UNITED
        STATES SECURITIES AND EXCHANGE COMMISSION
 WASHINGTON,
        D.C. 20549
 FORM
        10-K
 
 x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
        ACT OF
        1934
 FOR
        THE
        FISCAL YEAR ENDED DECEMBER 31, 2005
  ̈ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
        ACT
        OF 1934
 COMMISSION
        FILE NUMBER: 000-33491
 
 CITADEL
        SECURITY SOFTWARE INC.
 (EXACT
        NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
 DELAWARE
                
                75-2873882(STATE
                    OR OTHER JURISDICTION OF INCORPORATION OR ORGANIZATION)
                
                (I.R.S.
                    EMPLOYER IDENTIFICATION NO.)
  TWO
        LINCOLN CENTRE, SUITE 1600, 5420 LBJ FREEWAY, DALLAS, TEXAS 75240
 (ADDRESS
        OF PRINCIPAL EXECUTIVE OFFICES)
 (214)
        520-9292
 (REGISTRANT’S
        TELEPHONE NUMBER, INCLUDING AREA CODE)
 
 SECURITIES
        REGISTERED PURSUANT TO SECTION 12(B) OF THE EXCHANGE ACT: NONE
 SECURITIES
        REGISTERED PURSUANT TO SECTION 12(G) OF THE EXCHANGE ACT:
 COMMON
        STOCK, PAR VALUE $.01 PER SHARE
 (TITLE
        OF
        CLASS)
 
 Indicate
        by check mark whether the registrant is a well-known seasoned issuer, as
        defined
        in Rule 405 of the Securities Act.   Yes  ̈ No x
 
 Indicate
        by check mark if the registrant is not required to file reports pursuant
        to
        Section 13 or Section 15(d) of the Act.  Yes  ̈ No x
 
 Indicate
        by check mark whether the registrant, (1) has filed all reports required
        to be
        filed by Section13 or 15(d) of the Securities Exchange Act of 1934 during
        the
        preceding 12 months (or for such shorter period the registrant was required
        to
        file such reports), and (2) has been subject to such filing requirements
        for the
        past 90 days.  Yes x No  ̈
 
 Indicate
        by check mark if disclosure of delinquent filers in response to Item 405
        of
        Regulation S-K is not contained herein , and will not be contained, to the
        best
        of registrant’s knowledge, in definitive proxy or information statements
        incorporated by reference in Part III of this Form 10-K or any
        amendment to this Form 10-K . x
 
 Indicate
        by check mark whether the registrant is a large accelerated filer, an
        accelerated filer, or a non-accelerated filer. See definition of “accelerated
        filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.
        (Check one):
 
 Large
                  accelerated filer ̈
              Accelerated
                  filer ̈
              Non-accelerated
                  filerx
 
 Indicate
        by check mark whether the registrant is a shell company (as defined in Rule
        12b-2 of the Act). Yes  ̈ No x
 
 The
        aggregate market value of the voting and non-voting common equity held by
        non-affiliates computed by reference to the price at which common equity
        was
        last sold, or the average of the bid and asked price of such common equity,
        as
        of the last business day of the registrant’s most recently completed second
        fiscal quarter (June 30, 2005) was $14,159,126. As of March 24, 2006 ,
        there
        were 30,518,230 shares of common stock, $.01 par value per share, outstanding.
 
 DOCUMENTS
        INCORPORATED BY REFERENCE
 The
        information required by Part III of this Report, to the extent not set forth
        herein, is incorporated by reference from the registrant’s definitive proxy
        statement to be filed with the Commission within one hundred and twenty (120)
        days following the registrant’s fiscal year end, or on or before April 30,
        2006.
  
  
  CITADEL
        SECURITY SOFTWARE INC.
 FORM 10-K
 ANNUAL
        REPORT
 FOR
        THE
        FISCAL YEAR ENDED
 DECEMBER
        31, 2005
  Table
                  of Contents
              PagePART
                  I****Item
                  1.
              Business
              4Item
                  1A.
              Risk
                  Factors
              20Item
                  2.
              Properties
              34Item
                  3.
              Legal
                  Proceedings
              34Item
                  4.
              Submission
                  of Matters to a Vote of Security
                  Holders
              35PART
                  II****Item
                  5.
              Market
                  for Registrant’s Common Equity, Related Stockholder
                  Matters and Issuer Purchases of Equity Securities
              36Item
                  6.
              Selected
                  Financial Data
              38Item
                  7.
              Management’s
                  Discussion and Analysis of Financial Condition
                  and Results of Operations
              38Item
                  7A.
              Quantitative
                  and Qualitative Disclosures about Market
                  Risk
              59Item
                  8.
              Financial
                  Statements and Supplementary
                  Data
              59Item
                  9.
              Changes
                  in and Disagreements with Accountants on Accounting
                  and Financial Disclosure
              59Item
                  9A.
              Controls
                  and Procedures
              59Item
                  9B.
              Other
                  Information
              59PART
                  III****Item
                  10.
              Directors
                  and Executive Officers of the
                  Registrant
              60Item
                  11.
              Executive
                  Compensation
              60Item
                  12.
              Security
                  Ownership of Certain Beneficial Owners and
                  Management and Related Stockholder Matters
              60Item
                  13.
              Certain
                  Relationships and Related
                  Transactions
              60Item
                  14.
              Principal
                  Accountant Fees and Services
              60PART
                  IVItem
                  15.
              Exhibits
                  and Financial Statement
                  Schedules
              61Signatures
              62
  2
 *Table
            of Contents*
  **PART
        I**
 
 **CAUTIONARY
        STATEMENT REGARDING FORWARD-LOOKING STATEMENTS**
 
 This
        report on Form 10-K contains forward-looking statements within the meaning
        of
        the Private Securities Litigation Reform Act of 1995. Citadel Security Software
        Inc. (“Citadel” or the “Company”) bases these forward-looking statements on its
        expectations and projections about future events, which Citadel has derived
        from
        the information currently available to it. In addition, from time to time,
        Citadel or its representatives may make forward-looking statements orally
        or in
        writing. Furthermore, forward-looking statements may be included in Citadel’s
        filings with the Securities and Exchange Commission or press releases or
        oral
        statements made by or with the approval of one of Citadel's executive officers.
        For each of these forward-looking statements, Citadel claims the protection
        of
        the safe harbor for forward-looking statements contained in the Private
        Securities Litigation Reform Act of 1995. These forward-looking statements
        relate to future events or Citadel’s future performance, including but not
        limited to:
 
 Ÿ
              possible
                  or assumed future results of operations;
 Ÿ
              future
                  revenue and earnings; and
 Ÿ
              business
                  and growth strategies.
 
 Forward-looking
        statements are those that are not historical in nature, particularly those
        that
        use terminology such as may, could, will, should, likely, expects, anticipates,
        contemplates, estimates, believes, plans, projected, predicts, potential
        or
        continue or the negative of these or similar terms. The statements contained
        in
        this Report that are not purely historical are forward-looking statements
        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
        statements regarding the Company’s expectations, beliefs, intentions or
        strategies regarding the future. Forward-looking statements are subject to
        certain known and unknown risks and uncertainties that could cause actual
        results to differ materially from those expressed in any forward-looking
        statements. These risks and uncertainties include, but are not limited to,
        the
        following important factors with respect to Citadel:
 
 Ÿ
              the
                  uncertainty of general business and economic conditions, including
                  the
                  potential for a slowdown in business and governmental expenditures
                  on
                  information technology and software;
 Ÿ
              the
                  impact of competition, both expected and unexpected;
 Ÿ
              adverse
                  developments, outcomes and expenses in legal proceedings;
 Ÿ
                the
                    risk that underlying assumptions or expectations related to the
                    spin-off
                    from our former parent company prove to be inaccurate or unrealized;
 Ÿ
                our
                  potential need for additional funds, and the difficulties we may
                  face in
                  obtaining such funds;
 Ÿ
              the
                  Company’s inability to realize the anticipated benefits of strategic and
                  operational initiatives related to increased productivity, new
                  product
                  development, technological advances, and the achievement of sales
                  growth
                  across the business segments; and
 Ÿ
              those
                  described under Risk Factorsincluded in Item 1A of this document.
 
 Forward-looking
        statements are only predictions as of the date they are made and are not
        guarantees of performance. All forward-looking statements included in this
        document are based on information available to Citadel on the date of this
        Report on Form 10-K. Readers are cautioned not to place undue reliance on
        forward-looking statements. The forward-looking events discussed in this
        Report
        on Form 10-K and other statements made from time to time by Citadel or its
        representatives may not occur, and actual events and results may differ
        materially and are subject to risks, uncertainties and assumptions about
        Citadel
        including without limitation those discussed elsewhere in this Form 10-K
        under
        the heading Risk Factors as well as those discussed elsewhere in this Form
        10-K,
        and the risks discussed in our Securities and Exchange Commission filings.
        Except for their ongoing obligations to disclose material information as
        required by the federal securities laws, Citadel is not obligated to publicly
        update or revise any forward-looking statement, whether as a result of new
        information, future events or otherwise. In light of these risks, uncertainties
        and assumptions, the forward-looking events discussed in this Report on Form
        10-K and in other statements made from time-to-time by Citadel or its
        representatives might not occur.
 
 “Citadel,”
        the "Company," “we,” “us,” and “our” refer to Citadel Security Software Inc.
        Hercules®, AssetGuardTM, ConnectGuardTM, Secure PCTM and NetOFFTM are trademarks or
        registered trademarks of Citadel Security Software Inc. Other trademarks
        that
        may be mentioned in this Form 10-K are intellectual property of their respective
        owners.
  3
 *Table
            of Contents*
  **ITEM
        1.  BUSINESS**
 
 **OVERVIEW**
 
 Citadel
        provides enterprise vulnerability management and policy compliance and
        enforcement software solutions that enable organizations to reduce the risk
        associated with computer network vulnerabilities. Citadel develops and markets
        full life cycle vulnerability management software solutions under
        the Hercules® brand
        name powered
        by automated vulnerability remediation technology which allows enterprises
        to
        neutralize security vulnerabilities across Windows, Linux, Mac and Unix
        platforms. In
        February 2006, Citadel received a patent on its Hercules automated vulnerability
        management solution. In
        addition, Hercules 4.0 is available in two formats, as traditional enterprise
        software or as software pre-installed on a hardware appliance. With Citadel's
        solutions, enterprises are able to realize cost and process efficiencies,
        proactively manage the latest threats and vulnerabilities, and demonstrate
        compliance with corporate mandates or government legislation. Vulnerabilities
        are one of the fastest growing threats to enterprise network security, and
        since
        its inception in 1996, Citadel has been developing software products and
        services to mitigate the risk of security vulnerabilities.
 
 The
        Company's security software business was formed in 1996 as the result of
        the
        acquisition of several technology businesses operated by a business incubator
        from 1996 through May 17, 2002 at which time Citadel was spun out from its
        former parent as a stand alone company. The Company is a Delaware corporation
        headquartered in Dallas, Texas with an additional office in Reston, Virginia.
        On
        April 30, 2004 the Company’s stock moved from the OTC Bulletin Board to the NASDAQ  Capital Market
        and trades under the symbol "CDSS". Citadel’s website can be found at
        www.citadel.com. We make
        available, free of charge, our annual reports on Form 10-K ,
        quarterly reports on Form 10-Q and current reports on Form 8-K, and any
        amendments to those reports filed pursuant to Section 13(a) or 15(d) of the
        Securities Exchange Act of 1934 through our Investor Relations web site,
        as soon
        as reasonably practicable after they are electronically filed with or furnished
        to the SEC. The contents of our website are not incorporated into, or otherwise
        to be regarded as a part of, this Annual Report on Form 10-K .
 
 We
        file
        registration statements, periodic and current reports, proxy statements,
        and
        other materials with the Securities and Exchange Commission, or SEC. You
        may
        read and copy any materials we file with the SEC at the SEC’s Office of Public
        Reference at 450 Fifth Street, NW, Room 1300, Washington, DC 20549.
        You may obtain information on the operation of the Public Reference Room
        by
        calling the SEC at 1-800-SEC-0330. The SEC maintains a web site at www.sec.gov that
        contains reports, proxy and information statements and other information
        regarding issuers that file electronically with the SEC, including our filings.
 
 **SECURITY
        SOFTWARE MARKET**
 
 The
        market for software and hardware security technology has many players and
        many
        products that secure networks systems from attack, accident or failure from
        outside and inside influences. We are actively engaged in the vulnerability
        management market and more specifically, in the “policy administration,
        compliance and enforcement” and “automated vulnerability remediation” markets.
        Hercules has been positioned in the heart of the vulnerability management
        market, specifically automated vulnerability remediation. Hercules also crosses
        over into policy compliance and enforcement.
 
 We
        believe that the market drivers are in part driven by mandates, liability
        concerns and the increase in network security breaches. Examples of each
        are as
        follows:
 
 ·
              The
                  audit community is addressing the implementation of the Sarbanes-Oxley
                  Act
                  and related regulations, as well as the related liability issues.
                  We
                  believe that both the internal and external audit community have
                  begun to
                  take the position that a key part of certifying the integrity of
                  financial
                  statements is the examination of the IT infrastructure and accompanying
                  security practices that are the basis of the protection of the
                  data and
                  systems that produce the financial
                  statements.
 ·
              The
                  issue of liability attached to successful compromises that may
                  produce an
                  adverse impact on information or data, such as theft, corruption,
                  manipulation, or similar actions, that could result in a financial
                  loss to
                  investors or shareholders. We believe that some insurance companies
                  are
                  beginning to examine vulnerability assessment and remediation practices
                  of
                  their insured base during the renewal application process for various
                  forms of liability and Internet risk insurance.
  4
 *Table
            of Contents*
  ·
              A
                  renewed focus on privacy issues being brought to a higher public
                  profile
                  by more the frequent announcements of data loss or systems compromise
                  to
                  unauthorized access. California bill SB1386 requires that a person
                  or
                  business that conducts business in California, that owns or licenses
                  computerized data that includes personal information to publicly
                  disclose
                  any breach of the security of the data to any resident of California
                  whose
                  unencrypted personal information was, or is reasonably believed
                  to have
                  been, acquired by an unauthorized person. Other states are proposing
                  similar laws.
  We
        see
        the security market being driven by the following prime factors:
 
 ·
              Existing
                  and potential legislation and mandates are requiring enhanced IT
                  security
                  in government and industry. These mandates are expected to drive
                  organizations to look at the potential liability and potential
                  loss
                  created by insecure networks.
 ·
              Vulnerabilities
                  are growing in number, scope and breadth of device coverage; exploits
                  of
                  vulnerabilities by worms, viruses, backdoors and other malware
                  are
                  becoming more malicious in nature resulting in potentially more
                  severe and
                  widespread damage; and the time between the identification of a
                  vulnerability and its exploit is shrinking from months to weeks
                  or days;
                  and
 ·
              Innovative
                  automated solutions are necessary to replace manual processes and
                  point
                  solutions.
 
 Our
        strategy is to address these market drivers with the suite of Hercules products,
        new product development and strategic marketing to the customers that have
        an
        identified need for vulnerability remediation.
 
 **LEGISLATION
        AND MANDATES**
 
 Government
        mandates and new legislation are driving public and private sector enterprises
        to improve the security of their networks. Mandates and laws affecting systems
        security include:
 
 ·
              Clinger-Cohen
                  Act of 1996 establishes responsibilities for information technology
                  investment decision making and capital planning, and establishes
                  the role
                  of the federal Chief Information Officer. In 2004 as part of the
                  National
                  Intelligence Reform Act of 2004, Congress amended the Clinger-Cohen
                  Act to
                  set forth information security as a required element of federal
                  information technology investment decision making and strategic
                  planning.
 ·
              Health
                  Insurance Portability And Accountability Act Of 1996 (“HIPAA”) - Certain
                  provisions of HIPAA require organizations to protect the privacy
                  of
                  patient data.
 ·
              Presidential
                  Directive 63 (PDD 63), May 1998 - This White Paper explains key
                  elements
                  of the Clinton Administration’s policy on critical infrastructure
                  protection.
 ·
              Gramm
                  Leach Bliley Act of 1999 (“GLB”) includes provisions to protect consumers’
                  personal financial information held by financial
                  institutions.
 ·
              Security
                  of Federal Automated Information Systems, November 2000 - This
                  OMB
                  memorandum is issued as a reminder to Federal agencies and departments
                  of
                  their responsibilities for the security of their respective automation
                  resources.
 ·
              Executive
                  Order 13231: Critical Infrastructure Protection in the Information
                  Age,
                  October 2001 - This order directs a senior executive branch board
                  to work
                  with state and local governments, industry and others to create
                  and manage
                  systems for cyber security threat warning and incident analysis.
 ·
              Title
                  III of the 2002 E-Gov Act - The Federal Information Security Management
                  Act (“FISMA”) mandates that each government agency perform a risk
                  assessment of the security of their information systems and mitigate
                  the
                  risk of attack.
 ·
              Sarbanes-Oxley
                  Act of 2002 - Section 404 of the act requires that auditors of
                  public
                  companies assess the effectiveness of management’s assessment of internal
                  controls including security controls against loss of data or unauthorized
                  access to data.
 
