell to the Professional Channel, can cause operating
results to vary from period to period.






15





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





Since our
primary suppliers are located in Korea, 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.**




There is
currently limited volume of trading in our Common Stock and on some days there
is no trading activity at all in our Common Stock. 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 or SmallCap 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 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.





16


**SUBSTANTIALLY
ALL OF OUR AUTHORIZED SHARES OF COMMON STOCK HAVE BEEN RESERVED FOR ISSUANCE
PURSUANT TO OUTSTANDING OPTIONS, WARRANTS, CONVERTIBLE NOTES AND OTHER
COMMITMENTS SO THAT ANY FUTURE EQUITY FINANCING OR USE OF COMMON STOCK FOR
BUSINESS ACQUISITIONS MAY REQUIRE US TO AMEND OUR CERTIFICATE OF INCORPORATION
TO INCREASE OUR AUTHORIZED COMMON STOCK. YOU SHOULD EXPECT THAT WE WILL SEEK
STOCKHOLDER APPROVAL OF SUCH AN AMENDMENT AT OR BEFORE OUR NEXT ANNUAL MEETING
OF STOCKHOLDERS.**





As of
March 31, 2005, there were issued and outstanding 49,047,949 shares of Common
Stock, and warrants, options and convertible notes to purchase, and commitments
to issue, an aggregate of approximately 20,075,000 additional shares of Common
Stock. We have a total of 75,000,000 shares of Common Stock authorized under our
certificate of incorporation. The proposed issuance of approximately 5,900,000
more shares of Common Stock in addition to those currently reserved for issuance
would require us to amend our certificate of incorporation to increase our
authorized Common Stock and/or effect a reverse stock split. You should expect
that such an amendment will be proposed for stockholder approval at or before
our next annual meeting of stockholders. No decision has been made as to the
size of any increase that may be sought, and no assurance can be given that any
such increase will be approved by our stockholders. Failure to increase our
authorized Common Stock could limit or restrict our ability to raise working
capital in a future equity financing and severely limit our ability to use
Common Stock for desirable business acquisitions.




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





A large
portion of our outstanding shares of Common Stock have recently become eligible
for sale in the public market, and it is anticipated that substantially all of
our remaining outstanding shares of Common Stock will become eligible for sale
in the public market in the second quarter of 2005. 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.




**OUR
DIRECTORS, EXECUTIVE OFFICERS AND PRINCIPAL STOCKHOLDERS OWN A SIGNIFICANT
PERCENTAGE OF OUR SHARES, WHICH WILL LIMIT YOUR ABILITY TO INFLUENCE CORPORATE
MATTERS.**




Our
directors, executive officers and principal stockholders beneficially owned
approximately 69% of our outstanding Common Stock as of March 31, 2005.
Accordingly, these stockholders could have a significant influence over 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.





17




**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
2004.




**PART
II**




**Item
      5.**
    **Market
      for Registrant’s Common Equity and Related Stockholder
      Matters.**




Our
Common Stock trades in the over-the-counter-market 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 periods preceding April 12, 2004, the date we effected a
one-for-65 reverse split of our Common Stock.




**Price****High**
    **Low****2003**First
      quarter
    $0.02
    $0.02Second
      quarter
    $0.03
    $0.01Third
      quarter
    $0.05
    $0.01Fourth
      quarter
    $0.10
    $0.01**2004**First
      quarter
    $0.51
    $0.02Second
      quarter
    $32.51
    $0.10Third
      quarter
    $6.00
    $1.10Fourth
      quarter
    $8.00
    $1.15




The
number of holders of record for our Common Stock as of December 31, 2004 was
approximately 165. This number excludes individual stockholders holding stock
under nominee security position listings.






18




**DIVIDEND
POLICY**




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.




**Item
      6.**
    **M****anagement’s
      Discussion and Analysis of Plan of
Operation.**




*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 complete video surveillance and security solutions incorporating
a complete line of video surveillance, access control and detection systems to
the homeland security, professional, business-to-business and retail market
segments . We provide a
strong combination of closed
circuit televisions ( CCTVs),
digital video recorders (DVRs), access control, Rapid Access
Portals, software
systems and networking products that
enhance life safety for both government agencies and the private sector. We are
the exclusive distributor of video surveillance and security products for
Samsung Electronics in North, Central and South America to professional end
users, installers and resellers, and a major national retailer. Our full
service Enterprise Solutions Group provides turnkey solutions and integrated
security systems for various government, homeland security, and Fortune 500
companies.




On
December 1, 2004, we acquired Rapor, Inc. in a merger in which we issued to
Rapor’s former stockholders an aggregate of 2,707,852 shares of our Common Stock
and seven-year warrants to purchase an aggregate of 1,353,925 shares of our
Common Stock at an exercise price of $3.04 per share. Rapor designs and
manufactures high security building access portals. Rapor's patented Fast
Trac TM Rapid
Access Portal is intended for use in new, high security installations, and can
also be seamlessly integrated with existing access control and surveillance
systems.




Prior to
the merger, Rapor sustained a net loss of $430,401 on revenues of $648,447 for
the year ended December 31, 2003, and a net loss of $570,304 on revenues of
$55,501 for the nine months ended September 30, 2004. In connection with the
closing of the merger, we also paid approximately $184,000 in cash, and issued
98,007 shares of Common Stock, in satisfaction of secured obligations of
Rapor.






19


**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. Sales are recognized
when revenue is realized or realizable and 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 revenues 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 estimation of sales volumes or redemption
rates, such as for volume rebates, we uses historical experience and internal
and customer data to estimate the sales incentive 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 based primarily upon actual
returns. We record estimated sales returns as a reduction 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 that 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 2004, we experienced losses, or recorded provisions for potential
losses, from customers' inability to make payments, totaling $250,000, or less
than 1% of revenues. 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, nonsellable or unusable items upon a
product-level review.






20




*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.




***Year
2004*** **compared
with** **Year 2003**




**Net
Revenues.** Total net
revenues increased 17.5% to approximately $66.2 million for the year 2004 from
approximately $56.3 million in 2003. The increase was due to an increase in
sales of our products in the Professional Channel, consistent with our focus to
provide complete solutions for our professional customers by providing a suite
of fully-integrated products. Professional Channel sales increased 45% to $36.2
million compared to $25.0 million in 2003, while sales in the Retail Channel
decreased 1.9% to $30.7 million compared to $31.3 in 2003. Negatively effecting
net revenues was an approximately $800,000 sales price concession granted in the
fourth quarter of 2004 to a large retailer, and our repurchase of inventory in
the fourth quarter of 2004, which reduced our net revenues by approximately
$400,000. We were required to repurchase this inventory as a result of entering
into the exclusive distribution arrangement with ESI, which precludes the sale
of our products to the Retail Channel by distributors other than ESI. Additionally,
we had reduced sales in the fourth quarter of 2004 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 this product. The
manufacturer corrected the defect and we were able to continue selling the
product at the beginning of the first quarter of 2005.





**Cost
of Goods Sold.** Total
cost of goods sold increased 24.6% to approximately $58.2 million in 2004 from
approximately $46.7 million in 2003. Contributing to this increase were the
following: 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, increased revenues, and higher inbound freight costs. As a
result of the changes in sales and costs of goods sold, gross profit for 2004
decreased to approximately $8.0 million from approximately $9.7 million for
2003, and gross profit as a percentage of net sales decreased to 12.2% for 2004,
compared with 17.2% for 2003.





**Operating
Expenses.** Total
operating expenses increased 93% to approximately $14.8 million in 2004 from
approximately $7.6 million in 2003, as follows.





*Sales
and Marketing.* **** Sales and
marketing expenses increased 71.4% to approximately $6.0 million in 2004 from
approximately $3.5 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 focuses on
providing fully-integrated security products solutions to the Professional
Channel.





*General
and Administrative.* **** General
and administrative expenses increased 115% to approximately $8.8 million in 2004
from approximately $4.1 million in 2003. The increase was primarily due to
increased salaries and wages associated with additional hires; **** increased
administrative, accounting, finance and legal costs associated with being a
public company following our merger in February 2004, as well as 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.





21


**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.





**Income
Tax Expense (benefit).** The
provision for federal, state and local income tax benefit was approximately
$413,000 for 2004, **** as
compared to income tax expenses of approximately $536,000 for 2003.  The
deferred tax asset for 2004 has been reduced by approximately $2.2 million, the
amount of a deferred tax valuation allowance. We established this 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. At December 31,
2004, the Company has a net operating loss carry-forward of approximately $1.2
million. This loss will expire in 2024.




Prior to
May 23, 2003, GVI was taxed under the provisions of Sub Chapter S of the
Internal Revenue Code. As a Sub Chapter S corporation, GVI 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 lost
its Sub Chapter S corporation status, and accordingly a provision was made for
the payment of income taxes based on GVI's prorated taxable income for
2003.




**Net
Income (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.





**Year
2003** **compared
with** **Year 2002**





**Net
Revenues.** Total net
revenues increased 52% to approximately $56.3 million for the year 2003 from
approximately $37.1 million in 2002. The increase was due to increases in sales
across the range of our products together with the introduction of several new
products manufactured by both Samsung Electronics and the other manufacturers
whose products we distribute.





**Cost
of Goods Sold.** Total
cost of goods sold increased 53% to approximately $46.7 million in 2003 from
approximately $30.5 million in 2002. The increase was due to the increased
revenue volume in addition to higher inbound freight costs and changes in our
product mix. As a result of the changes in sales and costs of goods sold, gross
profit for 2003 increased to approximately $9.7 million from approximately $6.6
million for 2002, and gross profit as a percentage of net sales decreased to
17.2% for 2003, compared with 17.7% for 2002.





**Operating
Expenses.** Total
operating expenses increased 49% to approximately $7.6 million in 2003 from
approximately $5.1 million in 2002, as follows.





*Sales
and Marketing.* **** Sales and
marketing expenses increased 30% to approximately $3.5 million in 2003 from
approximately $2.6 million in 2002. The increase was primarily due to increased
commissions, salaries and travel-related expenses.





*General
and Administrative.* **** General
and administrative expenses increased 69% to approximately $4.1 million in 2003
from approximately $2.5 million in 2002. The increase was primarily due to
increased salaries and wages associated with additional hires and additional
provision for doubtful accounts resulting from our higher revenues.





22


**Interest
Expense.** Interest
expense for 2003 decreased 7% to approximately $228,000 in 2003 from
approximately $244,000 in 2002. The decrease was primarily related to lower
interest rates during 2003 compared with 2002.





**Provision
For Income Taxes.** The
provision for federal, state and local income taxes was approximately $536,000
for 2003 and approximately $56,000 for 2002. Prior to May 23, 2003, GVI was
taxed under the provisions of Sub Chapter S of the Internal Revenue Code. As a
Sub Chapter S corporation, GVI did not provide for or pay any Federal or certain
corporate or state income taxes on its taxable income for the year ended
December 31, 2002 and for the period from January 1, 2003 until May 2003. In May
2003, GVI lost its Sub Chapter S corporation status, and accordingly a provision
was made for the payment of income taxes based on GVI's prorated taxable income
for 2003.





**Net
Income.** As
a result of the items discussed above, net income for 2003 was approximately
$1.3 million, compared with net income of approximately $1.1 million for 2002,
an increase of 11%.




**Liquidity
and Capital Resources**




Historically,
GVI has funded its operations primarily through cash generated from operations
as well as borrowings under secured revolving credit facilities.




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 accounts receivable loan facility. At closing, we borrowed $5 million
under the term loan and $10 million under the receivable facility, and used
$10,016,000 of the proceeds to repay in full the indebtedness outstanding under
our 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 940,000 shares of our Common Stock at a price of $3.50 per
share. We issued a similar warrant to purchase 94,000 shares of Common Stock to
the finder at a price of $3.50 per share. Borrowings under the Laurus financing
are secured by all of our assets.




The term
loan is evidenced by a Secured Convertible Term Note and, subject to monthly
adjustments as set forth below, bears interest at an initial 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. Amortizing payments of principal on the term loan commenced September
1, 2004. Remaining monthly payments are set forth in the table
below.




Period
    Principal
      AmountJanuary 2005 through May 2005
    $75,000
      per monthJune 2005 through May 2006
    $150,000
      per monthJune 2006 through April 2007
    $190,000
      per monthMay 2007
    $435,000





The
interest rate under the Term Note is subject to downward adjustment at the end
of each month as follows. If at the end of the applicable month we have
registered the shares of Common Stock underlying the Term Note with the SEC,
interest payable on the term loan will be adjusted downward by 200 basis points
(two percent) for each incremental 25 percent increase in the market price of
our Common Stock, at the end of the month, in excess of the conversion price
under the Term Note.






23




Amounts
outstanding under the Term Note are convertible into Common Stock at Laurus's
option at a conversion price initially equal to $2.70 per share, and currently
equal to $1.91 per share. 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,
scheduled principal and interest payments under the Term Note will be made in
shares of Common Stock valued at the conversion price. Prepayments under the
Term Note are subject to a premium in the amount of 20% of the principal being
prepaid.




Subject
to monthly adjustments as set forth below, borrowings under the receivable
facility bear interest at an initial rate per annum equal to the prime rate
minus two percent. The interest rate under the receivable facility is subject to
downward adjustment at the end of each month in the same manner as provided for
under the Term Note. If the market price of Common Stock is below the conversion
price at the end of a month, the interest rate under the receivable facility
will be reset to equal the prime rate plus two percent. The receivable facility
terminates, and borrowings thereunder become due, on May 27, 2007.




Amounts
outstanding under the receivable facility are convertible to Common Stock at
Laurus's option at a conversion price initially equal to $3.38 per share, and
currently equal to $2.22 per share. To the extent we repay loans outstanding
under the receivable facility and/or Laurus converts loans under the receivable
facility into Common Stock, we may reborrow or make additional borrowings under
the receivable facility, provided that aggregate loans outstanding under the
receivable facility at any time may not exceed the lesser of $10 million or a
borrowing base equal to the sum of 90% of "eligible accounts" plus 60% of
"eligible inventory" (with borrowings based on eligible inventory limited to $2
million).




The
conversion prices under the Term Note and the receivable facility are subject to
equitable adjustment for stock splits, stock dividends and similar events, and
"weighted average" adjustment for future stock issuances (other than stock
issuances in specifically excepted transactions) in accordance with a formula
specified under our agreements with Laurus.




The loan
documents with Laurus required our 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 we issued Laurus additional seven-year warrants to
purchase an aggregate of 400,000 shares of our Common Stock at a price of $3.50
per share.





The loan
documents also required us to have an effective registration statement covering
the Common Stock underlying the Warrants and $10 million in principal amount of
the Notes, by September 27, 2004. A registration statement covering those shares
of Common Stock was not declared effective until October 15, 2004. As a result,
from September 28, 2004 through October 15, 2004, the rate at which interest
accrued on $10 million in principal amount of those Notes increased by 12% per
annum.




From time
to time we deposit cash collateral with financial institutions to secure letters
of credit issued to vendors to purchase products. At December 31, 2004, we had
no letters of credit outstanding.




At
December 31, 2004, we had cash and cash equivalents of approximately $13.4
million, working capital of approximately $21.7 million, an outstanding balance
of $4.7 million under the Laurus Term Loan, and outstanding accounts receivable
loans from Laurus of approximately $5.5 million, with additional borrowing
availability under such facility of approximately $3.9 million. At December 31,
2003, we had cash and cash equivalents of approximately $69,000, working capital
of approximately $10.7 million, and outstanding revolving loans of approximately
$8.6 million, with approximately $1.4 million of additional availability under a
Credit Agreement with our prior lender.






24




Our
December 31, 2004 balance sheet also reflects restricted cash in the amount of
$10 million, which represents the portion of the proceeds of our December 2004
private placement that we were required to use to repurchase shares of Common
Stock from a stockholder of ours, as described below.




Management
believes that the net proceeds from the private placement we completed in
December 2004 (described below), together with cash generated from operations
and borrowings available under our agreements with Laurus, will be sufficient to
meet our cash requirements for calendar 2005.




**October
2004 Bridge Financing**




On
October 29, 2004, in a private placement exempt from registration under the
Securities Act, we sold 23 “Units” for an aggregate purchase price of
$1,150,000, to a group of five purchasers, all of whom are our affiliates. 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 our
Common Stock.




The Notes
were repaid in full in accordance with their terms in December 2004 upon the
closing of the private placement described below. As a result of the December
2004 private placement, and in accordance with the terms of the bridge
financing, for each $50,000 in principal amount of notes purchased, such
purchaser was issued a five-year warrant to purchase 33,333 shares of Common
Stock at an exercise price of $1.50 per share.




**December
2004 Private Placement**




On
December 27, 2004, we completed a private placement of approximately 22,620,000
shares of Common Stock at a price of $1.50 per share, 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 a revolving promissory note, and $1.15 million of the proceeds were
used to repay the notes issued in the 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 6,666,667 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
have been and will be used primarily for working capital, general corporate
purposes and acquisitions.





The
Common Stock issued in the private placement was sold to persons we reasonably
believe are accredited investors, without public solicitation or advertising,
and the certificates issued for the Common Stock issued in the private placement
were endorsed with an appropriate restrictive legend.





25


In
accordance with our obligations under the private placement, in January 2005 we
filed a registration statement to register under the Securities Act the resale
of the shares of Common Stock issued in the private placement.





As a
result of the closing of the private placement, the Company issued warrants to
purchase an aggregate of 766,666 shares of Common Stock at a price of $1.50 per
share to the investors in the October 2004 bridge financing, in accordance with
our obligations under such financing.


**Item 7.**
    **Financial
      Statements.**




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-KSB.





**Item
      8.**
    **Changes
      in and Disagreements With Accountants on Accounting and Financial
      Disclosure.**




Not
Applicable.




**Item
8A.        Controls and
Procedures** **.**




Nazzareno
Paciotti, ou r Chief
Executive and Chief Financial Officer ha s concluded, based on hi s evaluation as of December 31, 200 4 , that
our disclosure controls and procedures are effective to ensure that information
required to be disclosed by us in the reports we file or submit under the
Securities Exchange Act of 1934, as amended, is recorded, processed, summarized
and reported  within
the time periods specified in the SEC’s rules and forms.