 Each
        of
        these directives places an emphasis on securing systems, personal data and
        financial information from intentional or unintentional unauthorized access.
  5
 *Table
            of Contents*
  **VULNERABILITIES**
 
 A
        vulnerability is any weakness in systems configuration, systems services
        or
        software code that may be exploited thereby allowing the running of a malicious
        code or the unauthorized access by an individual to obtain information or
        do
        damage to an organization’s computing environment. We classify vulnerabilities
        into five classes: unnecessary services, mis-configurations, backdoors, unsecure
        accounts and software defects. Vulnerabilities are proliferating rapidly
        in
        number, sophistication and scope of coverage. CERT/CC® at Carnegie Mellon
        University’s Software Engineering Institute (http://www.cert.org) has identified
        over 22,700 unique vulnerabilities since 1995 that negatively affect computer
        systems. Vulnerabilities are the targets of such well publicized malicious
        code
        as MyDoom, SQL Slammer, Blaster, Nimda, Code Red and Sasser. These worms
        look
        for vulnerabilities to exploit in networked systems in order to do damage.
 
 In
        addition, the scope or breadth of coverage of vulnerabilities is also growing
        as
        the number of internet connected devices continues to rise. A January 2006
        Internet Domain Survey published by the Internet Software Consortium
        (http://www.isc.org) reports that the number of named internet protocol (“IP”)
        addresses is approximately 395,000,000. This is up approximately 77 million
        IP
        addresses from a year earlier survey, opening up more pathways to systems
        that
        have unremediated vulnerabilities.
 
 *Implement
        Best Practices*
 
 We
        believe that the risk of exploitation and the associated cost of a potential
        attack, can be mitigated through the implementation of best practices including
        proactive vulnerability management including hardening systems, implementation
        of security policies, frequent assessment of the security posture, automated
        remediation of identified vulnerabilities, and routine and frequent monitoring
        of compliance with the organization’s predefined security policies. The best
        practice of proactive vulnerability management is the process of independent
        assessment, compliance validation, reporting of non-compliance and then an
        independent remediation of vulnerabilities found in computer systems and
        networks. We believe that these steps are the cornerstone requirements of
        vulnerability management capabilities. The strength of sound vulnerability
        management best practices is the timely remediation of the vulnerabilities
        and
        then the ongoing monitoring of compliance with established security policies.
        Identifying, reporting and then managing vulnerabilities in any system without
        proactive remediation and compliance monitoring processes leaves that system
        as
        vulnerable to attack, accident or failure, just as if no risk assessment
        had
        been performed. Also, independent assessment and independent remediation
        functions provide information assurance due to the separation of the two
        duties.
 
 In
        order
        to ensure the highest level of security (as it relates to vulnerability
        remediation) with the least amount of interruption, we recommend adherence
        to
        best practices policy outlined below:
 
 ·
              Identify
                  Devices - Administrators should use an assessment tool or network
                  mapping
                  software that can scan all networks (and sub-networks) to determine
                  used
                  TCP/IP addresses and the associated devices connected to them.
                  Administrators should also determine which systems are most critical
                  to
                  prioritize and protect.
 ·
              Assess
                  Vulnerabilities - This is typically performed using an independent
                  vulnerability assessment tool. Hercules is interoperable with one,
                  or can
                  aggregate output data from multiple independent scanners including:
                  FoundStone® FoundScan EngineTM, Harris STAT® Scanner, ISS Internet
                  Scanner®, ISS System Scanner®, ISS Site Protector, Microsoft® MBSA,
                  nCircle IP360TM, Nessus Scanner, netVigilance SecureScout NX, Qualys
                  QualysGuardTM Scanner, Retina® Digital Security Scanner, Saint Corp. SAINT®
                  Scanning Engine and Tenable NeWT.
 ·
              Review
                  Vulnerabilities - Once the vulnerability assessment data has been
                  imported
                  into Hercules, the administrator should review the vulnerabilities
                  and the
                  remediation steps that Hercules will take to resolve the vulnerability
                  prior to approving the remediation.
 ·
              Remediate
                  Vulnerabilities - Once the vulnerabilities have been reviewed,
                  each
                  device, or group of devices, can be selected and scheduled for
                  remediation.
 ·
              Proactively
                  Manage New Vulnerabilities - Since new vulnerabilities are identified
                  daily, and users can also re-introduce vulnerabilities into their
                  environments, it is important to regularly assess and remediate
                  network
                  devices.
 
 We
        encourage our customers to adopt a proactive approach to vulnerability
        management through the adoption of Citadel's best practices policy outlined
        above.
  6
 *Table
            of Contents*
  **INNOVATIVE
        SOLUTIONS REPLACE INEFFICIENT PROCESSES**
 
 The
        2004
        E-Crime Watch survey conducted by CERT/CC® noted that the most common
        technologies deployed to combat e-crimes are firewalls (used by 98% of
        respondents), followed by physical security systems (94%) and manual patch
        management (91%). Ranking the effectiveness of various technologies, firewalls
        were considered most effective (71%), followed by encryption of critical
        data in
        transit (63%) and encryption of critical data in storage (56%). Manual patch
        management, the third most common technology in use, was rated as the single
        least effective technology (23%). Among policies and procedures, conducting
        regular security audits was listed as the most effective method (51%), and
        recording or reviewing employee phone conversations is listed as one of the
        least effective (26%).
 
 The
        manual patch management process was reported by the survey respondents as
“the
        least effective technology”. Citadel’s solutions were designed and developed to
        go far beyond the automation of the manual patch management process and in
        addition to patching, address the remediation of vulnerabilities that are
        directly related to an organization’s security policies, often associated with
        the other four classes of vulnerabilities: unnecessary services,
        mis-configurations, backdoors, unsecure accounts, as well as patch management.
        Our solutions address the maintenance of an organization’s security
        configuration posture to proactively protect its information technology
        infrastructure through the implementation of best security practices.
 
 **POLICY
        ADMINISTRATION/COMPLIANCE**
 
 The
        policy administration and compliance market is a mature market with many
        players
        including Symantec, Microsoft and Computer Associates, to name a few. This
        market has grown around the need for organizations to control access to desktop
        and system settings, thereby reducing costs associated with downtime and
        reconfiguration of systems, and the need to control unauthorized access,
        whether
        internal or external to the company, of confidential information thereby
        meeting
        organizational or mandated security and privacy requirements. Healthcare,
        Financial Services, Education and eCommerce are just a few of the industries
        that require tools to protect private information and to restrict user access
        to
        system settings that can cause down time and require extensive cost and time
        to
        repair.
  **OUR
        PRODUCTS**
 
 *HERCULES*
 
 The
        Hercules 4.0 Enterprise Vulnerability Management Suite is a comprehensive
        solution for vulnerability management, security compliance and automated
        remediation and consists of the following components:
 
 ·
              Compliance
                  Manager for compliance audit and enforcement,
 ·
                Remediation
                    Manager for vulnerability remediation,
 ·
                Patch
                  Manager for comprehensive automated patch
                  management,
 ·
              AssetGuard
                  for asset inventory and security risk assessment,
 ·
              ConnectGuard
                  for endpoint security and
 ·
              Enterprise
                  Reporting Manager for enterprise-wide reporting.
 
 Hercules
        reduces vulnerability remediation time from months to minutes, using the
        world’s
        largest library of over 25,000 proven remedies (as of March 18, 2006). Hercules
        supports remediation on multiple operating systems, including Microsoft Windows,
        UNIX, Linux and Mac OS X; is certified on Windows 2000 and 2003; and we believe
        that it is the only remediation solution that has achieved Common Criteria
        Certification, Evaluation Assurance Level 3 ("EAL 3"). In addition, Hercules
        is
        Open Vulnerability Assessment Language  (OVAL)
        and Common Vulnerabilities and Exposures (CVE) compliant.
  7
 *Table
            of Contents*
  *Compliance
        Manager*
 
 Compliance
        Manager provides network security policy audit and compliance management
        capability in one integrated solution. Compliance Manager contains automated
        processes to identify workstations and servers in a network, creates an
        inventory of the hardware, software and services on the identified devices,
        and
        then executes a compliance audit on those devices by comparing device level
        security settings against the expected security policy for those networked
        assets. In addition, Compliance Manager ships with pre-defined policy templates
        with configuration guidelines established by security bodies that address
        the
        requirements of government legislation and industry standards, such as the
        Sarbanes-Oxley Act and the Gramm Leach Bliley Act. The templates provide
        systems
        administrators with an out-of-the-box capability to perform a compliance
        audit
        to determine whether vulnerabilities exist on the networked devices as well
        as
        reporting on the compliance status of those devices.
  *Remediation
        Manager*
 
 Remediation
        Manager automates the processes for removing vulnerabilities and enforcing
        security policy compliance. This software solution manages many aspects of
        compliance enforcement and automated vulnerability remediation, including
        execution of compliance audits (in conjunction with Compliance Manager),
        the
        remediation of discovered vulnerabilities and the enforcement of IT security
        policies. Remediation Manager automatically coordinates the remediation
        technologies and processes needed to reduce the systems risk created by each
        major class of vulnerability, and offers role-based security, detailed reports,
        and a dashboard visualization of remediation activities.
 *Patch
          Manager*
 
 Hercules
          automatically acquires and manages patches from third-party, independent
          software vendors (ISVs) and provides remedies to correctly install the
          patch.
          Remedies are a series of actions, which may include one or more patches,
          taking
          into account patch inter-dependencies, pre-install requirements, and conflict
          resolution. The Citadel Security Group thoroughly tests the Hercules patch
          remedies to ensure fast and accurate patch application. The key benefits
          of the
          Hercules patch management solution are its easy-to-use interface, centralized
          agent management, a large patch remedy repository, automated remediation,
          and
          detailed reporting. In addition to providing comprehensive patch management
          solutions for multiple operating systems, including Microsoft Windows,
          AIX,
          HP-UX, Solaris, Linux and Mac OS X, Hercules also provides patches for
          many
          applications such as Microsoft Office, Internet Explorer, Front Page, SQL
          Server, anti-virus products from Symantec and McAfee, and UNIX applications
          such
          as Apache and OpenSSL.
  *AssetGuard*
 
 AssetGuard
        provides the ability to collect detailed workstation and server device
        information and store that information in the Hercules database. By providing
        complete inventory data on network connected workstations and servers,
        AssetGuard enables the administrator to perform detailed queries to rapidly
        identify devices that need vulnerability remediation or configuration policy
        enforcement. The detailed data collected allows the administrator to target
        devices for vulnerability remediation or configuration policy enforcement
        based
        on specific attributes, such as a common operating system, patch level or
        configuration.
 
 By
        comparing inventory data from a baseline to a current or historical snapshot,
        AssetGuard enables security administrators to identify changes to hardware,
        software or services running on network connected devices that might impact
        the
        security of the network. AssetGuard leverages comprehensive device information
        to provide a strategic advantage when responding to critical IT security
        vulnerabilities. AssetGuard mitigates the immediate threat of a newly emerging
        vulnerability by targeting only those devices that need remediation or security
        configuration changes to meet security configuration policies. The solution
        also
        calculates the overall risk rating for each device based upon the technical
        asset value and business impact assigned by the user. By understanding a
        network’s compliance status with security policies coupled with its risk rating,
        IT management can make informed decisions about what actions, if any, to
        take to
        improve system security.
 
 *ConnectGuard*
 
 ConnectGuard
        provides endpoint security by quarantining remote and local machines before
        allowing them to reconnect to the network, checking for security policy
        compliance, and applying remedies to out of compliance machines before releasing
        the quarantine and allowing network access. This network access control solution
        prevents infected devices from gaining access to the network, ConnectGuard
        provides the ability to defend against recurring cyber threats, and provide
        a
        more secure environment as devices disconnect and reconnect to the
        network.
 
 One
        of
        the key benefits of ConnectGuard is its flexible administration and control
        capabilities. ConnectGuard can be enabled for individual devices, groups
        of
        devices, or servers. Administrators may set network access policy for any
        protected device connecting either to the Hercules network or a foreign network.
        Foreign networks are typically those accessed in hotels, airports, or Internet
        cafes, through wireless networks or home via an Internet service provider.
        Administrators may also allow users to override ConnectGuard, giving them
        the
        option to connect to the corporate network or a foreign network without
        quarantine or remediation.
  8
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            of Contents*
  *Enterprise
        Reporting Manager*
 
 Enterprise
        Reporting Manager is an optional component that enables enterprise-wide
        reporting across multiple Hercules servers.
 
 *Hercules
        Security Appliance*
 
 We
        released for shipment a new security appliance product powered by Hercules
        was
        released for shipment in June 2005. The Hercules Security Appliance is an
        all-in-one rack-mountable appliance that offers our full suite of proven
        vulnerability management solutions. The Security Appliance includes Hercules
        Compliance Manager and Hercules Remediation Manager pre-configured and ready
        to
        install in any sized organization. With the Security Appliance, organizations
        can immediately receive the benefit of enterprise-class security compliance
        and
        enforcement, along with vulnerability assessment and remediation with minimal
        implementation requirements.
 
 The
        Hercules Security Appliance is comprised of the same components as the
        enterprise software version including Compliance Manager, Remediation Manager,
        AssetGuard, and ConnectGuard. Each component may be licensed individually
        or in
        the aggregate however, Compliance Manager is required to operate Remediation
        Manager. Enterprise Reporting Manager is also available as an add-on
        component.
 
 *Hercules
        Operating Features*
 
 *Full
        Control and Automated Flexibility*
 
 Hercules
        allows users full control over the vulnerability remediation process, enabling
        efficient aggregation, prioritization and resolution of vulnerabilities across
        a
        network. Administrators maintain complete control over scheduling remediation,
        selecting when and which vulnerabilities to be resolved or if desired, remediate
        on demand. We believe that the ever growing number of vulnerabilities, the
        increase in the maliciousness of the attacking code and the potential liability
        from an attack, now requires a twenty-four hour commitment to security
        management in order to mitigate the risk of data and financial loss. Hercules
        replaces the time consuming process of patch and security configuration often
        performed manually, one device at a time. In some cases, customers have used
        point solutions for patch management or software distribution tools to deploy
        scripts. However, neither of these tools were designed to be a comprehensive
        vulnerability management solution that address all five classes of
        vulnerabilities and access to a library of more than 25,000 tested remedies
        (as
        of March 18, 2006).
 
 *Interoperability*
 
 Hercules
        is interoperable with industry leading vulnerability assessment tools
        (“Scanners”) including Foundstone® FoundScan EngineTM, Harris STAT® Scanner, ISS
        Internet Scanner®, ISS System Scanner®, ISS SiteProtector®, Microsoft® MBSA,
        Nessus Scanner, NextaniS SecureScout SPTM, Qualys QualysGuardTM Scanner, eEye
        Retina® Digital Security Scanner, Saint Corp. SAINT® Scanning Engine, Tenable
        NeWT and nCircle IP360TM. The independency of the scanner and Hercules
        remediation provides a level of information assurance that is typically attained
        from a separation of duties. We believe that interoperability with multiple
        scanners gives Hercules distinct advantages over other solutions, including:
 
 ·
              Hercules
                  allows customers to leverage their existing investment in the
                  vulnerability assessment tools already in
                  use.
 ·
              Customers
                  have the option to add scanners for redundancy or to meet specific
                  needs
                  of internal controls and corporate or government
                  mandates.
 ·
              Interoperability
                  with multiple scanners provides for the separation of duties -
                  independent
                  assessment followed by independent
                  remediation.
 ·
              Scan
                  data from multiple scanners can be aggregated and correlated to
                  specific
                  devices or groups of devices. Remediation can then be scheduled
                  based on
                  the customer’s priority.
  9
 *Table
            of Contents*
  Hercules
        goes beyond rudimentary patch management utilities and systems configuration
        management solutions. Patch management solutions generally address only software
        defects. Some patch management solutions have a built-in scanner that finds
        only
        those vulnerabilities which the patch management solution can patch, thereby
        covering only a small percentage of security breaches on the network and
        leaving
        the system susceptible to other vulnerabilities and out of compliance with
        mandates. Some solutions apply patches indiscriminately without regard to
        having
        previously applied the patch. In addition, solutions with built-in scanners
        do
        not meet information assurance requirements for separation of duties,
        independent assessment and remediation.
 
 Systems
        configuration management and software distribution solutions were not designed
        as security solutions and therefore do not address vulnerabilities without
        a
        programmer writing scripts for each remediation. This takes time and personnel
        resources away from network operations. Alternatively, a customer using Hercules
        does not need to write the remedies to remove a vulnerability. Hercules has
        a
        repository of over 25,000 remediation actions (as of March 18, 2006) that
        have
        been thoroughly tested and are available to Hercules customers under the
        support
        services agreement offered by Citadel.
 
 In
        addition to the tactical application of remediation actions, Hercules also
        provides an intuitive framework for managing the remediation process by allowing
        customers to prioritize and aggregate vulnerability information based upon
        groups, devices or severity and provides centralized command and control
        of the
        entire remediation effort. Hercules utilizes a server for the presentation
        of
        the Hercules console and the residence of the remediation action database.
        The
        Hercules console is the central point of control for the systems administrator
        ("SA") functionality.
 
 *Architecture
        and Ease of Use*
 
 Hercules
        utilizes a 3-tier architecture to manage and control the remediation process.
        To
        illustrate the 3-tiers we will use the traditional bottoms up approach discussed
        above. The first step is for the assessment to take place utilizing any of
        the
        supported scanners. Scan data from the vulnerability assessment tools is
        then
        imported into the Hercules Server. Next, the systems administrator, or SA
        will
        execute an updated via V-Flash, our automated delivery mechanism, to access,
        via
        the Internet, the latest remedies retained in the secured V-Flash server
        that
        are continually updated by a team of Citadel security engineers. The secured
        V-Flash server contains the remedies that are then matched to the
        vulnerabilities identified by the scanners. During the V-Flash update, the
        customer also downloads new vendor patches from the vendor sites for storage
        on
        the customer’s server. Each patch is downloaded only once and stored for
        remedial action on the Hercules server thereby reducing the time for deploying
        a
        patch. Using the Hercules console, the SA will follow best practices and
        select
        the vulnerabilities to be remediated. The SA may remediate all or only selected
        vulnerabilities. Our vulnerability management best practices recommend that
        vulnerabilities be selected in groups and scheduled for remediation. This
        best
        practice allows the SA to manage the process to suit time requirements, system
        availability and to prioritize the remedy of the vulnerabilities that are
        of
        high priority as may be determined by the SA.
 
 Once
        remediation actions have been applied and completed, the SA has the option
        to
        run a differential scan to confirm the application of the remediation actions
        and to set a baseline for the next assessment and remediation process. In
        addition, detailed reports of the entire process can be run to highlight
        the
        number and severity of remediation actions taken, the severity of the
        vulnerabilities and the vulnerabilities that can only be remediated manually.
        An
        example of a remediation action that must be performed manually is a
        vulnerability that can only be remediated through the acquisition of another
        license from the vendor or one that requires a user intervention.
 
 Hercules
        is an enterprise class product that under appropriate licensing may be deployed
        with vulnerability assessment tools and Hercules consoles anywhere in a network,
        including across geographies. Access to V-Flash updates is available over
        the
        Internet or through offline updates for an additional fee. All communication
        between the various Hercules endpoints is performed using the industry standard
        Hypertext Transfer Protocol (“HTTP”) and Simple Object Access Protocol (“SOAP”)
        protocols.
 
 *Vulnerability
        Intelligence Gathering and the Remedies*
 
 A
        vulnerability is any weakness in system configuration, systems services or
        software code that may be exploited thereby allowing the running of a malicious
        code or the unauthorized access by an individual to obtain information or
        do
        damage to an organization’s computing environment. An exploit is an identified
        action in the form of a worm, virus, malware or other software code that
        has
        been written by a hacker to attack a specific vulnerability.
 
 Our
        Remediation Security Group monitors the sources of potential attack information
        (such as Internet Relay Chat (“IRC”) channels and alerts from our scanning
        partners) and collects and compiles vulnerability data, creates new remedies
        and
        makes them available to our customer base on a routine basis during the term
        of
        the customer support agreement. Less than 20-30% of vulnerabilities are related
        to software defects which are repaired by installing a software patch. The
        remaining 70 to 80% of vulnerabilities are related to unsecured accounts,
        backdoors, unnecessary services and mis-configurations which collectively
        define
        the five classes of vulnerabilities. These last four classes of vulnerabilities
        require configuration changes and settings to be revised.
  10
 *Table
            of Contents*
  When
        new
        vulnerabilities are identified the our team of security engineers known as
        the
        Remediation Security Group, researches the possible solutions and writes
        a
        remedy for the identified vulnerability. The remedy is then tested before
        it is
        made available to our customers. Using V-Flash, our automated delivery
        mechanism, the customer can download the new remedies through the Hercules
        server to provide their networks access to the latest source of remedies
        available. In addition to delivering new remedies, our Remediation Security
        Group also continually monitors and updates research information and URL
        links
        for patches and related content to ensure that all links and research material
        are timely and relevant.
 
 In
        addition to V-Flash delivered remedies, Hercules provides the functionality
        for
        customers to write their own remedies or customize existing remedies using
        a
        graphical interface. This interface provides all the power and flexibility
        in
        writing remedies that is available to Citadel’s in-house security team. Using
        this feature, our customers can develop and deliver remedies for custom
        applications. Our Remediation Security Group has used this capability to
        create
        baseline configurations such as the organization known as SANS (an acronym
        for
        SysAdmin, Audit, Network, Security) and National Security Agency (“NSA”) Guides
        or other configuration guideline standards. These configuration templates
        ship
        with the Hercules product.
 
 *Hercules
        Certifications*
 
 The
        Common Criteria (“CC”) certification project was developed by the United States,
        Canada and Europe to establish a set of international standards for information
        security products that became ISO International Standard 15408 in 1999. The
        United States is represented within the CC Project by the National Information
        Assurance Partnership (“NIAP”), a joint National Institute of Standards and
        Technology (“NIST”) and NSA project. The CC provides a comprehensive, rigorous
        method for specifying security functionality and assurance requirements for
        IT
        security products (or classes of products).
 
 On
        January 1, 2001, the federal government issued a policy stating that preference
        was to be given to the acquisition of Commercial Off-The-Shelf (“COTS”)
        Information Assurance (“IA”) IT products (to be used on systems entering,
        processing, storing, displaying, or transmitting national security information)
        which had been evaluated and validated, as appropriate, in accordance with:
 
 ·
              The
                  International Common Criteria for Information Security Technology
                  Evaluation Mutual Recognition Arrangement;
 ·
              The
                  National Security Agency (NSA) /National Institute of Standards
                  and
                  Technology (NIST) National Information Assurance Partnership (NIAP)
                  Evaluation and Validation Program;
                  or
 ·
              The
                  NIST Federal Information Processing Standard (FIPS) validation
                  program.
 
 Effective
        July 1, 2002, the federal government issued a policy stating that the
        acquisition of all COTS IA and IA-enabled IT products to be used on the systems
        specified above would be limited only to those which have been evaluated
        and
        validated in accordance with the criteria, schemes, or programs specified
        by CC,
        NIAP or FIPS.
 
 Recognizing
        that CC certification was required for defense department agencies to purchase
        IT security products, Hercules was registered for Common Criteria evaluation
        in
        March 2003. Products undergoing Common Criteria testing are required to have
        an
        independent lab certify the product. The testing is done according to strict
        criteria and designated an evaluation assurance level (“EAL”). The Hercules
        product achieved EAL 3 certification through Electronic Warfare Associates
        -
        Canada, Ltd ("EWA") on March 1, 2004. Citadel has a continuous maintenance
        program with EWA to ensure future updates and revisions are reviewed and
        re-evaluated as needed. There are no current plans to seek a higher level
        of
        compliance; however, as major versions of the product are released in the
        future
        we will consider the need to increase the level of compliance which is
        appropriate to the then current installed base.
 
 Hercules
        has undergone testing at the US Army’s Information Systems Engineering Command,
        Technology Integration Center (“TICLabs”) at Ft. Huachuca, Arizona. TICLabs
        performs independent product evaluations and evaluated the functionality,
        manageability and security of Hercules that would be applicable and valuable
        to
        the Department of Defense. Hercules was put through a rigorous set of test
        requirements, passing each of the requirements tested. TICLabs concluded
        that
        Hercules performed as expected and automates the remediation process as
        represented in the technical specifications.
  11
 *Table
            of Contents*
  Hercules
        achieved certification for installation on Windows Server 2000 and 2003 Standard
        Editions to support remediation of those environments. This certification
        demonstrates to customers that Hercules provides the highest levels of
        reliability running on Windows and automating the mitigation of vulnerabilities
        identified on the Windows family of products. In addition, Citadel attained
        Microsoft Gold Certification Partnership status demonstrating Citadel’s
        competence on the latest Microsoft technologies and a commitment to delivering
        high quality solutions for the Windows platform. The Microsoft Gold Certified
        Partner Program was established to identify Microsoft Certified Partners
        who
        have proven their commitment and expertise in building or delivering solutions
        based on Microsoft technologies. By becoming a Gold Certified Partner, we
        demonstrated our expertise in the remediation of Windows platforms and believe
        we will now be able to leverage Microsoft’s referral program to customers
        looking for a complete vulnerability remediation solution.
 
 *Product
        Pricing*
 
 With
        the
        release of Hercules 4.0 in June 2005 we introduced a new pricing model for
        the
        Hercules Security Appliance and the Hercules Enterprise Software options.
        Compliance Manager may be licensed and priced separately from Remediation
        Manager, or they may be licensed and priced together under suite pricing.
        The
        suite list price is generally less than the aggregate of the individual
        component prices. Pricing options include:
 
 ·
              Usage
                  Based pricing combines a flat monthly service fee with a “pay as you use”
                  transaction price for each compliance check and each remediation
                  executed.
                  This offers the customer a low cost of entry and a manageable usage
                  fee
                  based on the number of transactions executed during a billing period,
                  typically a month. Content (i.e., access to V-Flash remedies),
                  standard
                  customer support services, and telephone support are included in the
                  usage based pricing. Twenty-four hour support services are available
                  for
                  an additional fee based on a percentage of the transaction
                  fee.
 
 ·
              Subscription
                  pricing in 1 to 3 year increments (generally paid annually in advance
                  of
                  the subscription start date) may be selected for any of the Hercules
                  components either as enterprise software or on the appliance. Pricing
                  varies by the number of devices in the customer's network. Subscription
                  pricing offers the customer a flat monthly fee that fits within
                  the
                  customer's operating budget constraints. Content (i.e., access
                  to V-Flash
                  remedies), standard customer support services, and telephone
                  support are included in the subscription pricing. Twenty-four hour
                  support services are available for an additional fee based on a
                  percentage
                  of the subscription fee.
 
 ·
              Perpetual
                  License pricing is a one-time perpetual license fee for Hercules
                  delivered
                  either as enterprise software or on the appliance. Perpetual license
                  pricing offers the customer complete control and maximum usage
                  of the
                  software with a fixed one-time license fee. Appliance pricing is
                  based on
                  increments of 500, 1000 or 1500 networked devices. Multiple appliances
                  may
                  be licensed for customers with networks consisting of more than
                  1500
                  devices who desire the appliance format in their network architecture.
                  Enterprise software under a perpetual license fee is based on the
                  number
                  of networked servers and workstations within a customer's network
                  with
                  prices set in device ranges of 1,500 to 5,000, 5,001 to 10,000,
                  and 10,001
                  to 25,000 devices. Enterprises with over 25,000 networked devices
                  fall
                  into pricing for enterprise-wide licensing which is based upon
                  the
                  topology and geography of the enterprise-wide network. Perpetual
                  license
                  customers are required to add customer support and content
                  contracts for telephone support and V-Flash remedies at list prices
                  ranging from 20% to 30% of the perpetual license
                  fee.
  *SECURE
        PC*
 
 Secure
        PC
        provides advanced features that allow security administrators to create,
        manage
        and deploy security policies for Windows computing environments. Secure PC
        establishes user and group profiles to enforce workstation and server security
        policies from a single point of control. These security policies can be
        configured to prevent changes to system settings and installation of
        unauthorized software. Secure PC “hardens” system files as a first line of
        defense against viruses, malicious code and unauthorized access or theft
        of
        confidential information. Hardening of files is crucial to defending against
        intentional and unintentional security breaches.
  12
 *Table
            of Contents*
  Secure
        PC
        offers support for computers running Microsoft Windows versions 95, 98, ME,
        NT,
        2000 and XP. Its advanced set of features allows administrators to apply
        security policies to users or groups of users within an organization. We
        sell
        this product in two configurations, Secure PC Workstation and Secure PC Network.
        Secure PC Workstation is designed for home, educational or commercial
        non-networked computers. Secure PC Network is designed for environments with
        multiple computers connected to a Windows or Novell network. The network
        version
        of Secure PC has been designed to scale dynamically within network environments
        ranging from departmental local area networks (LANs) to global wide area
        network
        (WAN) capacity and includes tools that provide remote installation and
        configuration of the Secure PC client software. Additional benefits include
        File
        and Folder Access Control, Prevent Un-Authorized Software Installation and
        Application Control. Secure PC is offered to our customers under a perpetual
        license. In March 2006 we announced that effective March 31, 2007 SecurePC
        will
        no longer be supported. We do not expect that this decision will have a material
        adverse effect on the results of operations or financial condition.
 
 *NETOFF*
 
 NetOFF
        allows administrators to secure unattended workstations from unauthorized
        access. A PC that stays connected to a network while users attend meetings
        - or
        leave the office for the night - is a wide-open door to the network. Customer
        files, patient records, classified information and proprietary documents
        are
        open to disclosure and theft through unattended PCs. With NetOFF, unattended
        PCs
        are a reduced security risk.
 
 NetOFF
        is
        designed to protect a network by shutting down unattended client PCs
        automatically after a specified period of inactivity. Through NetOFF,
        administrators can define policies that trigger a graceful logoff of unattended
        or inactive workstations. Through a graceful logoff, all user data is saved,
        applications are closed and workstations are logged off the network. Network
        administrators may also use NetOFF to shut down PCs to enhance backup operations
        or assist with the distribution of new software and anti-viral updates. NetOFF
        is available for Windows operating environments including Windows 2000, Windows
        2003 and Windows XP desktop PCs. NetOFF is offered to our customers under
        a
        perpetual license. In March 2006 we announced that effective March 31, 2007
        NetOFF will no longer be supported. We do not expect that this decision will
        have a material adverse effect on the results of operations or financial
        condition.
 
 **PRODUCT
        DEVELOPMENT**
 
 In
        developing new Citadel security products, we strive to meet the following
        standards in product development:
 
 ·
              Standards
                  Compliance and Network Compatibility. Our products comply with
                  industry
                  standards and are designed to be compatible with the leading operating
                  systems, including Microsoft, Unix and Linux variants. To that
                  end, our
                  products are currently developed using standard tools such as XML,
                  C++,
                  C#, Microsoft.Net and various platform dependent toolkits.
 ·
              Ease
                  of Use. Our products are designed to function without extensive
                  and
                  continual user involvement. The aim is to simplify, not complicate,
                  the
                  user’s work environment
 ·
              Commitment
                  to Quality Assurance including Common Criteria (“CC”). On March 1, 2004,
                  Hercules was certified under Common Criteria Evaluation Assurance
                  Level 3
                  (“EAL 3”).
 
 We
        plan
        to capitalize on our existing security and network administration technology
        and
        our expertise in research, development and marketing to expand our business
        into
        products that address the growing market for security. Our internal development
        work remains the key component of bringing new product lines to market. In
        addition, we may pursue an alliance strategy to develop new products. Our
        internal research and development staff is currently working on the development
        of the next version of Hercules with an expected release in the second quarter
        of 2006. This planned release is expected to include enhancements to our
        UNIX
        platform support, scanner import functionality and patch auditing. Schedules
        for
        the development and release of high technology products are inherently difficult
        to predict, therefore there can be no assurance that we will achieve targeted
        customer shipment dates for any of our products, or at all. In addition,
        we may
        pursue acquisitions of technologies or products that complement our products
        and
        product strategy. Acquisitions of technology are risky and we may not be
        successful in finding the right technology products or, once acquired,
        integrating the new technology with existing development projects.
 