There
were no significant changes in our internal controls over financial reporting
that occurred during our fourth
fiscal quarter that has materially affected, or is reasonably likely to
materially affect, our internal
control over financial reporting.




**Item
8B.        Other
Information.**




Not
Applicable.




**PART
III**




**Item
      9.**
    **Directors
      and Executive Officers of the
Registrant.**




The
information required to be disclosed hereunder will be incorporated by reference
to our proxy statement, if filed by May 2, 2005 or, if such proxy statement is
not filed by such date, such information will be disclosed by amendment to this
Form 10-KSB prior to May 2, 2005.




**Item
      10.**
    **Executive
      Compensation.**




The
information required to be disclosed hereunder will be incorporated by reference
to our proxy statement, if filed by May 2, 2005 or, if such proxy statement is
not filed by such date, such information will be disclosed by amendment to this
Form 10-KSB prior to May 2, 2005.




**Item
      11.**
    **Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters.**




The
information required to be disclosed hereunder will be incorporated by reference
to our proxy statement, if filed by May 2, 2005 or, if such proxy statement is
not filed by such date, such information will be disclosed by amendment to this
Form 10-KSB prior to May 2, 2005.






26




**Item
      12.**
    **Certain
      Relationships and Related
Transactions.**




The
information required to be disclosed hereunder will be incorporated by reference
to our proxy statement, if filed by May 2, 2005 or, if such proxy statement is
not filed by such date, such information will be disclosed by amendment to this
Form 10-KSB prior to May 2, 2005.




**Item
      13.**
    **Exhibits
      and Reports on Form 8-K.**




(a)  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
    By-Laws
      of GVI Security Solutions, Inc.***3.4
    Certificate
      of the Designations, Powers, Preferences and Rights of the Series B
      Convertible Preferred Stock of Thinking Tools, Inc.****4.1
    2004
      Long-Term Stock Incentive Plan #4.2
    Securities
      Purchase Agreement, dated May 27, 2004, by and between GVI Security
      Solutions, Inc. and Laurus Master Fund, Ltd. ##4.3
    Secured
      Convertible Term Note, dated May 27, 2004, made by GVI Security Solutions,
      Inc. to Laurus Master Fund, Ltd. ##4.4
    Common
      Stock Purchase Warrant, dated May 27, 2004, issued to Laurus Master Fund,
      Ltd. ##4.5
    Security
      Agreement, dated May 27, 2004, by and between GVI Security Solutions, Inc.
      and Laurus Master Fund, Ltd. ##4.6
    Secured
      Convertible Minimum Borrowing Note, dated May 27, 2004, made by GVI
      Security Solutions, Inc. to Laurus Master Fund, Ltd. ##4.7
    Secured
      Revolving Note, dated May 27, 2004, made by GVI Security Solutions, Inc.
      to Laurus Master Fund, Ltd. ##4.8
    Registration
      Rights Agreement, dated May 27, 2004, by and between GVI Security
      Solutions, Inc. and Laurus Master Fund, Ltd. ##4.9
    Master
      Security Agreement, dated May 27, 2004, by GVI Security Solutions, Inc.
      and GVI Security, Inc. in favor of Laurus Master Fund, Ltd.
    ##
   27
  4.10
    Subsidiary
      Guarantee, dated May 27, 2004, by GVI Security, Inc. in favor of Laurus
      Master Fund, Ltd. ##4.11
    Stock
      Pledge Agreement, dated May 27, 2004, by and among GVI Security Solutions,
      Inc. and Laurus Master Fund, Ltd. ##4.12
    Registration
      Rights Agreement, dated as of February 19, 2004, by and among the
      Registrant and the stockholders of the Registrant party
      thereto.*4.13
    Registration
      Rights Agreement, dated as of July, 2004, by and among the GVI Security
      Solutions, Inc. and the former stockholders of Rapor.####4.14
    Form
      of Subscription Agreement for Units purchased by investors in October 2004
      Bridge Financing+4.15
    Form
      of Warrant issued to investors in October 2004 Bridge
      Financing+4.16
    Security
      Purchase Agreement, dated as of December 21, 2004, by and among GVI
      Security Solutions, Inc. and the Purchasers listed on Schedule A
      thereto.+++10.1
    Distributor
      Agreement between Samsung Electronics Co., Ltd. and GVI Security, Inc.
      ***10.2
    Executive
      Employment Agreement, dated as of January 24, 2005, by and between the
      Registrant and Nazzareno E. Paciotti ++++10.3
    Consulting
      Agreement, dated as of February 17, 2004, by and between the Registrant
      and November Group, Ltd. #10.4
    Consulting
      Agreement, dated as of February 18, 2004, by and between the Registrant
      and Europa International, Inc. ***10.5
    Commercial
      Industrial Lease Agreement,
      effective as of April 1, 2004, between,
      CSHV Texas Industrial, L.P., as Landlord, andGVI
      Security, Inc., as Tenant***10.6
    Settlement
      Agreement and General Release, dated as of October 13, 2004, between the
      Registrant, GVI Security, Inc., William A. Teitelbaum and Alarmax
      Distributors, Inc. ***10.7
    Mutual
      Separation Agreement, dated as of September 30, 2004, by and among GVI
      Security, Inc., GVI Security Solutions, Inc. and Thomas Wade.
      ####10.8
    Memorandum
      of Understanding dated November 5, 2005 between GVI Security Solutions,
      Inc. and E&S International Enterprises, Inc.++21
    Subsidiaries
      of the Registrant ++++31
    Certification
      of Nazzareno Paciotti, Chief Executive Officer and Chief Financial Officer
      of the Registrant, pursuant to Rules 13a-14(a) and 15(d)-14(a) of the
      Securities Exchange Act of 193432
    Certification
      of Nazzareno Paciotti, Chief Executive Officer and Chief Financial Officer
      of the Registrant, pursuant to Rules 13a-14(B) and 15(d)-14(b) of the
      Securities Exchange Act of 1934
   28
 
 *  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 Current Report on Form 8-K, as filed with the SEC on March 22,
2000.





#  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.





+  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 November 9,
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 December
30, 2004.





++++  Incorporated
by reference to the similarly described exhibit previously filed as an exhibit
to our Registration Statement on Form SB-2 (Registration No.
33-122314).





(b)
Reports on Form 8-K




On October
19, 2004, we filed a Current Report on Form 8-K, Item 1.01, with
respect to a Mutual
Separation Agreement we entered
into with Thomas Wade .




On
November 4, 2004, we filed a Current Report on Form 8-K, Item 3.02, and on
November 10, 2004 and December 13, 2004, we filed Current Reports on Form 8-K/A,
Item 3.02, with respect to our October 2004 bridge financing provided by certain
affiliates of ours.




On
November 9, 2004, we filed a Current Report on Form 8-K, Items 1.01, 2.02 and
3.02, with respect to our entering into of a Memorandum of Understanding with
ESI and a press release we had issued with respect to third quarter revenues.




On
December 7, 2004, we filed a Current Report on Form 8-K, Items 2.01 and 3.02,
with respect to our merger with Rapor, Inc. and the issuance of our securities
in connection therewith.






29




On
December 28, 2004, we filed a Current Report on Form 8-K, Item 3.02, with
respect to our December 2004 private placement.




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




The
information required to be disclosed hereunder will be incorporated by reference
to our proxy statement, if filed by May 2, 2005 or, if such proxy statement is
not filed by such date, such information will be disclosed by amendment to this
Form 10-KSB prior to May 2, 2005.







30





**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, on this 14 th day of
April, 2005.




GVI SECURITY SOLUTIONS,
      INC.By:
    /s/ Nazzareno E.
      PaciottiNazzareno E. PaciottiChief 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/
      Nazzareno E. Paciotti
      Nazzareno
      E. Paciotti
    Chief
      Executive Officer (Principal Executive Officer), Chief Financial Officer
      (Principal Accounting and Financial Officer) and Director
    April
      14, 2005/s/
      Howard Safir
      Howard
      Safir
    Chairman
      of the Board of Directors
    April
      14, 2005/s/
      Richard Berman
      Richard
      Berman
    Director
    April
      14, 2005/s/ Bruce
      Galloway
      Bruce
      Galloway
    Director
    April
      14, 2005/s/ Frederick
      W. Gluck
      Frederick
      W. Gluck
    Director
    April
      14, 2005/s/
      Joseph R. Rosetti
      Joseph
      R. Rosetti
    Director
    April
      14, 2005/s/
      Moshe Zarmi
      Moshe
      Zarmi
    Director
    April
      14, 2005










31




FINANCIAL
STATEMENTS




PageReports of Independent Registered
      Public Accounting Firms
    F-2Balance
      Sheet of GVI Security Solutions, Inc.as
      of December 31, 2004
    F-4Statements
      of Operations of GVI Security Solutions, Inc.for
      the years ended December 31, 2004 and 2003
    F-5Statement
      of Changes in Stockholders' Equity of GVI SecuritySolutions,
      Inc. for the years ended December 31, 2004 and 2003
    F-6Statements
      of Cash Flows of GVI Security Solutions, Inc.for
      the years ended December 31, 2004 and 2003
    F-7Notes to Financial Statements
    F-8








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 balance sheet of GVI Security Solutions, Inc. and Subsidiaries as of
December 31, 2004, and the related statements of operations, stockholders’
equity and cash flows for the year 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 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 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 audit provides 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, 2004, and the results of their operations and
their cash flows for the year then ended, in conformity with U.S. generally
accepted accounting principles.











/s/
Mercadien, P.C.


Hamilton,
New Jersey





March 28,
2005





F-2







REPORT OF
INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM








To the
Board of Directors and


Stockholders
of GVI Security Solutions, Inc.








We have
audited the accompanying statements of operations, stockholders’ equity, and
cash flows of GVI Security, Inc., the predecessor business of GVI Security
Solutions, Inc., for the year ended December 31, 2003. All 2003 shareholders’
equity share and per share amounts in the financial statements give retroactive
effect to the reverse merger of GVI Security, Inc. with Thinking Tools, Inc. as
described in the notes to the financial statements. 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
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 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 audit provides a
reasonable basis for our opinion.





In our
opinion, the financial statements referred to above present fairly, in all
material respects, the results of operations and cash flows of GVI Security,
Inc., the predecessor business of GVI Security Solutions, Inc., for the year
ended December 31, 2003, after giving retroactive effect to the reverse merger
as discussed in Note 1 to the financial statements, in conformity with
accounting principles generally accepted in the United States of
America.

















**WEAVER
AND TIDWELL, L.L.P.**





Dallas,
Texas


March 29,
2004, except for Notes 1 and 10


as to which the date is September 27, 2004





F-3





GVI
SECURITY SOLUTIONS, INC.
BALANCE
SHEET
DECEMBER
31, 2004
($ in
thousands, except per share data)

ASSETS
CURRENT
ASSETS
Cash
      and Equivalents
    
    $
    13,398Restricted
      Cash
    
    
    10,000Accounts
      receivable, net of allowance for doubtful accounts of
      $250
    
    
    8,324Inventory
    
    
    12,563Other
      receivables
    
    
    1,402Prepaid
      expenses and other assets
    
    
    380Refundable
      income taxes
    
    
    643Total
      current assets
    
    
    46,710PROPERTY
      AND EQUIPMENT, net
    
    
    1,982OTHER
      ASSETSDeferred
      loan origination fee, net of accumulated amortization
    
    
    1,409Intangibles,
      net
    
    
    1,220Investment
    
    
    250Other
    
    
    34TOTAL
      ASSETS
    
    $
    51,605LIABILITIES
      AND STOCKHOLDERS' EQUITYCURRENT
      LIABILITIESAccounts
      payable
    
    $
    11,344Debt
    
    
    1,596Accrued
      expenses
    
    
    2,081Stock
      Repurchase Obligation
    
    
    10,000Total
      current liabilities
    
    
    25,021DEBT,
      Non-current portion
    
    
    9,057TOTAL
      LIABILITIES
    
    
    34,078STOCKHOLDERS'
      EQUITYPreferred
      Stock Series B, $.001 Par Value, 200 Shares authorized, 200 Shares
      Issued and Outstanding
    
    
    —Preferred
      Stock, Undesignated, $.001 Par Value, 2,999,800Shares
      authorized, None Issued Or Outstanding
    
    
    —Common
      stock - $.001 par value; 75,000,000 shares authorized; 49,012,946
      shares issued and outstanding
    
    
    49Additional
      paid-in capital
    
    
    22,741Accumulated
      deficit
    
    
    (5,263
    )Total
      stockholders' equity
    
    
    17,527TOTAL
      LIABILITIES AND STOCKHOLDERS' EQUITY
    
    $
    51,605

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

F-4

GVI
SECURITY SOLUTIONS, INC.


STATEMENTS
OF OPERATIONS
 YEARS
ENDED DECEMBER 31, 2004 AND 2003
 
 ($ In
thousands, except income (loss) per share data)


2004
    
    
    2003PredecessorBusinessINCOMESales,
      net of returns, allowances and discounts
    
    $
    66,206
    
    $
    56,336Cost
      of Goods Sold
    
    
    58,164
    
    
    46,667GROSS
      PROFIT
    
    
    8,042
    
    
    9,669Selling,
      General and Administrative Expenses
    
    
    14,786
    
    
    7,649OPERATING
      INCOME (LOSS)
    
    
    (6,744
    )
    
    2,020Interest
      Expense
    
    
    691
    
    
    228Other
    
    
    (156
    )
    
    —INCOME
      (LOSS) BEFORE TAXES
    
    
    (7,591
    )
    
    1,793INCOME
      TAX EXPENSE (BENEFIT)Current
      tax provision
    
    
    (625
    )
    
    748Deferred
      tax (benefit)
    
    
    212
    
    
    (212
    )Total
      income tax expense (benefit)
    
    
    (413
    )
    
    536NET
      INCOME (LOSS)
    
    $
    (7,178
    )
    $
    1,257Income
      (Loss) Per ShareBasic
    
    $
    (0.24
    )
    $
    0.04Diluted
    
    $
    (0.24
    )
    $
    0.04Shares
      Used in Calculation of Net Income (Loss)Per
      shareBasic
    
    
    30,135
    
    
    28,215Diluted
    
    
    30,135
    
    
    28,215


The Notes
to Financial Statements are an integral part of these
statements.
 F-5
 GVI
SECURITY SOLUTIONS, INC.
STATEMENTS
OF CHANGES IN STOCKHOLDERS' EQUITY
YEARS
ENDED DECEMBER 31, 2004 AND 2003
 Common Stock
    
    
    Preferred A
    
    
    Preferred B
    
    
    Preferred D
    
    
    Preferred E
    
    
    AdditionalPaid-in
    
    
    Retained earningsShares
    
    
    Amount
    
    
    Shares
    
    
    Amount
    
    
    Shares
    
    
    Amount
    
    
    Shares
    
    
    Amount
    
    
    Shares
    
    
    Amount
    
    
    Capital
    
    
    (Deficit)
    
    
    TotalBalance,
      December 31, 2002(Predecessor
      Business)
    
    
    230,000
    
    $
    230
    
    
    
    
    $
    --
    
    
    
    
    $
    --
    
    
    
    
    $
    --
    
    
    
    
    $
    --
    
    $
    574,770
    
    $
    873,034
    
    $
    1,448,034Conversion
      toPreferred
      Series E
    
    
    (230,000
    )
    
    (230
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,000,000
    
    
    1,000
    
    
    (770
    )
    
    
    
    
    1,000Net
      income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,256,862
    
    
    1,256,862Distributions
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (215,001
    )
    
    (215,001
    )Balance,
      December 31, 2003(Predecessor
      Business)
    
    
    --
    
    
    --
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,000,000
    
    
    1,000
    
    
    574,000
    
    
    1,914,895
    
    
    2,489,895Thinking
      ToolsCapitalization
    
    
    157,032
    
    
    157
    
    
    1,148,799
    
    
    1,149
    
    
    200
    
    
    --
    
    
    10,000
    
    
    10
    
    
    
    
    
    
    
    
    20,789,166
    
    
    (22,611,032
    )
    
    (1,820,550
    )Eliminate
      Thinking Toolsto
      Recapitalize GVI
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (21,094,042
    )
    
    22,611,034
    
    
    1,516,992Conversion
      to Common
    
    
    44,185
    
    
    44
    
    
    (1,148,799
    )
    
    (1,149
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,105Conversion
      to Common
    
    
    1,187,983
    
    
    1,188
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (10,000
    )
    
    (10
    )
    
    
    
    
    
    
    
    (1,178
    )Conversion
      to Common
    
    
    28,214,587
    
    
    28,215
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,000,000
    )
    
    (1,000
    )
    
    (27,215
    )Warrants
      issued
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    212,235
    
    
    
    
    
    212,235Shares
      issued
    
    
    650,000
    
    
    650
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    155,350
    
    
    
    
    
    156,000Acquisition
      of Rapor
    
    
    2,805,858
    
    
    2,806
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    670,600
    
    
    
    
    
    673,406Private
      Placement
    
    
    22,619,968
    
    
    22,620
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    31,454,237
    
    
    
    
    
    31,476,857Stock
      Repurchase Obligation
    
    
    (6,666,667
    )
    
    (6,667
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (9,993,333
    )
    
    
    
    
    (10,000,000
    )Net
      loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (7,177,712
    )
    
    (7,177,712
    )Balance,
      December 31, 2004
    
    
    49,012,946
    
    $
    49,013
    
    
    --
    
    $
    --
    
    
    200
    
    $
    --
    
    
    --
    
    $
    --
    
    
    -- $
    
    
    --
    
    $
    22,740,925
    
    
    ($5,262,815
    )
    $
    17,527,123
 
  The Notes
to Financial Statements are an integral part of these
statements.
  F-6
 GVI
SECURITY SOLUTIONS, INC.
 STATEMENTS
OF CASH FLOWS
 YEARS
ENDED DECEMBER 31, 2004 AND 2003
 ($ In
thousands)
 CASH
FLOWS FROM OPERATING ACTIVITIES:
 2004
    