 We
        capitalize software development costs at the time technological feasibility
        is
        established, which generally occurs at the time the design and analysis plan
        is
        completed and programming begins. The costs and expenses that qualify for
        capitalization primarily consist of salaries, benefits and the direct and
        indirect costs associated with the development staff or with the specific
        development projects. Costs and expenses that do not qualify for capitalization
        and all costs and expenses incurred prior to technological feasibility are
        expensed and classified as product development expense. During the year ended
        December 31, 2005, we incurred $2,443,864 of product development expense,
        which
        is net of $2,574,984 of capitalized software development costs. During the
        year
        ended December 31, 2004, we incurred product development expenses of $1,995,612,
        net of $3,261,210 of capitalized software costs.
  13
 *Table
            of Contents*
  Capitalized
        software development costs and product development expense are expected to
        remain at the current levels of capitalization and expense during the year
        2006.
        However, changes in product plans, technologies or in development engineering
        staffing levels can alter these expectations. Historical product development
        expense and the capitalization rate have fluctuated from period to period,
        and
        may continue to fluctuate from period to period in the future depending upon
        the
        number and status of software development projects that are in process and
        the
        related number of employees assigned to those projects. At December 31, 2005,
        we
        employed 23 software product development and quality assurance engineers,
        including our Executive Vice President of R&D and our Chief Technology
        Officer.
  **SALES,
        MARKETING AND BUSINESS DEVELOPMENT**
 
 As
        is
        common in the software industry, our customers are granted a license right
        to
        use our technology, as opposed to owning our technology. We receive a license
        fee in return for granting this right. Each server and desktop on which our
        software is installed must be licensed for use of the software. Therefore,
        each
        customer enters into a license agreement stating the terms under which our
        software may be used. The license agreement is displayed on a screen during
        the
        software installation process where the customer indicates acceptance to
        the
        terms of the license. A paper copy of the license is included in the product
        documentation shipped to the customer. In some cases, the customer will sign
        a
        software license agreement or we will sign a master agreement with a customer
        for an enterprise-wide software license. An enterprise license offers the
        customer a set number of licenses that may be deployed across the customer's
        entire enterprise. In some arrangements, the enterprise license allows the
        customer an unlimited number of license copies. A customer may license our
        products for perpetual use or for limited terms under a subscription. Generally,
        license fees are computed based on the mix of servers and desktops that make
        up
        the customer's network. Discounts are available for volume purchases.
 
 In
        addition to technology licenses, we offer one-year renewable customer support
        agreements generally referred to as maintenance or post contract customer
        support agreements. Customers have an option to subscribe to telephone support,
        software updates and the Hercules V-Flash remedies separately or in combination.
        Signing a customer support agreement for all three services is more cost
        effective for the end user customer. Telephone support is staffed by security
        engineers that are knowledgeable about the use of our products. Customers
        may
        contract for standard support available during normal business hours or for
        a
        premium payment, customers may sign up for 24 hour, 7 days a week ("24/7")
        support availability. Support cases are opened for each telephone support
        call
        and the cases are tracked through the customer support system until the solution
        is determined and the case is closed. Software updates are made available
        to
        customers on a "when and if available" basis (i.e. when needed as determined
        by
        development management and not on a guaranteed time schedule). Software updates
        include hotfixes, point releases and new version releases of our products.
        Software updates do not include the V-Flash remedies which are available
        to our
        Hercules customers. Our library of over 25,000 remedies (as of March 18,
        2006)
        is available to our Hercules customers separately or in combination with
        the
        telephone support and software updates.
 
 Even
        though our technology is licensed and not sold, we refer to the persons who
        license our products to our end user customers as our “sales organization”. The
        sales organization consists of experienced sales representatives who have
        been
        trained on the use of each of our products. Our sales representatives are
        assigned sales quotas and territories by geography or by industry. At December
        31, 2005, we employed 17 quota carrying sales representatives in regions
        around
        the United States, including regional vice presidents and inside telesales
        representatives. We also employed 2 quota carrying agents who cover territories
        in Europe and the Middle East. This total of 19 quota carrying sales
        representatives compares to 25 quota sales representatives at December 31,
        2004.
        The regional sales representatives report to regional vice presidents covering
        the United States in two main territories, east and west, as well as a sales
        unit that covers federal government agencies and state and local governments.
        The sales representatives are supported by a team of software pre-sales
        engineers. These pre-sales engineers assist with the technical sales component
        of the sales process and are responsible for conducting product demonstrations
        to prospective customers and responding to the potential customer's technical
        questions raised about the product's use within the customer's IT environment.
  14
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            of Contents*
  Marketing
        efforts are targeted to provide qualified leads and leverage the opportunities
        presented by our vulnerability assessment partners. Sales leads are generated
        through various marketing activities including trade shows, conferences,
        webinars, direct mail campaigns, partner relationships and other marketing
        programs. The marketing department also includes 3 inside telesales
        representatives whose activities are aimed at generating leads for the sales
        organization and closing small dollar amount sales directly. The Citadel
        website
        is a marketing tool that contains the most up to-date product and company
        information and can be found at www.citadel.com .
        From
        time-to-time we participate in partner events and regional seminars.
 
 Sales
        leads are qualified by inside sales representatives gathering such
        characteristics from potential customers as size of the customer’s organization
        and network infrastructure, geographic location and whether an attack or
        other
        event had occurred on the customer’s systems. All sales leads are entered and
        tracked utilizing a web based customer relationship management system. Once
        the
        lead is qualified, the opportunity is assigned to a territory sales
        representative who arranges for meetings with the customer, a product
        demonstration and eventually moves the opportunity to closure. In addition,
        our
        executive management team is highly involved in the selling process.
 
 Each
        sales representative is assigned a sales quota and receives incentive
        compensation based on achieving the assigned sales target, in addition to
        a base
        salary and benefits package. Higher incentive compensation may be earned
        when a
        sales representative exceeds the assigned sales quota. Special incentives
        may be
        offered from time-to-time to encourage the sales team to achieve specific
        sales
        goals.
 
 Some
        sales to agencies of the federal government are facilitated through prime
        government contractors such as BAE Systems Information Technology, Northrop
        Grumman Information Technology, Hewlett Packard and RS Information Systems,
        as
        well as approved resellers to the federal government including Apptis, Inc.
        and
        Merlin Technical Solutions. Government agencies may also purchase our products
        and services on General Services Administration (“GSA”) contract schedule 70,
        contract no. GS-35F-5907H. We are authorized to sell under the Procurement
        of
        Computer Hardware and Software (“PCHS”) contract for purchasing by the hospitals
        under the Department of Veteran Affairs. In addition, we are a Catalog
        Information Systems Vendor for Texas (Vendor No. 1752873882000) and are listed
        on the California Multiple Award Schedules (CMAS) for sales to the state
        agencies in California. In January 2004, Hercules was added as an approved
        product under the US Army’s Blanket Purchase Agreement under CECOM Acquisition
        Center, Southwest Operation Office (CAC-S), Ft. Huachuca, AZ.
 
 Our
        business development personnel have been engaged in building strategic alliances
        related to marketing and licensing our software products. With Hercules,
        we are
        seeking to work with companies which have technologies for scanning for
        vulnerabilities within a network structure. We have established relationships
        with several scanning technology companies including CSC, Foundstone (now
        part
        of McAfee), Harris Corporation, Internet Security Systems, nCircle, and Qualys,
        Inc. By entering into strategic alliances with these companies, we seek to
        leverage their existing installed customer base to sell Hercules and broaden
        their opportunity to sell more scanners.
 
 Through
        alliances and marketing relationships, we believe that the number of leads
        that
        can be cultivated by the Citadel sales team will increase. By working with
        the
        sales teams of these third parties, we believe that we can increase the revenue
        generated from Citadel products without adding significant cost, and provide
        qualified customer leads for our inside sales staff. We believe that our
        direct
        selling model, coupled with targeted marketing activities, focused alliance
        efforts with vulnerability scanning providers, and federal government
        contracting vehicles will enable Citadel to increase market penetration into
        large corporate and government enterprises. Increased market penetration
        should
        increase awareness of our vulnerability management and policy compliance
        solutions and lead to increased revenue; although no assurances can be made
        that
        this objective will be achieved.
  15
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            of Contents*
  **CUSTOMER
        SUPPORT**
 
 We
        believe that a broad range of services are essential for a successful continuing
        relationship with our customers. Customer support services are provided under
        a
        customer support services agreement under such policies as are in effect
        on the
        date customer support services are ordered. There are three components to
        customer support that may be contracted individually or in combination. These
        components include telephone support, software updates and Hercules V-Flash
        remedies.
 
 Customer
        telephone support services are renewable annually and may be purchased in
        two
        tiers:
 ·
              Standard
                  Customer Support Services provides the customer with a toll-free
                  telephone
                  number for problem reporting available 7 a.m. to 7 p.m. Central
                  Time
                  Monday through Friday excluding holidays.
 ·
              Premium
                  Customer Support Services provides the customer 24 hour a day,
                  365 days a
                  year access to support engineers with a toll-free telephone number
                  for
                  problem resolution.
 
 Software
        updates are made available to customers under contract support plans on a
        "when
        and if available" basis (i.e. when needed as determined by development
        management and not on a guaranteed time schedule). Software updates include
        hotfixes, point releases and new version releases of our products. Software
        updates do not include the V-Flash remedies which are available to our Hercules
        customers. Our library of over 25,000 remedies (as of March 18, 2006) is
        available to our Hercules customers separately on a subscription basis or
        in
        combination with the telephone support and software updates purchased under
        a
        customer support services agreement.
 
 All
        Support Service Levels include levels of web and e-mail support. All customers
        have access to our web site which includes a series of frequently asked
        questions addressing the most commonly encountered issues and their resolutions.
        All customers who have purchased a support plan have access to customer service
        engineers through the Citadel Support Portal. The support portal allows the
        customer to log a case and then track the progress of the case. They also
        have
        access to all their open and closed case history in the portal. In addition,
        they have access to all published solutions through the support portal.
 
 The
        Citadel Customer Support Center is staffed by highly qualified support
        engineers. Our support engineers assist the customer in diagnosing and resolving
        problems experienced with using our products. Those problems that cannot
        be
        resolved by our support engineers are escalated to a team of level 2 customer
        support engineers who have the ability to examine the source code, replicate
        the
        customer’s environment and test the source code for confirmation of the
        customer’s issue. Source code that needs to be modified is escalated to the
        development team who then schedules and develops a software hotfix. Once
        tested,
        the hotfix is made available to all customers who request the update from
        customer support.
  The
          Remediation Security Group is a team of security engineers that support the
          Hercules solution by writing and testing the content of the Hercules remedy
          database. This team monitors intelligence sites on the Internet, converses
          with
          our scanning partners and scans research from third party intelligence
          sources
          to identify new vulnerabilities. When new vulnerabilities are identified
          and
          confirmed, the team writes the remedies. Once written, the remedies are
          tested
          across all the platforms supported by Hercules. The remedies are then released
          to the V-Flash database for deployment to our installed customer base.
          This
          service is provided to our customers under the terms of the customer support
          agreement that is sold with the software license. As a result, the costs
          and
          expenses associated with this service are not eligible for capitalization
          under
          the accounting rules for capitalization of software development costs.
          At
          December 31, 2005 we employed 8 security engineers in the Remediation Security
          Group.
 **TRAINING**
 
 We
        offer
        training courses for Hercules administrators. We recommend that all system
        administrators go through a series of training courses we offer. Training
        courses are available as instructor led, computer based, or virtual on-demand
        classrooms, in which students are assigned a virtual network for the purpose
        of
        training on the best practices and live use of the Hercules product. The
        currently available product training classes are listed below:
 
 ·
              Online
                  Hercules Operator Training
 This
        course provides an understanding of the concepts and skills necessary to
        perform
        the Hercules remediation process, following best practices procedures. The
        students, through the use of interactive virtual machines (VMs), configure
        Hercules to remediate a network based on imported scan data and network
        topology.
 
 ·
              On
                  Site- Hercules Operator Training
 This
        course provides an understanding of the concepts and skills necessary to
        perform
        the Hercules remediation process, following best practices procedures. This
        course is comprised of hands-on training with Hercules. The students will
        configure Hercules to remediate a network based on imported scan data and
        network topology.
  16
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            of Contents*
  ·
              Hercules
                  Advanced Training Course
 This
        course provides an understanding of the concepts and skills necessary to
        architect, implement and customize your Hercules installation. This course
        focuses on the following:
 o
              Set-up
                  of the enterprise architecture
 o
              Understanding
                  the internal Hercules architecture
 o
              Building
                  custom remedies and
 o
              Troubleshooting
 
 **PROFESSIONAL
        SERVICES**
 
 We
        launched our professional services organization and related offerings in
        2004.
        At the option of the customer, services provided include:
 
 ·
              Planning
                  and Implementation
 Planning
        and Implementation Services are designed for customers who require assistance
        throughout the complete implementation and deployment of Citadel’s software
        products. These services are ideal for large enterprises and government
        agencies, business partners and system integrators that utilize Citadel’s
        professional services staff to support their product deployment efforts and
        to
        perform any additional customization services. Citadel’s Professional Services
        utilize a proven methodology to plan, design, develop and implement our software
        products in our customers’ environments. We seek to demonstrate a commitment to
        shared risk and accountability through fully scoped statements of work,
        measurable results and deliverables-based pricing.
 
 ·
              Training
                  Services
 Citadel
        Security Software provides extensive training programs, including self-paced
        online courses and instructor-led, training courses.
 
 ·
              Consulting
 Consulting
        Services are provided to customers who require strategic security information
        consulting before and after product deployment. Citadel professional services
        can assist customers in the following areas:
 o
              Life
                  Cycle Vulnerability Management,
 o
              Assessment
                  Services,
 o
              Risk
                  Assessment,
 o
              Incident
                  Response,
 o
              Penetration
                  Testing,
 o
              Operational
                  Forensics, and
 o
              Network
                  Vulnerability Assessment.
 
 During
        2005, our significant services engagements included work performed for MCI,
        Inc,
        the Department of Veteran Affairs, Citigroup, and Defense Information Systems
        Agency ("DISA"). At December 31, 2005 we had services engagements in process
        or
        scheduled at Northrop Grumman, Fifth Third Bank, and DISA among other customer
        engagements.
 
 **COMPETITION**
 
 We
        believe that Hercules is the only automated vulnerability remediation solution
        today that addresses all five classes of vulnerabilities with a library of
        over
        25,000 V-Flash remedies. Companies that create patch management utilities
        sometimes compete with Hercules at the low end of the security software market
        where customers may be looking for a point solution and quick fix to patch
        their
        networks. However patching is only one of the five classes of vulnerabilities
        that affect the enterprise. Patch management utilities are generally not
        scalable to a large enterprise network where we believe Hercules is a more
        appropriate security solution. Companies that have products that compete
        at the
        low end price points of the market include BigFix, Inc., PatchLink Corporation,
        Shavlik Technologies and Secure Elements, among others.
 
 We
        have
        also seen customers use configuration management or software distribution
        applications as security management tools. Customers must write the scripts
        to
        manage their vulnerabilities which prove costly in terms development time
        and
        lost productivity. While it is possible to use these solutions to manage
        vulnerabilities, we believe that our library of over 25,000 remedies (as
        of
        March 18, 2006) provides Hercules an important competitive advantage over
        these
        solutions. Companies at this end of the market include Altiris, Inc., Computer
        Associates, IBM Tivoli and Microsoft, among others. The security software
        industry is intensely competitive and rapidly changing and we expect that
        in the
        future other companies may develop vulnerability management enterprise solutions
        that will compete directly with Hercules.
  17
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            of Contents*
  In
        desktop policy administration, we compete against large companies (such as
        Microsoft, Novell, Cisco, Computer Associates, Internet Security Systems,
        McAfee, Symantec and others) that offer network and desktop PC security and
        administration software as a segment of their businesses. We also compete
        with a
        large number of small companies that offer security and administration software
        for networks and desktop PCs. Some of these competitors offer products that
        address multiple aspects of network and desktop security and administration
        and
        management, while other competitors market products that provide narrow
        solutions.
 
 Many
        of
        our competitors have longer operating histories and significantly greater
        financial, technical, sales, marketing and other resources, as well as greater
        name recognition and a larger installed customer base, than we do. Further,
        many
        competitors have established relationships with our customers and end users
        of
        our products. Our competitors could, in the future, introduce products with
        more
        features and lower prices than our product offerings. These companies could
        also
        bundle existing or new products with other, more established products in
        order
        to compete with us.
 