    2003PredecessorBusinessNet
      income (loss)
    
    $
    (7,178
    )
    $
    1,257Adjustments
      to reconcile net income (loss) to netcash
      provided by (used in) operating activities:Used
      in operating activitiesDepreciation
      and amortization
    
    
    846
    
    
    164Amortization
      of deferred loan originationfees
      & intangibles
    
    
    312
    
    
    —Deferred
      tax provision
    
    
    213
    
    
    (212
    )Compensation
      costs for stock and warrantsissued
    
    
    189
    
    
    —Increase
      (decrease) in cash flows due to changesin
      operating assets and liabilities:Accounts
      receivable
    
    
    4,095
    
    
    (6,899
    )Inventory
    
    
    (3,916
    )
    
    (2,097
    )Other
      receivables
    
    
    38
    
    
    (381
    )Prepaid
      expenses and other assets
    
    
    76
    
    
    (53
    )Accounts
      payable
    
    
    —
    
    
    2,623Accrued
      expenses
    
    
    822
    
    
    416Other
    
    
    (34
    )
    
    —Refundable
      income taxes/Federal income taxespayable
    
    
    (1,099
    )
    
    456Net
      cash used in operating activities
    
    
    (5,636
    )
    
    (4,725
    )CASH
      FLOWS FROM INVESTING ACTIVITIES:Purchase
      of property and equipment
    
    
    (1,741
    )
    
    (460
    )Purchase
      of Rapor assets
    
    
    (288
    )
    
    —Purchase
      of investment
    
    
    (250
    )
    
    —Net
      cash used in investing activities
    
    
    (2,279
    )
    
    (460
    )CASH
      FLOWS FROM FINANCING ACTIVITIES:Private
      placement proceeds
    
    
    31,476
    
    
    —Proceeds
      from loan/line of credit
    
    
    17,580
    
    
    —Repayments
      of loan/line of credit
    
    
    (10,905
    )
    
    —Proceeds
      from prior lines of credit
    
    
    —
    
    
    44,744Repayments
      of prior lines of credit
    
    
    (5,304
    )
    
    (39,440
    )Distribution
    
    
    —
    
    
    (215
    )Restricted
      cash
    
    
    (10,000
    )
    
    —Loan
      origination fees
    
    
    (1,604
    )
    
    —Net
      cash provided by financing activities
    
    
    21,243
    
    
    5,089Net
      increase (decrease) in cash
    
    
    13,328
    
    
    (96
    )CASH,
      BEGINNING OF YEAR
    
    
    69
    
    
    166CASH,
      END OF YEAR
    
    $
    13,398
    
    $
    69SUPPLEMENTARY
      INFORMATION TOSTATEMENT
      OF CASH FLOWS:Cash
      paid for interest
    
    $
    356
    
    $
    209Cash
      paid for taxes
    
    $
    468
    
    $
    200SUPPLEMENTARY
      SCHEDULE OF NONCASH INVESTINGAND
      FINANCING ACTIVITIESLiabilities
      assumed in acquisition andRecapitalization
    
    $
    1,821
    
    $
    —Capital
      lease equipment acquisitions
    
    
    501
    
    
    —Conversion
      of related party note and loanand
      accrued interest
    
    
    1,517
    
    
    —Loan
      origination fee compensation cost forwarrant
      issued
    
    
    112
    
    
    —Rapor
      assets net of liabilities assumed
    
    
    741
    
    
    —Stock
      Repurchase Obligation
    
    
    10,000
    
    
    —
 
 The Notes
to Financial Statements are an integral part of these
statements


F-7





**GVI
SECURITY SOLUTIONS, INC.**





**Notes
to the Financial Statements**





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 1,833,947,909 shares of Thinking Tools,
Inc. common stock, and ultimately converted into 28,214,587 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. See also Note 13.





GVI is a provider
of video
surveillance and security solutions incorporating
a line of video surveillance, access control and detection systems to the
homeland security, professional, business-to-business and retail market
segments . GVI provides
a combination of closed
circuit televisions ( CCTVs),
digital video recorders (DVRs), access control, Rapid Access
Portals, software
systems and networking products for both
government agencies and the private sector. GVI is the
exclusive distributor of video surveillance and security products for Samsung
Electronics (Samsung) in North, Central and South America to professional end
users, installers and resellers, and a major national retailer. During each of
the years ended December 31, 2004 and 2003, sales in the United States comprised
86% of total sales, and international sales comprised 14% of total
sales.





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 2,707,852 shares of common stock and seven-year warrants to
purchase an aggregate of 1,353,925 shares of common stock at an exercise price
of $3.04 per share. In connection with the closing of the merger, the Company
also paid approximately $184,000 in cash, and issued 98,007 shares of common
stock, in satisfaction of secured obligations of Rapor. Rapor designs and
manufactures high security building access portals.





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. (for the period December 1, 2004 through December 31, 2004). All
material inter-company transactions, balances and profits have been
eliminated.





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
      and short-term investments - The carrying amount approximates fair value
      because of the short maturity of those instruments.





F-8





**GVI
SECURITY SOLUTIONS, INC.**





**Notes
to the Financial Statements**





NOTE 1 ~
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, Continued




·
    Long-term
      investments - The fair value of investments is normally based on quoted
      market prices for those or similar investments. It was not practicable to
      estimate the fair value of an investment representing a 5 percent
      membership of an untraded company without incurring excessive costs; that
      investment is carried at its original cost of $250,000 in the balance
      sheet.




·
    Long-term
      debt - Based on the borrowing rates currently available to the Company 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.




Cash and
Cash Equivalents




The
Company considers all highly liquid investments with an original maturity of
three months or less when purchased to be cash equivalents. The Company held no
cash equivalents as defined at December 31, 2004 or 2003.




Accounts
Receivable




Trade
receivables are presented on the balance sheet at outstanding principal adjusted
for any charge offs. The Company maintains an allowance for doubtful receivables
based on previous 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. The allowance for doubtful accounts
at December 31, 2004 was $250,000.




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, nonsellable or unusable
items based upon a product-level review.





Property
and Equipment





Fixed
assets are stated at cost. Depreciation and amortization are provided for on
straight-line and accelerated methods 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.





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 and the
useful lives of property and equipment.




Revenue
Recognition





Sales are
recognized when revenue is
realized or realizable and has been earned. The
Company 's policy is
to recognize revenue when
risk of loss and title to the product transfers to the customer. Net sales is
comprised of gross revenues 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 the
Company  recognizes
the related








F-9


****


**GVI
SECURITY SOLUTIONS, INC.**




**Notes
to the Financial Statements**




NOTE 1 ~
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, Continued




revenue
or the date on which the Company offers the incentive. The Company allows
customers to return products when they meet certain Company-established criteria
as outlined in the Company's trade terms. The Company regularly reviews and
revises, when deemed necessary, its estimates of sales returns based primarily
upon actual returns. The Company records sales returns as a reduction 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 that
the Company expects to realize upon their subsequent disposition. The physical
condition and marketability of the returned products are the major factors
considered by the Company in estimating realizable value. Actual returns, as
well as realized values on returned products, may differ significantly, either
favorably or unfavorably, from the Company's estimates if factors such as
customer inventory levels or competitive conditions differ from the Company's
estimates and expectations and, in the case of actual returns, if economic
conditions differ significantly from the Company's 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 Issues
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 revenue is recognized.  In
the event that the actual results of these items differ from the estimates,
adjustments to the sales incentive accruals would be recorded.




Shipping
and Handling Costs for Purchases and Sales




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




Income
Taxes




Until
May, 2003, the Company elected to be taxed under the provisions of Sub-Chapter S
of the Internal Revenue Code. Under those provisions, the Company did not
provide for or pay Federal and certain corporate state income taxes on its
taxable income, instead, the stockholders were liable for individual Federal and
State income taxes on their share of the Company's taxable income.




In May,
2003, the Company lost its status as an "S" Corporation and became a "C"
corporation when a disqualified entity acquired stock. 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.




Net
Income (Loss) Per Share




The
Company follows Statement of Financial Accounting Standards (SFAS) No. 128
"Earnings Per Share." Due to the Company's loss from continuing operations in
2004, all convertible securities, options and warrants at December 31, 2004 are
anti-dilutive; hence both basic and diluted loss per share for that year are
computed based on the weighted average number of shares of common stock
outstanding during the period.





F-10





**GVI
SECURITY SOLUTIONS, INC.**




**Notes
to the Financial Statements**





NOTE 1 ~
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, Continued




For the
year ended December 31, 2003, earnings per share assumes conversion of the
Series E Preferred Stock. Exercisable options were not considered in the
earnings per share calculations because the effect would have been
anti-dilutive.