 **CUSTOMERS
        AND PRODUCT LICENSING**
 
 We
        license our software products to corporations, government organizations and
        entities that need to reduce computing vulnerabilities and manage security
        and
        privacy policies within their computing environments. Our products are licensed
        for perpetual use on standalone computers, within a single network, or within
        a
        network of computers across single or multiple customer sites. Our license
        agreement restricts the use of the software to a single computer or designated
        network or site(s) and generally prohibits the reproduction, transfer, reverse
        engineering and disclosure of the program code. A form of perpetual license
        that
        we offer is an enterprise-wide license. This form of license allows the customer
        to deploy a contractually set number of licenses anywhere in their enterprise.
        In some very large customers accounts, we may allow the customer unlimited
        licenses to deploy across their networks. The terms and conditions of use
        of the
        enterprise-wide license is generally set forth in a written enterprise license
        agreement.
 
 In
        addition to perpetual licenses, we offer our customers a subscription to
        use our
        products over a contractual period of time, generally from one to five years.
        At
        any time during the subscription period, the customer may opt to pay an
        additional fee to convert the subscription to a perpetual license.
 
 For
        the
        years ended December 31, 2005 and 2004, revenue from the DISA accounted for
        approximately 32% and 39% of total revenue, respectively. For the years ended
        December 31, 2005, 2004 and 2003, revenue from hospitals under the Department
        of
        Veterans Affairs accounted for approximately 21%, 41% and 67% of total revenue,
        respectively. No other customers individually accounted for more than 10%
        of
        total revenue for 2005 or 2004. Although these customers represent a large
        portion of our total revenue, we do not expect to rely on any one customer,
        group of customers or industry segment for a significant and recurring source
        of
        revenue. We foresee that revenue from the licensing of Hercules will be derived
        from large enterprises consisting of Fortune 2000 companies and large government
        agencies. Therefore any one customer or groups of customers in the same industry
        segment could be a significant component of revenue in any future quarter
        or
        year. We also expect that in the future our customers will enter into annual
        renewal contracts for post sale customer support services. However no assurance
        is provided that these expectations will be met.
 
 Customers
        that represent over $50,000 in revenue during 2005 include:
 
 ·
              Argosy
                  Gaming Company
 ·
              Carreker
                  Corporation
 ·
              Children’s
                  Hospitals and Clinics
 ·
              Citigroup,
                  N.A.
 ·
              Department
                  of Veterans Affairs
 ·
              DISA
                  - Defense Information Systems
                  Agency
 ·
              Howard
                  University Hospital
 ·
              IXIS
                  Capital Markets
  18
 *Table
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  ·
              Iron
                  Mountain Information Management
 ·
              MCI,
                  Inc.
 ·
              OfficeMax
 ·
              Providence
                  Health Care Systems
 ·
              Raytheon
                  Company
 ·
              State
                  Street Corporation
 ·
              Supermercados
                  Internacionales HEB
 ·
              U.
                  S. Army
 ·
              Wachovia
                  Bank
 
 **INTELLECTUAL
        PROPERTY RIGHTS**
 
 We
        regard
        some features of our software and documentation to be proprietary intellectual
        property. We have been and will be dependent in part on our ability to protect
        our proprietary technology under copyrights, trademarks and patents. We will
        seek to use patents, copyright, trademarks, trade secret laws, confidentiality
        and assignment of invention agreements and other measures if necessary to
        establish and protect our rights in our proprietary technology. We have filed
        five United States patent applications and four related Patent Cooperation
        Treaty patent applications, one of which has been the basis for eleven pending
        foreign patent applications with respect to some of our business applications
        and intellectual property rights related to our Hercules software. On February
        14, 2006 the United States Patent and Trademark Office issued U.S. Patent
        No.
        7,000,247 (the “’247 Patent”) to Citadel for our proprietary Hercules
        technology. On March 2, 2006, Citadel received notification that an unidentified
        third party petitioned the United States Patent and Trademark Office to
        re-examine the ‘247 Patent. Also, as detailed in the “Legal Proceedings” section
        below, the ‘247 Patent is the subject of patent litigation with Secure Elements,
        Inc (Secure Elements).
 
 We
        do
        have one registered copyright on the code for the Hercules software, but
        this
        does not change the conclusion that we cannot be certain that others will
        not
        develop substantially equivalent or superseding proprietary technology.
        Furthermore, there can be no assurance that any confidentiality and assignment
        of invention agreements between our employees or third parties and us will
        provide meaningful protection of our proprietary information in the event
        of any
        unauthorized use or disclosure of such proprietary information. We also have
        four trademarks registered with the United States Trademark Office as well
        as
        thirteen pending trademark applications, including three allowed applications.
        While the statutory rights in the registered trademark and the common law
        rights
        in the trademarks underlying the pending applications may provide a basis
        for
        protection against competitors using confusingly similar trademarks, we cannot
        be certain that others will not use similar trademarks and will not compete
        with
        substantially equivalent or superseding proprietary technology.
 
 There
        can
        be no assurance that we will not become the subject of claims of infringement
        with respect to intellectual property rights associated with our products.
        In
        addition, we may initiate claims or litigation against third parties for
        infringement of our proprietary rights or to establish the validity of our
        proprietary rights. Any such claims could be time consuming and could result
        in
        costly litigation or lead us to enter into royalty or licensing agreements
        rather than disputing the merits of such claims.
 
 **EMPLOYEES**
 
 As
        of
        December 31, 2005, we employed 94 professionals. We employed 45 professionals
        in
        sales activities including, field sales, telesales, professional services,
        training, business development, pre-sales engineering, lead generation and
        marketing. Included in the 45 were 19 quota carrying sales representatives
        focused on the commercial and government markets, including 2 regional or
        industry segment sales managers, 9 sales engineers that provide pre-sales
        support the commercial and government sales organizations, 2 sales management
        personnel, 5 professionals focused on marketing and lead generation, 4 employees
        managed the commercial and government business development activities and
        6
        employees were in professional services and training activities. Product
        development and quality assurance had 23 professionals, customer support
        employed 4 engineers and the remediation security group employed 8
        professionals. We also employed 14 people employed in the functional areas
        of
        information technology, finance, administration and general management including
        our CEO and CFO. At December 31, 2004 we had 138 employees, including 61
        professionals in sales, sales engineering, customer support and marketing,
        63 in
        product development, and 14 people in information technology, finance, and
        administration.
  19
 *Table
            of Contents*
  Competition
        for employees in the software industry and specifically the security software
        market is highly competitive. We offer competitive compensation packages
        and
        benefits but companies with greater resources than ours may have a competitive
        hiring advantage. The employees are not organized under a union and we believe
        that the relationship with our employees as a group is good. Our 2006 operating
        plan calls for our hiring to level off at between 100 and 110 personnel.
        We
        believe that this level of employee resources is sufficient to achieve our
        operating plan during 2006 but there can be no assurances that changes in
        competitive forces, technologies or other business requirements will not
        alter
        the number of employee resources required.
 
 **GOVERNMENT
        REGULATION**
 
 Except
        for the costs associated with the implementation of the Sarbanes-Oxley Act
        of
        2002 ("SOX") described below, government regulation has not had a material
        effect on the conduct of our business to date. Except for the requirement
        of
        compliance with United States export controls relating to the export of high
        technology products, we are not subject to government approval procedures
        or
        other regulations for the licensing of our products. The nature of our business
        does not subject us to environmental laws in any material manner. As the
        United
        States and other governments address via legislation the growing requirements
        for increased security and privacy of data, particularly health, financial
        and
        personal information, new opportunities to license our existing and future
        products may arise.
  **ITEM
        1A.  RISK FACTORS**
 
 Investing
        in our common stock involves a high degree of risk. The following risk factors
        and all of the other information in this Annual Report should be carefully
        considered. The risks and uncertainties described below are not the only
        ones
        Citadel will face. Additional risks and uncertainties not presently known
        to
        Citadel or that it currently believes to be immaterial may also adversely
        affect
        Citadel’s business.
 
 If
        any of
        the following risks and uncertainties develops into actual events, the business,
        financial condition or results of operations of Citadel could be materially
        adversely affected. If that happens, the trading prices of our shares of
        common
        stock could decline significantly and could result in a complete loss of
        your
        investment.
 
 The
        risk
        factors below contain forward-looking statements. Actual results could differ
        materially from those set forth in the forward-looking statements. See
        Cautionary Statement Regarding Forward-Looking Statements above.
 
 **WE
        HAVE A HISTORY OF NET LOSSES AND MAY NEED OR DECIDE TO SEEK ADDITIONAL FINANCING
        TO FUND OPERATIONS.**
 
 At
        December 31, 2005, we had cash and cash equivalents of approximately $1.3
        million and stockholders’ deficit of approximately $865 thousand. In addition,
        the Company used cash in its operating activities totaling approximately
        $12.6
        million and incurred a net loss of approximately $18.6 million during the
        year
        ended December 31, 2005.
  20
 *Table
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  We
        have
        had a history of annual operating losses and have reported a net loss to
        common
        shareholders in the year ended December 31, 2005 of approximately $19 million.
        If the operating losses continue, we may be required, or could elect, to
        seek
        additional funding. Our future capital requirements will depend on many factors,
        including our rate of revenue growth, the timing and extent of spending to
        support product development initiatives and expansion of sales and marketing,
        the timing of introductions of new products, enhancements to existing products,
        and the general market acceptance of our products. We cannot assure you that
        additional equity or debt financing will be available to us at the time we
        require the financing or available on acceptable terms. The terms of our
        preferred stock, loan agreement and factoring agreement may also make it
        more
        difficult for us to raise additional funds if needed. In the event we are
        required to seek additional capital, our shareholders may be diluted and
        any
        additional financing may have a material adverse effect on our results of
        operations and share price. Our sources of liquidity beyond twelve months,
        in
        our opinion, will be our then current cash balances, funds from operations,
        debt
        or equity financings and any credit facilities we may arrange. If we are
        unable
        to obtain additional funds, our business may be materially and adversely
        affected, our share price would be materially and adversely affected, and
        we may
        be forced to seek protection under the bankruptcy laws.
 
 In
        October 2005, Citadel and Lawrence Lacerte (“Lacerte”) entered into a Loan and
        Security Agreement and Intellectual Property Security Agreement. Lacerte
        agreed
        to advance $3.75 million to Citadel with a maturity date of October 10, 2007
        and
        interest payable at 12%. The proceeds of the loan were used to retire notes
        payable to Comerica Bank of approximately $2.9 million and for general working
        capital purposes. As a result of the retirement of the Comerica notes payable,
        the loan and security agreement between the Company and Comerica terminated,
        including all debt covenants. The holder of our preferred stock agreed to
        permit
        Citadel to issue this senior security to Lacerte in consideration for a
        reduction in the exercise price of their warrants from $1.75 per share to
        $1.56
        per share.
 
 In
        October 2005, we also entered into a Factoring Agreement and related agreements
        (the “Agreements”) with Allied Capital Partners, L.P. (“Allied”) whereby we will
        offer to Allied certain accounts receivable (“accounts”) and, if Allied chooses
        to accept the accounts, Allied will factor the accounts and pay to Citadel
        a
        discounted amount of the face value of the accounts according to terms and
        conditions specified in the Factoring Agreement. The Agreement has a one
        year
        term, renewable for another one year term at least 30 days prior to the
        expiration of the first one-year term. During 2005 we transferred $3,514,248
        of
        our accounts receivable to Allied, for which we received $2,864,112 in cash
        proceeds. We retain the right to sell more accounts to Allied during the
        term of
        the Agreement subject to Allied’s acceptance of other existing accounts and/or
        new accounts which may be generated.
  During
          2005 the Company took actions to improve financial performance including
          reductions in costs and expenses, the hiring of new sales management and
          the
          reorganization of the sales team. We also began offering new ways for our
          customers to license our software solution including usage based pricing,
          subscription pricing and Hercules on an appliance. Some of the benefits
          of these
          actions began to be realized during the third and fourth quarters of 2005.
 
 We
          believe that the current sales management, the reorganization of the sales
          team,
          the new selling models introduced in 2005 and selling models that may be
          introduced in 2006 can continue the trend in increased orders for the next
          twelve months, although any one quarter's total orders could be skewed
          upward or
          downward resulting from the timing of the booking of large contracts that
          are in
          the pipeline. The expected increase in orders is expected to cause a
          corresponding increase in cash inflows to the Company.
 
 During
          the third and fourth quarters of 2005 we took actions to reduce costs and
          expenses. A substantial portion of these actions was a reduction in force.
          We
          expect to replace key positions as necessary and will add additional personnel
          to support additional contract order opportunities. In addition discretionary
          spending has been reduced. As a result of these cost and expense reduction
          actions taken in 2005, we expect that the total of our fixed costs and
          discretionary expenses will be reduced as much as $1.5 million to $2 million
          per
          quarter in 2006.
 
 Historically
          the Company has had access to additional capital and has raised money through
          both equity and debt financings. We believe that we will continue to have
          access
          to capital to fund the operations but the Company has no plans as of the
          filing
          date of this report to raise additional funds. From time-to-time in 2005
          the
          Company's CEO has advanced funds to the Company to meet short-term working
          capital needs. The total amounts advanced during 2005 were approximately
          $881,000, all of which was repaid to the CEO by February 1, 2006. The Company's
          CEO has committed to advance the Company up to three million dollars in
          funding
          should it be necessary for short term working capital needs through March
          2007.
          The terms and conditions of any advance to the Company from the CEO will
          be
          established by the Company's Board of Directors.
 
 The
          Company believes that the execution of its business plan including strategies
          to
          grow revenue and control costs and expenses, combined with liquidity available
          from our Factoring Agreement and the commitment from the Company's CEO,
          is
          sufficient to fund operations for the next twelve months. If needed, Citadel
          may
          also consider raising additional debt or equity capital under the right
          circumstances. However, there can be no assurance that the Company will
          be able
          to raise debt or equity capital at terms it considers reasonable and prudent
          or
          that the Company will be able to fully execute its business plan in
          2006.
  **OUR
        OPERATING RESULTS MAY BE ADVERSELY AFFECTED BY THE UNCERTAIN GEOPOLITICAL
        ENVIRONMENT AND UNFAVORABLE FACTORS AFFECTING ECONOMIC AND MARKET CONDITIONS.**
 
 Adverse
        factors affecting economic conditions worldwide have contributed to a general
        slowdown in information technology and software spending and may continue
        to
        adversely impact our business, resulting in:
 
 ·
              Reduced
                  demand for our products as a result of a decrease in technology
                  spending
                  by our customers and potential customers;
 ·
              Increased
                  price competition for our products; and
 ·
              Higher
                  overhead costs as a percentage of revenues.
 
 Terrorist
        and military actions may continue to put pressure on economic conditions.
        If the
        economic and market conditions in the United States do not improve, or
        deteriorate further, we may continue to experience material adverse impacts
        on
        our business, operating results, and financial condition as a consequence
        of the
        above factors or otherwise.
 
 **ECONOMIC
        CONDITIONS AND CONDITIONS AFFECTING THE NETWORK SECURITY MARKET IN PARTICULAR
        MAY HAVE A NEGATIVE IMPACT ON OUR REVENUES AND MARGINS.**
 
 The
        market for our products depends on various economic conditions including
        those
        affecting the network security, Internet infrastructure and other related
        markets. Any slowdown in corporate earnings or tightening of corporate or
        government budgets may cause potential customers to delay or cancel security
        projects, reduce their overall or security-specific information technology
        budgets, or reduce or cancel orders for our products. Further, if economic
        conditions deteriorate, customers may experience financial difficulty, cease
        operations or fail to budget for the purchase of our products. This, in turn,
        may lead to longer sales cycles, price pressures and collection issues, causing
        us to realize lower revenues and margins. In addition, many parts of the
        world
        are experiencing economic instability, and we cannot predict how these
        conditions may affect our customers or business.
  21
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  **CITADEL
        STOCKHOLDERS MAY EXPERIENCE SIGNIFICANT DILUTION IF FUTURE EQUITY OFFERINGS
        ARE
        USED TO FUND OPERATIONS OR ACQUIRE COMPLEMENTARY BUSINESSES OR RESULT FROM
        OPTION AND WARRANT EXERCISES.**
 
 If
        future
        operations or acquisitions are financed through the issuance of equity
        securities, Citadel stockholders could experience significant dilution. In
        addition, securities issued in connection with future financing activities
        or
        potential acquisitions may have rights and preferences senior to the rights
        and
        preferences of our common stock.
 
 We
        have
        granted options to purchase shares of our common stock to our directors,
        employees and consultants and we will grant additional options in the future.
        Options to purchase 8,843,250 shares of common stock and warrants to issue
        4,336,641 shares of common stock were outstanding as December 31, 2005. The
        issuance of shares of our common stock upon the exercise of these options
        may
        result in dilution to our stockholders.
 