Accrued
Expenses





Accrued
      expenses at December 31, 2004 ($ in thousands):Accrued
      wages, commissions, and related payroll taxes
    
    $
    798Inventory
      - received not invoiced
    
    
    369Legal
      and professional fees
    
    
    251Sales
      Tax Payable
    
    
    151Deferred
      Rent
    
    
    136Other
      expenses
    
    
    376$
    2,081








Stock
Based-Compensation





In
December 2002, the Financial Accounting Standards Board Issued SFAS No. 148,
"Accounting for Stock-Based Compensation - Transition and Disclosure - an
amendment of SFAS No. 123." This statement amends SFAS No. 123, "Accounting for
Stock-Based Compensation," to provide alternative methods of transition for a
voluntary change to the fair value based method of accounting for stock-based
employee compensation. In addition, this Statement amends the disclosure
requirements of SFAS No. 123 to require prominent disclosures in financial
statements about the method of accounting for stock-based employee compensation
and the effect of the method used on reported results. The Company accounts for
stock-based compensation using Accounting Principles Board (APB) Option No. 25,
"Accounting for Stock Issued to Employees" and has not adopted the recognition
provisions of SFAS No. 123, as amended by SFAS No. 148. The exercise price of
options granted under the stock option plan (Note 10) is equal to or less than
the market price of the underlying stock on the date of grant. Therefore, no
compensation cost was recorded under APB No. 25.





If the
Company had determined compensation cost for the stock-based compensation plan
in accordance with the fair value method prescribed by SFAS No. 123, proforma
net income for the years ended December 31, 2004 and 2003 would have been as
follows ($ in thousands, except per share amounts):





2004
    
    
    2003Net
      Income (Loss), as reported
    
    $
    ( 7,178
    )
    $1,257Stock-based
      employee compensation expense, net of related tax effects
    
    
    (104
    )
    (11)Net Income (Loss), pro forma
    
    $
    (
      7,282
    )
    $1,246Net income (loss) per share:Basic as reported
    
    $
    (0.24
    )
    $0.04Basic pro forma
    
    $
    (0.24
    )
    $0.04Diluted as reported
    
    $
    (0.24
    )
    $0.04Diluted pro forma
    
    $
    (0.24
    )
    $0.04





The
weighted average fair value of options granted during each of 2004 and 2003 was
$.01. 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:





F-11





**GVI
SECURITY SOLUTIONS, INC.**





**Notes
to the Financial Statements**





NOTE 1 ~
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES, Continued





Risk
      free rate of return
    
    
    3.5
    %
    
    1.5
    %Option
      lives in years
    
    
    3.0
    
    
    3.0Annual
      volatility of stock price
    
    
    74
    %
    
    --
    %Dividend
      yield
    
    
    --
    %
    
    --
    %





Advertising





Advertising
costs are expensed as incurred. Some advertising costs, which included various
promotional incentives and trade show participation, for the years ended
December 31, 2004 and 2003 were reimbursed by Samsung in the form of marketing
incentives and reimbursement for trade show participation.





NOTE 2 ~
PROPERTY AND EQUIPMENT





Property
and equipment at December 31, 2004 ($ in thousands):











Useful
      Lives
      In
      YearsFurniture
      and fixtures
    
    
    5-7
    
    $
    303Office
      and warehouse equipment
    
    
    2-7
    
    
    236Leasehold
      improvements
    
    
    2-7
    
    
    126Computer
      equipment and software
    
    
    3-5
    
    
    475Demonstration
      and sample equipment
    
    
    1-2
    
    
    1,943Subtotal
    
    
    
    
    
    3,083Less:
      accumulated depreciation
    
    
    
    
    
    1,101$
    1,982





NOTE 3 ~
CREDIT FACILITIES





Laurus
Debt/Lines of Credit





On May
27, 2004, the Company closed a $15 million convertible debt financing with
Laurus Master Fund, Ltd. under which the Company was provided with a $5 million
term loan and a $10 million accounts receivable loan facility. At closing, the
Company borrowed $5 million under the term loan and $10 million under the
receivable 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 940,000 shares of Common
Stock at a price of $3.50 per share. The Company also issued a similar warrant
to purchase 94,000 shares of Common Stock to the finder. Borrowings under the
Laurus financing are secured by all assets of the Company. At December 31, 2004,
$4.7 million in principal was outstanding under the Term Loan and $5.5 million
in principal was outstanding under the accounts receivable 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 Convertible Term Note and, subject to monthly
adjustments as set forth below, bears interest at an initial 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. Amortizing payments of principal on the term loan commenced September
1, 2004, with a final payment due on May 27, 2007 as set forth in the table
below.





F-12





**GVI
SECURITY SOLUTIONS, INC.**





**Notes
to the Financial Statements**





NOTE 3 ~
CREDIT FACILITIES, Continued











Period
    Principal
      AmountSeptember 2004 through May 2005
    $
      75,000 per monthJune 2005 through May 2006
    $150,000
      per monthJune 2006 through April 2007
    $190,000
      per monthMay 2007
    $435,000




The
interest rate under the Term Note is subject to downward adjustment at the end
of each month as follows. If at the end of the applicable month the Company has
registered the shares of Common Stock underlying the Term Note with the SEC,
interest payable on the term loan will 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 convertible into Common Stock at Laurus's
option at a conversion price initially equal to $2.70 per share. In December,
2004 the conversion price was reduced to $1.91 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, scheduled principal and interest payments under the Term Note will
be made in shares of Common Stock valued at the conversion price. Prepayments
under the Term Note are subject to a premium in the amount of 20% of the
principal being prepaid.





Subject
to monthly adjustments as set forth below, borrowings under the receivable
facility bear interest at an initial rate per annum equal to the prime rate
minus two percent. The interest rate under the receivable facility is subject to
downward adjustment at the end of each month in the same manner as provided for
under the Term Note. In addition, on and after November 26, 2004, if the market
price of the Common Stock is below the fixed conversion price at the end of a
month, the interest rate under the receivable facility will be reset to equal
the prime rate plus two percent. The receivable facility terminates, and
borrowings thereunder become due, on May 27, 2007.





Amounts
outstanding under the receivable facility were convertible to Common Stock at
Laurus's option at a conversion price initially equal to $3.38 per share. In
December, 2004 the conversion price was reduced to $2.22 under the terms of the
anti-dilution feature of the facility. To the extent the Company repays loans
outstanding under the receivable facility and/or Laurus converts loans under the
receivable facility into Common Stock, the Company may reborrow or make
additional borrowings under the receivable facility, provided that aggregate
loans outstanding under the receivable facility at any time may not exceed the
lesser of $10 million or a borrowing base equal to the sum of 90% of "eligible
accounts" plus 60% of "eligible inventory" (with borrowings based on eligible
inventory limited to $2 million).





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 400,000 shares of Common Stock
at a price of $3.50 per share. The Company’s Common Stock began being quoted on
the NASD Over the Counter Bulletin Board on December 13, 2004. Compensation
expense of approximately $16,000 was recorded for the issuance of these
warrants.





F-13





**GVI
SECURITY SOLUTIONS, INC.**





**Notes
to the Financial Statements**





NOTE 3 ~
CREDIT FACILITIES, Continued





Loan
Origination Fees





The loan
origination and finders fees of $1.8 million for the Laurus loans and line of
credit were capitalized and will be amortized to interest expense over three
years. Included in loan origination fees is compensation of $112,000 relating to
the issuance of warrants to purchase 1,034,000 shares of the company's common
stock.





Capitalized
Leases





There are
four capital leases for a trade show booth, warehouse racking, and 2 office
furniture leases that have a total value of $430. These leases will be paid over
terms ranging from 24 to 60 months and payments will be allocated to debt and
interest expense over the term of the leases.





Amortization
Table: ($ in thousands)





2005
    
    
    2006
    
    
    2007
    
    
    2008
    
    
    2009Capital Leases
    
    $
    172
    
    $
    118
    
    $
    77
    
    $
    51
    
    $
    12








NOTE 4 ~
INCOME TAXES





The
current tax provision consists of the following ($ in thousands):





2004
    
    
    2003FederalCurrent
    
    $
    (647
    )
    $
    868Deferred
    
    
    212
    
    
    (212
    )State, current
    
    
    22
    
    
    92$
    (413
    )
    $
    748





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





2004Current
      deferred taxesAccounts
      receivable allowances
    
    $
    540Inventory
      reserve
    
    
    367Uniform
      capitalization of inventory costs
    
    
    113Net
      operating loss carry-forward
    
    
    1,2472,267Noncurrent
      deferred tax liabilitiesProperty
      and equipment
    
    
    (
      130
    )Non
      Cash compensation
    
    
    13(
      117
    )Less:
      Deferred tax valuation allowance
    
    
    (
      2,150
    )Net
    
    $
    --








F-14





**GVI
SECURITY SOLUTIONS, INC.**





**Notes
to the Financial Statements**





NOTE 4 ~
INCOME TAXES, Continued





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





2004
    
    
    2003Income
      tax at statutory rates (34%)
    
    $
    (2,581
    )
    $
    609Effects
      of permanent differences
    
    
    --
    
    
    25State
      income tax expense
    
    
    15
    
    
    61Deferred
      tax valuation allowance
    
    
    2,150
    
    
    --Other
    
    
    3
    
    
    --Effects
      of change in tax status
    
    
    -
    
    
    (159
    )Income
      tax (benefit) provision
    
    $
    (
      413
    )
    $
    536





As
described in Note 1, the Company converted from an "S" corporation to a "C"
corporation in May, 2003. Prior thereto, the Company was not liable for federal
or certain state income taxes.