 **OUR
        CONVERTIBLE PREFERRED STOCK AND DEBT MAY ADVERSELY IMPACT CITADEL AND OUR
        COMMON
        STOCKHOLDERS OR HAVE A MATERIAL ADVERSE EFFECT ON CITADEL.**
 
 We
        have
        issued shares of Series A Convertible Preferred Stock (the “Series A Preferred”)
        and shares of Series B Convertible Preferred Stock (the “Series B Preferred”
and, together with the Series A Preferred, the “Preferred Stock”), the terms of
        which may have a material adverse effect on Citadel and its financial condition
        and results of operations. The Series A Preferred has a liquidation preference
        in the amount of $15 million plus accrued and unpaid dividends, if any, and
        the
        Series B Preferred has a liquidation preference in the amount of $7 million,
        all
        of which must be paid before common stockholders would receive funds in the
        event of a liquidation of Citadel, including some changes of control. In
        addition, Citadel is required to redeem the shares of Preferred Stock in
        certain
        circumstances, including Citadel’s failure to deliver shares of common stock to
        the holder of the Preferred Stock in connection with the conversion of the
        shares of Preferred Stock or a change in control of Citadel. Citadel has
        also
        agreed not to issue securities senior to or on a par with the Preferred Stock
        (other than the Lacerte facility currently in place ) while the Preferred
        Stock
        is outstanding, which could materially and adversely affect the ability of
        Citadel to raise funds necessary to continue its business. The shares of
        our
        Preferred Stock (and related warrants) are convertible into 9,516,129 shares
        of
        our common stock at current conversion prices. The conversion prices are
        subject
        to antidilution protective provisions. In the event we issue shares of our
        common stock (or securities convertible into shares of our common stock)
        below
        the current conversion prices of the shares of Preferred Stock and warrants,
        the
        antidilution provisions would result in the issuance of substantial additional
        shares of our common stock upon any conversion. The issuance of shares of
        our
        common stock upon the conversion of our Preferred Stock and warrants (including
        as a result of the antidilution provisions) may result in substantial dilution
        to our stockholders, and could have a material adverse effect on the trading
        price of our shares of common stock.
 
 As
        a
        result of the retirement of the Comerica notes payable, the loan and security
        agreement, as amended, between Citadel and Comerica, including debt covenants,
        was terminated. The terms of the Agreement with Lacerte include that interest
        is
        payable each quarter with the principal balance due at maturity. The loan
        is
        secured by a security interest in the Company’s assets except trade accounts
        receivable. Our factoring agreements with Allied provide for a security interest
        in the accounts receivable that we factor with Allied. As a result, we have
        limited flexibility in selling or granting security interests in our assets,
        which could limit our ability to raise additional funds and have a material
        adverse effect on our business and financial condition.
 
 **CITADEL
        HAS A LIMITED OPERATING HISTORY AS AN INDEPENDENT PUBLIC COMPANY AND HAS
        BEEN
        AND MAY CONTINUE TO BE UNABLE TO OPERATE PROFITABLY AS A STANDALONE COMPANY.**
 
 Citadel
        has a limited operating history as an independent public company since May
        2002.
        Prior to May 2002, since the businesses that comprise each of Citadel and
        its
        former parent company were combined under one holding company, they were
        able to
        rely, to some degree, on the earnings, assets, and cash flow of each other
        for
        capital requirements. Following May 2002, Citadel has relied solely on its
        security software business for such requirements. The security software business
        has operated at a loss in the past for Citadel's former parent company and
        for
        Citadel following May 2002, and there can be no assurance that such losses
        will
        not continue or increase.
  22
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  **WE
        RECEIVED A LETTER FROM THE NASDAQ STOCK MARKET CONCERNING A POTENTIAL DELISTING
        OF OUR COMMON STOCK FROM THE NASDAQ CAPITAL MARKET, AND ANY DELISTING COULD
        HAVE
        A MATERIAL ADVERSE EFFECT ON US.**
 
 On
        June
        23, 2005, we received a letter from The NASDAQ Stock Market (the "Notice")
        notifying us that for the 30 consecutive trading days preceding the date
        of the
        Notice, the bid price of our common stock had closed below the $1.00 per
        share
        minimum required for continued inclusion on The NASDAQ Capital Market pursuant
        to NASDAQ Marketplace Rule 4310(c)(4). The Notice further stated that we
        would
        be provided 180 calendar days, or until December 20, 2005, to regain compliance
        with the $1.00 per share bid price requirement in accordance with NASDAQ
        Marketplace Rule 4310(c)(8)(D). To regain compliance with the bid price
        requirement, the bid price of our common stock was required to close at or
        above
        $1.00 per share for a minimum of ten consecutive trading days prior to December
        20, 2005. If by December 20, 2005 we had not regained compliance with the
        minimum bid price requirement, we would be granted an additional 180 day
        grace
        period to regain compliance under applicable NASDAQ rules, provided we met
        The
        NASDAQ Capital Market initial listing criteria (other than the minimum bid
        price
        requirement) at that time. Because we were not eligible for an additional
        compliance period at December 20, 2005, the NASDAQ provided written notification
        to us that our securities would be delisted unless we requested a hearing
        to
        appeal the NASDAQ’s determination to delist the securities to a NASDAQ Listing
        Qualifications Panel.
  On
        December 21, 2005, Citadel received a letter from The NASDAQ Stock Market
        notifying Citadel that the Company had not regained compliance with the NASDAQ's
        Marketplace Rule 4310(c)(4) within 180 days of the previously announced failure
        to comply with the Rule. Citadel was not eligible for an additional 180 day
        compliance period because Citadel did not meet The NASDAQ Capital Market
        initial
        inclusion criteria set forth in Marketplace Rule 4310(c), including the minimum
        stockholders' equity, net income or market value criteria.
  Citadel
        requested a hearing to appeal the NASDAQ Staff's determination to a NASDAQ
        Listing Qualifications Panel, in accordance with the Marketplace Rule 4800
        Series, and in February 2006, Citadel participated in a hearing. On March
        10,
        2006, Citadel  received
        a letter from The NASDAQ Stock Market notifying Citadel that the NASDAQ Listing
        Qualifications Panel has granted Citadel’s request for continued listing,
        subject to the conditions that (1) on or before April 13, 2006, Citadel must
        have evidenced a closing bid price of at least $1.00 per share for a minimum
        of
        ten consecutive trading days, and (2) on or before May 15, 2006, Citadel
        must
        report in its Quarterly Report on Form 10-Q for the period ending March 31,
        2006, actual stockholders’ equity at March 31, 2006 of at least $2,500,000. In
        addition, Citadel must be able to demonstrate compliance with all requirements
        for continued listing on the NASDAQ Capital Market. Failure to meet any of
        these
        conditions may result in the delisting of Citadel’s common stock from The NASDAQ
        Stock Market. There can be no assurance that we will regain compliance with
        the
        NASDAQ listing requirements. If our securities are delisted from the NASDAQ
        Capital Market, the market for our securities would be impaired and our stock
        price may decline. Our agreements with the holders of preferred stock require
        that our securities be listed on NASDAQ in order for us to be able to require
        the holders of the preferred stock to convert their shares of preferred stock
        into shares of common stock at maturity, and in the event our shares are
        delisted, we would be required to repay the liquidation preference in cash,
        which would have a material adverse effect on our financial condition and
        results of operations, and could require us to seek protection under bankruptcy
        laws. In addition, if our securities are delisted, it would be more difficult
        for us to raise additional funds, which could have a material adverse effect
        on
        our financial condition.
 
 **OUR
        EARNINGS AND STOCK PRICE ARE SUBJECT TO SIGNIFICANT FLUCTUATIONS.**
 
 Due
        to
        the factors noted in our Form 10-KSB for year ending December 31, 2004, our
        Form
        10-Q filings for March 31, 2005, June 30, 2005, and September 30, 2005, and
        in
        this Report, our earnings and stock price have been and may continue to be
        subject to significant volatility, particularly on a quarterly basis. We
        have
        stated previously and continue to state that our revenues are difficult to
        forecast. We have previously experienced shortfalls in revenue and earnings
        from
        levels expected by investors and analysts, which have had an immediate and
        significant adverse effect on the trading price of our common stock and has
        resulted in shareholder litigation. This may occur again in the future.
  23
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  **IF
        WE LOSE THE SERVICES OF ANY OF OUR KEY PERSONNEL, INCLUDING OUR CHIEF EXECUTIVE
        OFFICER OR OUR DIRECTORS, OUR BUSINESS MAY SUFFER.**
 
 We
        are
        dependent on our key officers, including Steven B. Solomon, our Chairman
        and
        Chief Executive Officer, our directors, and our key employees in our finance,
        technology, sales and marketing operations. Our business could be negatively
        impacted if we were to lose the services of one or more of these persons.
  **MEMBERS
        OF CITADEL'S BOARD OF DIRECTORS AND MANAGEMENT MAY HAVE INTERCOMPANY CONFLICTS
        OF INTEREST AFTER OUR SPIN-OFF.**
 
 Members
        of the board of directors and management of Citadel own shares of both Citadel
        and CT Holdings common stock after our spin-off from our former parent company
        because of their prior relationship and, in some cases, continuing relationships
        as directors or executive officers with CT Holdings. In addition, following
        the
        spin-off, three of the five directors of Citadel are also directors of CT
        Holdings, and the Chief Executive Officer and Chief Financial Officer of
        Citadel
        also continue to serve as Chief Executive Officer and Chief Financial Officer
        of
        CT Holdings. These relationships could create, or appear to create, potential
        conflicts of interest when Citadel's directors and management are faced with
        decisions that could have different implications for Citadel and CT Holdings.
        Examples of these types of decisions might include the resolution of disputes
        arising out of the agreements governing the relationship between CT Holdings
        and
        Citadel following the spin-off. Also, the appearance of conflicts, even if
        such
        conflicts do not materialize, might adversely affect the public's perception
        of
        Citadel following the spin-off.
 
 **OUR
        INDUSTRY IS CHARACTERIZED BY RAPID TECHNOLOGICAL CHANGE AND WE WILL NEED
        TO
        ADAPT OUR DEVELOPMENT TO THESE CHANGES.**
 
 We
        participate in a highly dynamic industry characterized by rapid change and
        uncertainty relating to new and emerging technologies and markets. Future
        technology or market changes may cause some of our products to become obsolete
        more quickly than expected.
 
 **INTRODUCTION
        OF NEW OPERATING SYSTEMS MAY CAUSE SIGNIFICANT FLUCTUATIONS IN OUR FINANCIAL
        RESULTS AND STOCK PRICE.**
 
 If
        we are
        unable to successfully and timely develop products that operate under existing
        or new operating systems, or if pending or actual releases of the new operating
        systems delay the purchase of our products, our future net revenues and
        operating results could be materially adversely affected. Additionally, as
        hardware vendors incorporate additional server-based network management and
        security tools into network operating systems, the demand may decrease for
        some
        of our products, including those currently under development.
 
 **THE
        TREND TOWARD CONSOLIDATION IN OUR INDUSTRY MAY IMPEDE OUR ABILITY TO COMPETE
        EFFECTIVELY.**
 
 As
        consolidation in the software industry continues, fewer companies dominate
        particular markets, changing the nature of the market and potentially providing
        consumers with fewer choices. Also, many of these companies offer a broader
        range of products than us, ranging from desktop to enterprise solutions.
        We may
        not be able to compete effectively against these competitors. Furthermore,
        we
        may use strategic acquisitions, as necessary, to acquire technology, people
        and
        products for our overall product strategy. The trend toward consolidation
        in our
        industry may result in increased competition in acquiring these technologies,
        people or products, resulting in increased acquisition costs or the inability
        to
        acquire the desired technologies, people or products. Any of these changes
        may
        have a significant adverse effect on our future revenues and operating results.
 
 **WE
        FACE INTENSE PRICE-BASED COMPETITION FOR LICENSING OF OUR PRODUCTS.**
 
 Price
        competition is often intense in the software market, especially for security
        software products. Many of our competitors have significantly reduced the
        price
        of their products. Price competition may continue to increase and become
        even
        more significant in the future, resulting in reduced revenue and/or profit
        margins.
  24
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  **WE
        MUST EFFECTIVELY ADAPT TO CHANGES IN THE DYNAMIC TECHNOLOGICAL ENVIRONMENT
        OF
        THE INTERNET IN A TIMELY MANNER.**
 
 Critical
        issues concerning the commercial use of the Internet, including security,
        reliability, cost, ease of use, accessibility, quality of service or potential
        tax or other government regulation, remain unresolved and may affect the
        use of
        the Internet as a medium to distribute or support our software products and
        the
        functionality of some of our products. If we are unsuccessful in timely
        assimilating changes in the Internet environment into our business operations
        and product development efforts, our future net revenues and operating results
        could be adversely affected.
 
 **PRODUCT
        RETURNS MAY AFFECT OUR NET REVENUES.**
 
 A
        customer may return a product under very limited circumstances during the
        first
        thirty to ninety days from shipment for a replacement if the media is damaged
        or
        for a full refund if the software does not perform in accordance with written
        specifications. Accordingly, the Company records a provision for returns
        against
        license revenue in the same period the revenue is recognized. The provision
        is
        estimated based on historical product returns and other known data as well
        as
        market and economic conditions. An allowance for returns, allowances and
        bad
        debts of $209,000 has been recorded at December 31, 2005. In the future,
        this
        estimate may fluctuate from period to period due to factors including but
        not
        limited to the value of actual returns, the average dollar value of licenses
        granted in the period and the relative product revenue volume for the period.
        In
        addition, future returns could exceed the reserves we have established, which
        could have a material adverse effect on our operating results.
 
 Current
        reseller agreements generally do not provide for a contractual right of return,
        future price concessions, or minimum purchase commitments. Payment is not
        contingent upon the reseller’s future licensing of products. Revenue generated
        from products licensed through various marketing channels where the right
        of
        return might expressly or implicitly exist is reduced by reserves for estimated
        product returns. Such reserves are estimates developed by management based
        on
        returns history and current economic and market trends. Management determined
        that no reserve for returns from resellers was required at December 31, 2005.
        However, future returns could exceed the reserves we have established, which
        could have a material adverse effect on our operating results.
 
 **OUR
        INCREASED USE OF SITE LICENSES MAY INCREASE FLUCTUATIONS IN OUR FINANCIAL
        RESULTS AND COULD AFFECT OUR BUSINESS.**
 
 We
        are
        increasingly emphasizing licenses to corporations and small businesses through
        volume licensing agreements. These licensing arrangements tend to involve
        a
        longer sales cycle than other distribution channels, require greater investment
        of resources in establishing the enterprise relationship and can sometimes
        result in lower operating margins. The timing of the execution of volume
        licenses, or their non-renewal or renegotiation by large customers, could
        cause
        our results of operations to vary significantly from quarter to quarter and
        could have a material adverse impact on our results of operations. In addition,
        if the corporate marketplace grows and becomes a larger component of the
        overall
        marketplace, we may not be successful in expanding our corporate segment
        to take
        advantage of this growth.
 
 **CHANGES
        MADE TO OUR SALES ORGANIZATION AND SALES STRATEGY COULD ADVERSELY AFFECT
        OUR
        FUTURE REVENUES.**
 
 Our
        sales
        team consists of a commercial sales team organized into two geographic regions
        and a public sector sales team focused on government agencies. Additionally,
        in
        the fourth quarter of 2005, we added two international agent sales
        representatives to market our products and services in Europe and the Middle
        East. In January of 2006, we reorganized our commercial sales team into two
        geographic regions focused on the commercial market. We have employed
        experienced and enterprise skilled sales managers to manage these sales regions
        and public sector sales organization. Each of these managers has employed
        experienced sales account executives and assigned sales territories,
        responsibilities and quotas to these sales account executives. We expect
        that
        these sales account executives will seek sales opportunities in large
        enterprises consisting of Fortune 2000 companies and large government agencies
        with large geographically disbursed networks.
 
 Sales
        cycles are expected to be longer than previously experienced, less predictable
        and we may not be successful in closing sales quickly or in a regular or
        consistent manner from quarter-to-quarter or year-to-year. Our dependence
        upon
        large enterprise sales may cause fluctuations in revenue from quarter-to-quarter
        or year-to-year.
  25
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  In
        addition, our revenue has been highly dependent upon revenue derived from
        the
        federal government and more specifically the Department of Veteran Affairs
        and
        the Department of Defense. We expect that our revenue mix for the near future
        to
        be weighted toward the federal government customers where we have been engaged
        in the sales cycle for many months. We anticipate that the percentage of
        our
        revenue derived from commercial enterprises will increase gradually in future
        quarters as our commercial sales executives reach the end of the long sales
        cycles in accounts in the commercial sector. However there can be no assurance
        that our sales executives will be successful in the near term or in the quarters
        or years in which we expect to realize the sales.
 