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.





At December 31,
2004 , the
Company has a
net operating loss carry-forward of approximately $1.2 million. This loss will
expire in 2024. 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 loss carryforward in the
future.


****


NOTE 5 ~
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.
Amounts accrued but not funded for the periods ended December 31, 2004 and 2003
were $90,000 and $0, respectively.





NOTE 6 ~
COMMITMENTS AND CONTINGENCIES





Lease and
Rents




The
Company leases warehouse and office space under an agreement which expires on
September 30, 2009. Under the terms of the lease, the Company pays no rent for
six months, and then pays monthly rent of $25,704 for the remainder of the
sixty-six month lease; for which the effects of the deferred rent have been
accrued.





The
minimum annual rentals under the non-cancelable lease are as follows ($ in
thousands):





For
      the years ended December 31,2005
    
    $
    3082006
    
    
    3082007
    
    
    3082008
    
    
    3082009
    
    
    258$
    1,490








F-15





**GVI
SECURITY SOLUTIONS, INC.**





**Notes
to the Financial Statements**





NOTE 6 ~
COMMITMENTS AND CONTINGENCIES, Continued





Rent
expense amounted to $371,000 and $141,000 for the periods ended December 31,
2004 and 2003, respectively.





Licensing
Agreement





The
company entered into a licensing agreement that commenced on January 1, 2005
with Cybasec LTD. Under the agreement, which has an initial term of three years,
but can be cancelled after the first year, Cybasec grants the company the
exclusive license to use, sell, market, distribute, service and customize the
Cybasec Enterprise Security Platform hardware and software applications in
exchange for the Company committing to purchase required amounts of products and
paying related agreed upon fees. Minimum required payments under this licensing
agreement are $1,047,000 for the year ending December 31, 2005.





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 650,000 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 other non-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
6,666,667 shares from William A. Teitelbaum for $10 million. At December 31,
2004, included in the balance sheet is restricted cash and a liability, each in
the amount of $10,000,000, and a reduction of stockholders’ equity, for the
purchase of these shares.





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 is
entitled to receive severance payments equal to one year of his annual base
salary of $350,000. In addition, for a period of one-year, Mr. Wade will
continue to receive a car allowance of $800 per month, an unaccounted for
expense reimbursement of $1,200 per month, and medical benefits. At December 31,
2004, approximately $281,000 for the remaining obligation has been included in
accrued expenses. The Company also agreed that Mr. Wade’s options to purchase
1,975,020 shares of our Common Stock vest in full. There was no effect on
earnings for this acceleration. Mr. Wade has 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.





Sales
Tax





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 that any liability that it may have for sales
taxes would not have a material effect on its financial condition or results of
operations.








F-16





**GVI
SECURITY SOLUTIONS, INC.**




**Notes
to the Financial Statements**





NOTE 7 ~
CONCENTRATIONS OF RISK




Samsung
Electronics Exclusive Product Distribution Agreement




The
Company has signed an exclusive product distribution agreement with Samsung that
is renewable annually if the Company purchases from Samsung the "Annual Volume
Targets," as defined, agreed to for that year. Under the terms of the product
distribution agreement, Samsung will provide a reasonable amount of products to
demonstrate its products and provide samples for customer testing, for
distributors’ use in training purchasers, wholesale distributors and the
Company's personnel and to support other distributors. In addition, the
agreement provides for Samsung to reimburse the Company for various marketing
and trade show expenses. The agreement also provides for the Company to earn a
commission on sales of private label products to new Original Equipment
Manufacturers. The amount captioned on the balance sheet "other receivables" is
comprised primarily of commissions and other amounts due from Samsung under the
distribution agreement. For the years ended December 31, 2004 and 2003, the
Company purchased approximately $39 million and $38 million, respectively, from
Samsung.




Major
Customer




The
Company has one major customer that is a purchasing entity for a major national
retailer. Approximately 44% and 53% of the Company's sales for the years ended
December 31, 2004 and 2003, respectively, were to this customer and
approximately $310,000 of the Company's accounts receivable at December 31,
2004, were due from the customer. Pursuant to a written agreement, this customer
purchases products from the Company at an initial price equal to 108% of the
base cost to the Company, subject to downward adjustment if the customer’s gross
margins fall below certain specified levels. The Company is responsible for all
warranty obligations with respect to these products. In connection with entering
this agreement, the Company agreed to issue this customer warrants to purchase
3,000,000 shares of common stock at a price of $1.50 per share, and to issue the
customer up to an additional 3,000,000 shares of common stock upon attaining
certain goals provided for in the agreement.




Cash and
Credit Risk Concentration




The
Company maintains accounts in a financial institution and at times the balances
may be in excess of the FDIC insurance limit. Collected balances are invested in
overnight repurchase agreements. The Company periodically evaluates this
financial institution and does not believe it is exposed to undue risk of loss.
At December 31, 2004, in addition to the amounts due from its major customer as
set forth above, approximately $1,529,000, 1,432,000 and $860,000, respectively,
of the Company's accounts receivable were due from three particular customers.
The Company performs ongoing credit evaluations of its customers and generally
requires no collateral from them.




NOTE 8 ~
RELATED PARTY TRANSACTIONS




In the
normal course of business, the Company conducted certain transactions with a
company owned by William Teitelbaum. During the years ended December 31, 2004
and 2003, the Company made sales of $3,587 and $299,846, respectively, to this
company. At December 31, 2004, no amounts were due from this company. Also see
Note 6 concerning settlement agreement with William Teitelbaum.




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 $5.10 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
766,666 shares of common stock were issued to these purchasers in December 2004
in accordance with the terms of the October 2004 private placement.





F-17





**GVI
SECURITY SOLUTIONS, INC.**




**Notes
to the Financial Statements**




NOTE 8 ~
RELATED PARTY TRANSACTIONS, Continued





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 346,060 shares
of common stock and warrants to purchase 135,787 shares of common stock, and the
partnership was issued 208,998 shares of common stock and warrants to purchase
104,499 shares of common stock.





NOTE 9 ~
LITIGATION





The
Company is a party to disputes in the normal course of business. Management
believes the ultimate resolution of such disputes will not have a material
effect on the financial condition or results of operations.





NOTE 10 ~
2004 LONG-TERM INCENTIVE PLAN





On July
22, 2003, the predecessor company, GVI Security, Inc., adopted the GVI Security,
Inc. 2003 Stock Incentive Plan and granted options to purchase 23,000 shares of
common stock under that plan. As a result of Merger, and after giving effect to
the 1-for-65 reverse stock split which occurred in April 2004, the options for
23,000 shares of GVI stock were converted to options to purchase 2,821,452
shares of common stock at a price of $.3185 per share. In February 2004, the
Company adopted its 2004 Long-Term Stock Plan and reserved up to 5,939,913
shares of Common Stock (after giving effect to the Reverse Stock Split) for
issuance thereunder. In addition, in February, the Company granted options for
common stock exercisable under the plan of 2,675,000 at $2.60 per share
(post-reverse stock split).





At
December 31, 2003 and 2004, the Company had stock-based employee compensation
plans, which are described more fully above. The Company accounts for those
plans under the recognition and measurement principles of APB Opinion No. 25,
Accounting for Stock Issued to Employees, and related Interpretations. No
stock-based employee compensation cost is reflected in net income, as all
options granted under those plans had an exercise price equal to the market
value of the underlying common stock on the date of grant.





A summary
of the status of the Company's stock options as of December 31, 2004 and 2003,
and the changes during the years ended December 31, 2004 and 2003, are presented
below:





Number
      of  Shares
    
    
    
    Range
      of
      Exercise
      PricesOutstanding
      at January 1, 2003
    
    24,122
    
    
    $
    32.50
      - 65.00Granted
    
    2,821,452
    
    
    $
    0.32
      - 0.32Exercised
    
    --
    
    
    $
    --Forfeited
    
    8,385
    
    
    $
    --Outstanding
      at December 31, 2003
    
    2,837,189
    
    
    $
    0.32
      - 65.00Granted
    
    2,675,000
    
    
    $
    2.60
      - 2.60Exercised
    
    --
    
    
    $
    --Forfeited
    
    (276,320
    )
    
    $
    0.32
      - 65.00Outstanding
      at December 31, 2004
    
    5,235,869
    
    
    $
    0.32
      - 65.00Weighted-average
      fair value of options remaining exercisableat
      December 31, 2004
    
    
    $
    0.01





F-18





**GVI
SECURITY SOLUTIONS, INC.**





**Notes
to the Financial Statements**





NOTE 10 ~
2004 LONG-TERM INCENTIVE PLAN, Continued





The
following table summarizes information about stock options outstanding as of
December 31, 2004:





Outstanding
      Options
    Exercisable
      OptionsExercise
      Prices
    Number Outstanding at December 31,
      2004
    Weighted-average
      Remaining Contractual Life
    Number
      Outstanding
      at December 31, 2004$
      0.32
    2,805,505
    8.6
      years
    2,404,3702.60
    2,414,627
    9.1
      years
    670,877Over
      $32.00
    15,431
    4.8
      years
    15,4315,235,869
    
    3,090,677







Statement
of Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation" ("SFAS 123"), requires the disclosure of pro forma net income and
earnings per share as if the Company adopted the fair value method for stock
based awards to directors and employees as of the beginning of the fiscal
period. Under SFAS 123, the fair value of the stock-based awards is calculated
through the use of option pricing models, even though such models were developed
to estimate the fair value of freely tradable, fully transferable options
without vesting restrictions, which significantly differ from the Company's
stock option awards. These models also require subjective assumptions, including
future stock option price volatility and expected time to exercise, which
greatly affect the calculated values. The Company's calculations were made using
the Black-Scholes option pricing models with the following weighted average
assumptions: expected life ranging from 3 to 5 years; 74%, stock volatility,
risk-free interest rates of approximately 3.5%; and no dividends during the
expected term. The results would have no material effect on the reported
earnings per share.