 Therefore
        any one customer, or groups of customers, in the same industry segment could
        become a material component of revenue in any future quarter or year. There
        can
        be no assurance that the historical distribution of revenue by industry segment
        or customer is representative of future revenue projections and we expect
        that
        our revenue by industry segment and customer will vary dynamically from period
        to period. In addition, the concentration of revenue in one industry or customer
        is largely dependent upon factors outside of our control including, but not
        limited to, the customer's information technology budgets and spending
        availability, the general economic and political environment, or the complexity
        of the customer's purchasing process, such as in the federal government.
        Due to
        the concentration of our sales, delays in licensing of our products by one
        or
        more large customers or potential customers would have a material adverse
        effect
        on our results of operations and financial condition.
 
 **OUR
        FINANCIAL FORECASTS MAY NOT BE ACHIEVED, INCLUDING DUE TO THE UNPREDICTABILITY
        OF END-OF-PERIOD BUYING PATTERNS, WHICH COULD MAKE OUR STOCK PRICE MORE
        VOLATILE.**
 
 We
        do not
        maintain significant levels of backlog. License fee revenue in any quarter
        is
        dependent, in significant part, on contracts entered into or orders booked
        and
        shipped in that quarter. The risk of quarterly fluctuations is increased
        by the
        fact that a significant portion of our quarterly net revenue has historically
        been generated during the last month of each fiscal quarter. Many enterprise
        customers negotiate site licenses near the end of each quarter. Due to these
        end-of-period buying patterns, forecasts may not be achieved, either because
        expected sales do not occur or because they occur at lower prices or on terms
        that are less favorable to us.
 
 In
        addition, fluctuations may be caused by a number of other factors, including:
 
 ·
              the
                  timing and volume of customer orders and customer cancellations;
 ·
              a
                  change in our revenue mix of products and services and a resulting
                  change
                  in the gross margins;
 ·
              the
                  timing and amount of our expenses;
 ·
              the
                  introduction of competitive products by existing or new competitors;
 ·
              reduced
                  demand for any given product;
 ·
              quarterly
                  seasonality of customer buying patterns due to holidays and vacation
                  patterns; and
 ·
              the
                  market’s transition between operating systems.
 
 Due
        to
        these factors, forecasts may not be achieved, either because expected revenues
        do not occur or because they occur at lower prices, at later times, or on
        terms
        that are less favorable to us. In addition, these factors increase the chances
        that our results could diverge from the expectations of investors and analysts.
        If so, the market price of our stock would likely decrease and may result
        in
        shareholder lawsuits.
 
 **WE
        FACE RISKS ASSOCIATED WITH GOVERNMENTAL CONTRACTING.**
 
 Our
        customers include agencies of the U.S. government and other U.S., state and
        local governments or agencies. Government agencies present us with processes
        that are unique to these organizations including procurement, budgetary
        constraints and cycles, contract modifications and cancellations, government
        audits and security clearances.
 
 Contracting
        with public sector customers is highly competitive and can be expensive and
        time-consuming, often requiring that we incur significant upfront time and
        expense without any assurance that we will win a contract. Public sector
        customers may also change the way they procure new contracts and may adopt
        new
        rules or regulations governing contract procurement, including required
        competitive bidding or use of “open source” products, where available. Demand
        and payment for our products and services are impacted by public sector
        budgetary cycles and funding availability, with funding reductions or delays
        adversely impacting public sector demand for our products and services.
  26
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  Public
        sector customers often have contractual or other legal rights to terminate
        current contracts for convenience or due to a default. If a contract is
        cancelled for convenience, which can occur if the customer’s product needs
        change, we may only be able to collect for products and services delivered
        prior
        to termination. If a contract is cancelled because of default, we may only
        be
        able to collect for products and services delivered, and we may be forced
        to pay
        any costs incurred by the customer for procuring alternative products and
        services. The U.S. government may also terminate contracts with us if we
        come
        under foreign government control or influence, require that we disclose our
        pricing data during the course of negotiations, ban us from doing business
        with
        any government entity and require us to prevent access to classified data.
 
 U.S.
        government and other state and local agencies routinely investigate and audit
        government contractors’ administrative processes. They may audit our performance
        and pricing and review our compliance with applicable rules and regulations.
        If
        they find that we have improperly allocated costs, they may require us to
        refund
        those costs or may refuse to pay us for outstanding balances related to the
        improper allocation. An unfavorable audit could result in a reduction of
        revenue, and may result in civil or criminal liability if the audit uncovers
        improper or illegal activities.
 
 Some
        agencies within the U.S. government require some or all of our personnel
        to
        obtain proper security clearance. If our key personnel are unable to obtain
        or
        retain this clearance, we may be unable to bid for or retain some government
        contracts.
 
 **WE
        ARE HIGHLY DEPENDENT ON REVENUE FROM OUR FLAGSHIP PRODUCT HERCULES.**
 
 We
        have
        historically derived the majority of our revenue from our flagship product
        Hercules. This product is expected to continue to account for a significant
        portion of our total revenue. Because of this revenue concentration, our
        business could be harmed by a decline in demand for, or in the price of,
        this
        product as a result of, among other factors, any change in our pricing model,
        or
        maturation in the markets for this product or other risks described in this
        document.
 
 **THE
        RESULTS OF OUR RESEARCH AND DEVELOPMENT EFFORTS ARE UNCERTAIN.**
 
 We
        believe that we will need to make significant research and development
        expenditures to remain competitive. While we perform extensive usability
        and
        beta testing of new products, the products we are currently developing or
        may
        develop in the future may not be technologically successful. If they are
        not
        technologically successful, our resulting products may not achieve market
        acceptance and our products may not compete effectively with products of
        our
        competitors currently in the market or introduced in the future.
 
 **THE
        LENGTH OF THE PRODUCT DEVELOPMENT AND SALES CYCLES ARE DIFFICULT TO PREDICT,
        WHICH MAKES IT DIFFICULT TO PREDICT FUTURE REVENUES AND WHICH MAY CAUSE US
        TO
        MISS ANALYSTS’ ESTIMATES AND INVESTOR EXPECTATIONS AND RESULT IN OUR STOCK PRICE
        DECLINING.**
 
 The
        length of our product development and sales cycles may be greater than
        originally expected. We may experience delays in future product development
        or
        sales. These delays could have a material adverse effect on the amount and
        timing of future revenues. Because our licensing cycle is a lengthy process,
        the
        accurate prediction of future revenues from new licenses is difficult. In
        addition, engineering services are dependent upon the varying level of
        assistance desired by licensees and, therefore, revenue from these services
        is
        also difficult to predict. We employ two methods of contract revenue accounting
        based upon the state of the technology licensed, the dollar magnitude of
        the
        program, and the ability to estimate work required over the contract period.
        We
        use ratable revenue recognition for mature technologies that require support
        after delivery of the technology. This method results in expenses associated
        with a particular contract to be recognized as incurred over the contract
        period, whereas contract fees associated with the contract are recognized
        ratably over the period during which the post-contract customer support is
        expected to be provided. We also use percentage-of-completion accounting
        for
        contracts that may require significant development and support over the contract
        term. There can be no assurance that we can accurately estimate the amount
        of
        resources required to complete projects, or that we will have, or be able
        to
        expend, sufficient resources required to complete a project. Furthermore,
        there
        can be no assurance that the product development schedule for these projects
        will not be changed or delayed. All of these factors make it difficult to
        predict future licensing revenue that may result in us missing analysts’
estimates and causing our stock price to decline.
  27
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  **OUR
        EFFORTS TO DEVELOP AND INTRODUCE HERCULES AS PART OF AN APPLIANCE TO THE
        MARKET
        IS UNPROVEN AND MAY NOT BE SUCCESSFUL AND OUR FUTURE REVENUE AND OPERATING
        RESULTS COULD BE ADVERSELY AFFECTED.**
 
 We
        have
        introduced the Hercules Security Appliance recently and because of our limited
        experience with the manufacturing of appliances, our efforts to develop and
        sell
        appliances may not be as successful as we anticipate. In addition, we expect
        that the gross margins generated from the revenue from our appliance will
        be
        lower than the gross margins generated from our software products. Our appliance
        solution may not achieve market acceptance and may not be able to compete
        with
        solutions either currently in the market or introduced in the future. In
        addition, we will sell the appliance under a new usage based pricing model
        which
        is largely untested in the software industry and may not be accepted by
        customers. We may also sell the appliance solution through channels in which
        we
        have only limited experience. If we are unable to achieve market acceptance
        of
        the appliance and new pricing and sales models or compete effectively with
        solutions of our competitors, our future net revenues and operating results
        could be adversely affected.
 
 We
        will
        rely on a third party to manufacture our appliance hardware product. Reliance
        on
        third-party manufacturers involves a number of risks, including the lack
        of
        control over the manufacturing process and the potential absence or
        unavailability of adequate capacity. If our third party manufacturer cannot
        or
        will not manufacture our appliance in required volumes on a cost-effective
        basis, in a timely manner, or at all, we will have to secure additional
        manufacturing capacity. Even if this additional capacity is available at
        commercially acceptable terms, the qualification process could be lengthy
        and
        could cause interruptions in appliance shipments. The unexpected loss of
        this
        third party manufacturer would be disruptive to our business.
 
 **IF
        THE CARRYING VALUE OF OUR LONG-LIVED ASSETS IS NOT RECOVERABLE, AN IMPAIRMENT
        LOSS MUST BE RECOGNIZED WHICH WOULD ADVERSELY AFFECT OUR FINANCIAL RESULTS.**
 
 We
        evaluate our long-lived assets, including property and equipment and capitalized
        software development costs whenever events or circumstances occur, which
        indicate that these assets might be impaired. Capitalized software development
        costs are evaluated annually for impairment in the fourth quarter of each
        fiscal
        year, regardless of events and circumstances. We will continue to evaluate
        the
        recoverability of the carrying amount of our long-lived assets, and we may
        incur
        substantial impairment charges, which could adversely affect our financial
        results.
 
 **WE
        MUST MANAGE AND RESTRUCTURE OUR OPERATIONS EFFECTIVELY.**
 
 We
        continually evaluate our product and corporate strategy. We have in the past
        undertaken and will in the future undertake organizational changes and/or
        product and marketing strategy modifications. These organizational changes
        increase the risk that objectives will not be met due to the allocation of
        valuable limited resources to implement changes. Further, due to the uncertain
        nature of any of these undertakings, these efforts may not be successful
        and we
        may not realize any benefit from these efforts.
 
 **WE
        MUST ATTRACT AND RETAIN PERSONNEL WHILE COMPETITION FOR PERSONNEL IN OUR
        INDUSTRY IS INTENSE.**
 
 We
        believe that our future success will depend in part on our ability to recruit
        and retain highly skilled management, sales and marketing and technical
        personnel. Competition in recruiting personnel in the software industry is
        intense. To accomplish our objectives, we believe that we must provide personnel
        with a competitive compensation package, including stock options which may
        require ongoing stockholder approval.
 
 **OUR
        SOFTWARE MAY BE SUBJECT TO DEFECTS AND PRODUCT LIABILITY.**
 
 Software
        products frequently contain errors or defects, especially when first introduced
        or when new versions or enhancements are released. We have not experienced
        any
        material adverse effects resulting from any of these defects or errors to
        date
        and we test our products prior to release. Nonetheless, defects and errors
        could
        be found in current versions of our products, future upgrades to current
        products or newly developed and released products. Software defects could
        result
        in delays in market acceptance or unexpected reprogramming costs, which could
        materially adversely affect our operating results. Most of our license
        agreements with customers contain provisions designed to limit our exposure
        to
        potential product liability claims. It is possible, however, that these
        provisions limiting our liability may not be valid as a result of federal,
        state, local or foreign laws or ordinances or unfavorable judicial decisions.
        A
        successful product liability claim could have a material adverse effect on
        our
        business, operating results and financial condition.
  28
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            of Contents*
  **OUR
        SOFTWARE PRODUCTS AND WEB SITE MAY BE SUBJECT TO INTENTIONAL
        DISRUPTION.**
 
 While
        we
        have not been the target of software viruses or other attacks specifically
        designed to impede the performance of our products or disrupt our website,
        such
        viruses or other attacks could be created and deployed against our products
        or
        web site in the future. Similarly, experienced computer programmers, or hackers,
        may attempt to penetrate our network security or the security of our web
        site
        from time to time. A hacker who penetrates our network or website could
        misappropriate proprietary information or cause interruptions of our services.
        We might be required to expend significant capital and resources to protect
        against, or to alleviate, problems caused by virus creators and hackers.
 
 **INCREASED
        CUSTOMER DEMANDS ON OUR TECHNICAL SUPPORT SERVICES MAY ADVERSELY AFFECT OUR
        FINANCIAL RESULTS.**
 
 We
        may be
        unable to respond quickly enough to short-term increases in customer demand
        for
        support services. We also may be unable to modify the format of our support
        services to compete with changes in support services provided by competitors.
        Further customer demand for these services without corresponding revenue
        could
        increase costs and adversely affect our operating results.
 
 **WE
        RELY ON THIRD PARTY TECHNOLOGIES.**
 
 Our
        software products are designed to run on multiple operating systems and
        integrate with security products from other vendors. Although we believe
        that
        the target operating systems and products are and will be widely utilized
        by
        businesses in the corporate market, no assurances can be given that these
        businesses will actually adopt such technologies as anticipated or will not
        in
        the future migrate to other computing technologies that we do not support.
        Moreover, if our products and technology are not compatible with new
        developments from these companies, as to which there can be no assurances,
        our
        business, results of operations and financial condition could be materially
        and
        adversely affected. Further, the determination by any of the companies which
        offer scanners not to permit us to support their scanners, could have a material
        adverse effect on our financial condition or results of operations.
 
 In
        addition, some of our products incorporate third party licensed software.
        We
        must be able to obtain reasonably priced licenses and successfully integrate
        this software with our technologies. In addition, some of our products may
        include “open source” software. Our ability to commercialize products or
        technologies incorporating open source software may be restricted because,
        among
        other reasons, open source license terms may be ambiguous and may result
        in
        unanticipated obligations regarding our products.
 
 **WE
        RELY ON OUTSIDE RESEARCH ORGANIZATIONS AND SCANNING VENDORS.**
 
 With
        respect to security vulnerability research, we monitor various security
        intelligence websites, Internet Relay Chat, or IRC channels and alerts from
        our
        scanning partners for the identification of new vulnerabilities and exploits
        and
        we have contracted with iDefense to provide updated vulnerability research
        data
        in addition to our own research efforts. Our own research team uses publicly
        available research to find information on vulnerabilities and their attributes.
        There can be no assurance that iDefense or the publicly available sites will
        continue to operate as a going concern and that the data they provide will
        be
        delivered without interruption. We have established business relationships
        with
        scanning vendors. Hercules is interoperable with their scanning tools and
        although not required for Hercules to remediate vulnerabilities, Hercules
        imports the scan data results from those scanning tools to perform remediation.
        The termination of one or more of the scanning vendor relationships with
        us
        could have a material adverse effect on our results of operations.
 
 **WE
        FACE AGGRESSIVE COMPETITION IN MANY AREAS OF OUR BUSINESS, AND OUR BUSINESS
        WILL
        BE HARMED IF WE FAIL TO COMPETE EFFECTIVELY.**
 
 We
        encounter aggressive competition from numerous competitors in many areas
        of our
        business. Many of our current and potential competitors have longer operating
        histories, greater name recognition and substantially greater financial,
        technical and marketing resources than we have. We may not be able to compete
        effectively with these competitors. To remain competitive, we must develop
        new
        products and periodically enhance our existing products in a timely manner.
        We
        anticipate that we may have to adjust the prices of many of our products
        to stay
        competitive. In addition, new competitors may emerge, and entire product
        lines
        may be threatened by new technologies or market trends that reduce the value
        of
        these product lines. The market in which we compete is influenced by the
        strategic direction of major computer hardware manufacturers and operating
        system software providers. Our competitiveness depends on our ability to
        enhance
        existing products and to offer successful new products on a timely basis.
        We
        have limited resources and must restrict product development efforts to a
        relatively small number of projects.
  29
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            of Contents*
  **WE
        RELY ON INTELLECTUAL PROPERTY AND PROPRIETARY RIGHTS.**
 
 We
        regard
        our software as proprietary and underlying technology as proprietary. We
        seek to
        protect our proprietary rights through a combination of confidentiality
        agreements and copyright, patent, trademark and trade secret laws. However,
        we
        do not employ technology to prevent copying of our products. Third parties
        may
        copy aspects of our products or otherwise obtain and use our proprietary
        information without authorization or develop similar technology independently.
        Patent, trademark and trade secret protection is important to us because
        developing and marketing new technologies and products is time-consuming
        and
        expensive.
 