NOTE 11 -
Warrants





Summary
of outstanding warrants at December 31, 2004:





Description
    
    
    Shares
    
    
    Approx.
      Remaining
      Term
      (Years)
    
    
    Exercise
      PriceLaurus
      Master Fund
    
    
    1,340,000
    
    
    6.5
    
    $
    3.50Laurus
      Finder’s Fee
    
    
    94,000
    
    
    6.5
    
    $
    3.50Vendor
    
    
    3,000,000
    
    
    5.2
    
    $
    1.50Rapor
      shareholders
    
    
    1,353,925
    
    
    7.0
    
    $
    3.04Oct.
      2004 bridge financing
    
    
    766,666
    
    
    5.0
    
    $
    1.50Related
      to 1999 Acquisition
    
    
    54,612
    
    
    0.2
    
    $
    32.50Former
      Vendor
    
    
    11,721
    
    
    0.2
    
    $
    0.65Other
    
    
    13,743
    
    
    2.0
    
    $
    7.80
      - $69.55








F-19





**GVI
SECURITY SOLUTIONS, INC.**





**Notes
to the Financial Statements**





NOTE 12 ~
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. 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%.





The EITF
reached a consensus on Issue 03-16, “Accounting for Investments in Limited
Liability Companies.” This EITF requires that an investment in a limited
liability company (“LLC”) that maintains a “specific ownership account” for each
investor similar to a partnership capital account structure, should be viewed
similar to an investment in a limited partnership for purposes of determining
whether a non-controlling investment in the LLC should be accounted for using
the cost method or equity method.  These requirements are applicable for
reporting periods beginning after June 15, 2004.  The adoption of EITF
03-16 did not have an impact on the Company’s financial statements.





NOTE 13 ~
RECAPITALIZATION





All share
and per share numbers in this Note give retroactive effect to the 1-for-65
reverse stock split of the Company’s common stock effected in April
2004.





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.





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 28,214,587
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 2,821,452
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 $.32 per share.





F-20





**GVI
SECURITY SOLUTIONS, INC.**





**Notes
to the Financial Statements**





NOTE 13 -
RECAPITALIZATION, Continued





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 1,187,983 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 of the State of
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
44,185 shares of the Company’s common stock.





NOTE 14 ~
FOURTH QUARTER 2004 ADJUSTMENTS




The
following year-end adjustments and fourth-quarter events were material to the
Company’s results for the fourth quarter of 2004: (i) a sales concession of
approximately $800,000 granted to a large retailer as a result of the retailer’s
difficulty in selling the Company’s products, (ii) the establishment of a
reserve of approximately $650,000 in connection with slow-moving inventory,
(iii) a write-down of inventory in the amount of approximately $800,000 to
reflect the net realizable value of that inventory, and (iv) costs of
approximately $470,000 resulting from the Company’s repurchase at a loss of
inventory that had been sold to distributors for sale to retailers, which
repurchase was required as a result of entering into an exclusive distribution
arrangement with a distributor that precluded the sale of the Company’s products
to retailers by other distributors.





NOTE 15 ~
NEW ACCOUNTING PRONOUNCEMENTS




In
December 2004, the FASB issued Statement No. 123R, ** *“Share-Based
Payment”* (SFAS
No. 123R), a revision to SFAS No. 123, ** *“Accounting
for Stock-Based Compensation”* (SFAS
No. 123).  SFAS No. 123R eliminates the alternative to use the Accounting
Principles Board Opinion 25’s (Opinion 25) intrinsic value method of accounting
that was provided in SFAS No. 123 as originally issued.




Under
Opinion 25, issuing stock options to employees generally resulted in recognition
of no compensation cost.  SFAS No. 123R requires companies to measure the
cost of employee services received in exchange for an award of equity
instruments based on the grant-date fair value of the award (with limited
exceptions). That cost will be recognized over the period during which an
employee is required to provide service, in exchange for the award - the
requisite service period (usually the vesting period).  No compensation
cost is recognized for equity instruments for which employees do not render the
requisite service.





Companies
will initially measure the cost of employee services received in exchange for an
award of instruments classified as liabilities (Leadership stock, Stock
Appreciation Rights (SARs)) based on its current fair value; the fair value of
the awards classified as a liability will be remeasured subsequently at each
reporting date through the settlement date.  Changes in fair value during
the requisite service period will be recognized as compensation cost over that
period.






F-21




**GVI
SECURITY SOLUTIONS, INC.**





**Notes
to the Financial Statements**





NOTE 15 ~
NEW ACCOUNTING PRONOUNCEMENTS, Continued




The
grant-date fair value of employee share options, or the Company’s restricted
stock and similar instruments classified in the Statement of Financial Position
as equity will be estimated using option-pricing models adjusted for the unique
characteristics of those instruments (unless observable market prices for the
same or similar instruments are available); the fair value of awards classified
as equity will not be remeasured.  If an equity award is modified after the
grant date, incremental compensation cost will be recognized in an amount equal
to the excess of the fair value of the modified award over the fair value of the
original award immediately before the modification.




Excess
tax benefits, as defined by SFAS No. 123R, will be recognized as an addition to
paid-in capital.  Cash retained as a result of those excess tax benefits
will be presented in the statement of cash flows as financing cash
inflows.  The write-off of deferred tax assets relating to unrealized tax
benefits associated with recognized compensation cost will be recognized as
income tax expense unless there are excess tax benefits from previous awards
remaining in paid-in capital to which it can be offset.




SFAS No.
123R applies to all awards granted after the required effective date and to
awards modified, repurchased, or cancelled after that date.  As of the
required effective date, companies that used the fair-value-based method for
either recognition or disclosure under SFAS No. 123 will apply SFAS No. 123R
using a modified version of prospective application.  Under that transition
method, compensation cost is recognized on or after the required effective date
for the portion of outstanding awards for which the requisite service has not
yet been rendered, based on the grant-date fair value of those awards calculated
under SFAS No. 123 for either recognition or pro forma disclosure.  The
cumulative effect of initially applying SFAS No. 123R, if any, is recognized as
of the required effective date.  SFAS No. 123R is effective, for public
entities that file as small business issuers, as of the beginning of the first
interim or annual reporting period that begins after December 15, 2005. Early
application is encouraged; however, the
Company is
currently evaluating the effect of SFAS No. 123R.




In
December 2004, FASB issued SFAS No. 151, *“Inventory Costs”* that
amends the guidance in Accounting Research Bulletin No. 43, Chapter
4, *“Inventory Pricing,”* (ARB No.
43) to clarify the accounting for abnormal amounts of idle facility expense,
freight, handling costs, and wasted material (spoilage).  In addition, this
Statement requires that an allocation of fixed production overheads to the costs
of conversion be based on the normal capacity of the production
facilities.  SFAS No. 151 is effective for inventory costs incurred during
fiscal years beginning after June 15,
2005 . 
Early application is permitted for inventory costs incurred during fiscal years
beginning after November
23,  2004 . The
Company is
evaluating the impact of SFAS No. 151 but adoption of this standard is not
anticipated to have a material effect on the Company’s financial
statements.




In
September 2004, the FASB issued EITF Issue No. 04-10, Applying
Paragraph 19 of FASB Statement No. 131, Disclosures about Segments of
an Enterprise and Related Information, in Determining Whether to Aggregate
Operating Segments That Do Not Meet the Quantitative Thresholds. EITF Issue
No. 04-10 establishes evaluation criteria for an enterprise to use when
determining whether operating segments that do not meet the quantitative
thresholds can still be aggregated in accordance with paragraph 19 of SFAS
No. 131, Disclosure about Segments of an Enterprise and Related
Information. We have evaluated EITF Issue No. 04-10 and have determined
that it has no impact on our financial statements.




In
November 2004, the Emerging Issues Task Force finalized the consensus in Issue
No. 04-8, “The Effect of Contingently Convertible Debt on Diluted Earnings per
Share” (EITF 04-8).  EITF 04-8 requires that contingent convertible
instruments be included in diluted earnings per share regardless of whether a
market price trigger or other contingent feature has been met.  EITF 04-8
is effective for reporting periods ending after December
15, 2004 and
requires restatement of prior periods. We are currently evaluating the impact of
EITF Issue No. 04-08 and have not determined its effect on our financial
statements.


F-22