 We
        have
        filed five United States patent applications and four related Patent Cooperation
        Treaty patent applications, one of which has been the basis for eleven pending
        foreign patent applications with respect to some of our business applications
        and intellectual property rights related to our Hercules software. On February
        14, 2006 the United States Patent and Trademark Office issued U.S. Patent
        No.
        7,000,247 (the “’247 Patent”) to Citadel for our proprietary Hercules
        technology. On March 2, 2006, Citadel received notification that an unidentified
        third party petitioned the United States Patent and Trademark Office to
        re-examine the ‘247 Patent. Also, as detailed in the “Legal Proceedings” section
        below, the ‘247 Patent is the subject of patent litigation with Secure Elements.
        We have one registered copyright in the code for our Hercules software and
        our
        United States registered trademark for the mark Hercules in Class 9. We may
        not
        obtain issued patents or other protection from any future patent applications
        owned by or licensed to us. Our future patents, if any, may be successfully
        challenged and may not provide us with any competitive advantages. We may
        not
        develop proprietary products or technologies that are patentable and other
        parties may have prior claims.
 
 In
        selling our products, we have in the past relied primarily on shrink wrap
        licenses that are not signed by licensees, and, therefore, such licenses
        may be
        unenforceable under the laws of some jurisdictions. In addition, existing
        copyright laws afford limited practical protection. Furthermore, the laws
        of
        some foreign countries do not offer the same level of protection of our
        proprietary rights as the laws of the United States.
 
 Our
        competitive position is also dependent upon unpatented trade secrets. Trade
        secrets are difficult to protect. Our competitors may independently develop
        proprietary information and techniques that are substantially equivalent
        to ours
        or otherwise gain access to our trade secrets, such as through unauthorized
        or
        inadvertent disclosure of our trade secrets.
 
 There
        can
        be no assurance that our means of protecting our proprietary rights will
        be
        adequate or that our competitors will not independently develop similar
        technology substantially equivalent or superseding proprietary technology.
        Furthermore, there can be no assurance that any confidentiality agreements
        between us and our employees will provide meaningful protection of our
        proprietary information, in the event of any unauthorized use or disclosure
        thereof. Any legal action that we may bring to protect proprietary information
        could be expensive and may distract management from day-to-day operations.
 
 **WE
        ARE INVOLVED IN LITIGATION, AND MAY BECOME INVOLVED IN FUTURE LITIGATION,
        WHICH
        MAY RESULT IN SUBSTANTIAL EXPENSE AND MAY DIVERT OUR ATTENTION FROM THE
        IMPLEMENTATION OF OUR BUSINESS STRATEGY.**
 
 We
        believe that the success of our business depends, in part, on obtaining
        intellectual property protection for our products, defending our intellectual
        property once obtained and preserving our trade secrets. Litigation may be
        necessary to enforce our intellectual property rights, to protect our trade
        secrets and to determine the validity and scope of our proprietary rights.
        A
        competitor has filed a lawsuit challenging the validity of our patent. The
        lawsuit and any additional litigation could result in substantial expense
        and
        diversion of our attention from our business, and may not adequately protect
        our
        intellectual property rights.
  30
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            of Contents*
  In
        addition, we may be sued by third parties who claim that our products infringe
        the intellectual property rights of others. This risk is exacerbated by the
        fact
        that the validity and breadth of claims covered in technology patents involve
        complex legal and factual questions for which important legal principles
        are
        unresolved. While we are not aware of any basis for such claims and are not
        currently party to any material infringement lawsuits, any litigation or
        claims
        against us, whether or not valid, could result in substantial costs, place
        a
        significant strain on our financial resources, divert management resources
        and
        harm our reputation. Such claims could result in awards of substantial damages,
        which could have a significant adverse impact on our results of operations.
        In
        addition, intellectual property litigation or claims could force us to:
 
 -
              cease
                  licensing, incorporating or using any of our products that incorporate
                  the
                  challenged intellectual property, which would adversely affect
                  our
                  revenue;
 -
              obtain
                  a license from the holder of the infringed intellectual property
                  right,
                  which license may not be available on reasonable terms, if at all;
                  and
 -
              redesign
                  our products, which would be costly and time-consuming.
 
 In
        January, February and March 2005, seven virtually identical lawsuits were
        filed
        against Citadel, Steven B. Solomon, our Chief Executive Officer and a Director,
        and Richard Connelly, our Chief Financial Officer. These suits have been
        consolidated in one action styled Ruth R. Lentz v. Citadel Security Software,
        Inc., et al., Civil Action No. 3:05-CV-0100-D, in the United States District
        Court for the Northern District of Texas. Each case was filed on behalf of
        a
        putative class of persons and/or entities who purchased our securities between
        February 12, 2004 and December 16, 2004, inclusive. The suits seek recovery
        of
        unspecified damages under Sections 10(b) and 20(a) of the Securities Exchange
        Act of 1934, as amended, and Rule 10b-5 promulgated thereunder. The suits
        were
        filed after our announcement on December 17, 2004 that our projection of
        revenue
        and earnings for the full year 2004 would be less than previously projected.
        On
        May 25, 2005, the court appointed a lead plaintiff and approved plaintiff's
        selection of lead counsel.  On August 19, 2005, the lead plaintiff filed a
        consolidated complaint. On October 18, 2005, the defendants filed a motion
        to
        dismiss this consolidated action, which motion is pending before the Court.
        We
        believe these suits are without merit and intend to vigorously defend them.
        Discovery has not yet commenced, and no trial date has been set. These lawsuits
        could be time-consuming and costly and could divert the attention of our
        management personnel.
 
 On
        April
        1, 2005, a shareholder derivative suit styled Harry Brantley, derivatively
        on
        behalf of Citadel Security Software Inc. v. Steven B. Solomon, Richard Connelly,
        Chris A. Economou, John Leide and Joe M. Allbaugh, Cause No. 05-03117-L,
        was
        filed in the 193 rd State
        District Court in Dallas County, Texas on behalf of Citadel against certain
        of
        the Company’s officers and directors: Steven B. Solomon, the Chief Executive
        Officer and a Director of the Company; Richard Connelly, the Company’s Chief
        Financial Officer; and Chris A. Economou, John Leide and Joe M. Allbaugh,
        Directors of the Company. The suit also names the Company as a nominal
        defendant. Based on allegations substantially similar to the federal securities
        action, the suit asserts claims for the defendants’ alleged violations of state
        law, including breaches of fiduciary duties, abuse of control, gross
        mismanagement, and waste of corporate assets, and unjust enrichment that
        allegedly occurred during the same period of time at issue in the federal
        securities action. The suit seeks the recovery of damages, fees, costs,
        equitable and/or injunctive remedies, and disgorgement of all profits, benefits
        and other compensation. On July 5, 2005, the Court entered an order staying
        and
        administratively closing this case subject to being reopened upon the motion
        of
        any party. The ultimate outcome is not currently predictable. This lawsuit
        could
        be time-consuming and costly and could divert the attention of our management
        personnel.
 
 On
        April
        28, 2005, a shareholder derivative suit styled *Hans
        J. Baier, derivatively on behalf of Nominal Defendant, Citadel Security Software
        Inc., v. Steven B. Solomon, Richard Connelly and Chris
        Economou,* Civil
        Action No. 3-05CV-0846-D, was filed in United States District Court for the
        Northern District of Texas, Dallas Division, against certain of the Company’s
        officers and directors: Steven B. Solomon, the Chief Executive Officer and
        a
        Director of the Company, Richard Connelly, the Company’s Chief Financial Officer
        and Chris Economou, a Director of the Company. The suit also names the Company
        as a nominal defendant. Based on allegations substantially similar to the
        federal securities action, the suit asserts claims for the defendants’ alleged
        violations of state law, including breaches of fiduciary duties, abuse of
        control, gross mismanagement, waste of corporate assets and unjust enrichment
        for the same period of time at issue in the federal securities action. The
        suit
        also purports to assert a claim against Steven B. Solomon and Richard Connelly
        pursuant to a federal statute for reimbursement of bonuses, profits and
        compensation. The suit seeks the recovery of damages, fees, costs, equitable
        and/or injunctive remedies, and disgorgement of all profits, benefits and
        other
        compensation. On September 12, 2005, the Court entered an order staying this
        case until thirty (30) days after the Court rules on the pending motion to
        dismiss filed by the defendants in the consolidated federal securities action
        described above. The ultimate outcome is not currently predictable. This
        lawsuit could be time-consuming and costly and could divert the attention
        of our
        management personnel.
  31
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  On
        April
        8, 2005, Meyers Associates, L.P. f/k/a Roan/Meyers Associates, L.P. and f/k/a
        Janssen-Meyers Associates, L.P. (“Meyers”) filed a lawsuit in the Court of
        Chancery of the State of Delaware, in New Castle County, against the Company,
        CT
        Holdings, Inc. f/k/a Citadel Technology, Inc. and f/k/a Citadel Computer
        Systems, Inc. (“CT Holdings”) and certain current and former officers and
        directors of the Company and/or CT Holdings, including Steven B. Solomon,
        the
        Chief Executive Officer and a Director of the Company, Chris A. Economou,
        a
        Director of the Company, Lawrence Lacerte, a former Director of the Company,
        and
        Phillip J. Romano, a former Director of the Company (the “Individual
        Defendants”). The suit alleges that in connection with an action filed in the
        Supreme Court of New York, New York County, to enforce a Settlement Term
        Sheet
        executed on July 7, 2000 by Meyers and CT Holdings, Meyers was awarded a
        judgment against CT Holdings in the amount of $3 million plus interest on
        the
        judgment at the rate of 9% from October 31, 2000 until the date of entry
        of that
        judgment and thereafter at the statutory rate (the “Judgment”). The suit alleges
        that CT Holdings’ May 2002 spin-off of its interests in Citadel to CT Holdings’
shareholders rendered CT Holdings insolvent and constituted a fraudulent
        conveyance to defraud CT Holdings’ creditors, including Meyers. The suit asserts
        fraudulent conveyance claims against Citadel and CT Holdings pursuant to
        Delaware statutory and common law. The suit also asserts a claim against
        Citadel
        for successor liability as the alleged successor in interest or alter ego
        of
        Citadel. The suit alleges that the Individual Defendants who were officers
        and/or directors of CT Holdings at the time of the spin-off breached fiduciary
        duties allegedly owed to creditors of CT Holdings, including Meyers, by
        approving and allowing the spin-off transaction. The suit seeks to void the
        spin-off transaction, to hold Citadel liable for the Judgment including
        interest, to recover damages against the Individual Defendants in an amount
        not
        less than the Judgment including interest, plus an unspecified amount of
        punitive, consequential and incidental damages, as well as attorneys’ fees and
        costs. The Company believes that this suit is without merit and intends to
        vigorously defend this action. The ultimate outcome is not currently
        predictable. This
        lawsuit could be time-consuming and costly and could divert the attention
        of our
        management personnel.
 
 On
        February 14, 2006, the day the ‘247 Patent was issued, Secure Elements filed a
        declaratory judgment action in the United States District Court for the District
        of Delaware seeking a declaration from the Court that the ‘247 patent was both
        invalid and not infringed by Secure Elements. On March 6, 2006 Citadel answered
        Secure Element’s complaint, asserted counterclaims against Secure Elements for
        willful infringement of the ‘247 Patent, and sought an undisclosed amount of
        damages, costs and attorney’s fees, and an injunction barring Secure Elements
        from infringing the ‘247 Patent in the future. This case is in its infancy. The
        court has not yet entered a scheduling order and no discovery has been sought
        or
        obtained by either party. We believe this suit is without merit and we intend
        to
        vigorously defend the suit. This lawsuit could be time-consuming and costly
        and
        could divert the attention of our management personnel. In the event the
        plaintiff prevails, our business could be materially adversely
        affected.
 
 From
        time
        to time, we may be subject to additional legal claims incidental to our
        business. We may suffer an unfavorable outcome as a result of one or more
        claims. We do not expect the final resolution of these claims to have a material
        adverse effect on our financial position, individually or in the aggregate.
        However, depending on the amount and timing of unfavorable resolutions of
        claims
        against us, or the costs of settlement or litigation, our future results
        of
        operations or cash flows could be materially adversely affected.
 
 Our
        former parent company, CT Holdings, is a party to some legal proceedings,
        to
        which Citadel is not a party. If a court in a lawsuit by an unpaid creditor
        or
        representative of creditors, such as a trustee in bankruptcy, were to find
        that
        at the time CT Holdings effected the spin-off of Citadel, CT Holdings or
        Citadel
        (1) was insolvent; (2) was rendered insolvent by reason of the spin-off
        distribution; (3) was engaged in a business or transaction for which their
        respective remaining assets constituted unreasonably small capital; or (4)
        intended to incur, or believed it would incur, debts beyond its ability to
        pay
        as such debts matured, such court may be asked to void the spin-off distribution
        (in whole or in part) as a fraudulent conveyance and require that the
        stockholders return the Citadel Shares (in whole or in part) to CT Holdings
        or
        require Citadel to fund certain liabilities for the benefit of creditors.
        Citadel believes that at the time of the spin-off distribution, the spin-off
        would not have given rise to any such claims.
 
 **SOME
        PROVISIONS OF OUR CERTIFICATE OF INCORPORATION AND BYLAWS MAY DISCOURAGE
        TAKEOVERS.**
 
 Our
        certificate of incorporation and bylaws contain some anti-takeover provisions
        that may make more difficult or expensive or that may discourage a tender
        offer,
        change in control or takeover attempt that is opposed by our board of directors.
        In particular, our certificate of incorporation and bylaws:
 
 ·
              classify
                  Citadel’s board of directors into three groups, so that stockholders elect
                  only one-third of the board each year;
  32
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  ·
              permit
                  stockholders to remove directors only for cause and only by the
                  affirmative vote of at least 80% of Citadel’s voting shares;
 ·
              permit
                  a special stockholders’ meeting to be called only by a majority of the
                  board of directors;
 ·
              do
                  not permit stockholders to take action except at an annual or special
                  meeting of stockholders;
 ·
              require
                  stockholders to give Citadel advance notice to nominate candidates
                  for
                  election to Citadel’s board of directors or to make stockholder proposals
                  at a stockholders’ meeting;
 ·
              permit
                  Citadel’s board of directors to issue, without stockholder approval,
                  preferred stock with such terms as the board may determine;
 ·
              require
                  the vote of the holders of at least 80% of Citadel’s voting shares for
                  stockholder amendments to Citadel’s bylaws; and
 ·
              require,
                  for the approval of a business combination with stockholders owning
                  5% or
                  more of Citadel’s voting shares, the vote of at least 50% of Citadel’s
                  voting shares not owned by such stockholder, unless certain fair
                  price
                  requirements are met or the business combination is approved by
                  the
                  continuing directors of Citadel.
 
 These
        provisions of our certificate of incorporation and bylaws, Delaware law and
        other measures we may adopt could discourage potential acquisition proposals
        and
        could delay or prevent a change in control of Citadel, even though a majority
        of
        Citadel’s stockholders may consider such proposals, if effected, desirable.
        These provisions could also make it more difficult for third parties to remove
        and replace the members of Citadel’s board of directors. Moreover, these
        provisions could diminish the opportunities for stockholders to participate
        in
        some tender offers, including tender offers at prices above the then-current
        market value of the our shares of common stock, and may also inhibit increases
        in the trading price of the our shares that could result from takeover attempts
        or speculation.
 
 In
        connection with the spin-off distribution, Citadel agreed to indemnify CT
        Holdings for all taxes and liabilities incurred as a result of Citadel’s or an
        affiliate’s post-distribution action or omission contributing to an Internal
        Revenue Service determination that the spin-off distribution was not tax-free.
        Unless CT Holdings effectively rebuts the presumption that a change in control
        transaction involving Citadel or disposition of Citadel occurring within
        the
        four-year period beginning two years prior to the distribution date is pursuant
        to the same plan or series of related transactions as the distribution, the
        Internal Revenue Service might determine that the distribution was not tax-free,
        giving rise to Citadel’s indemnification obligation. These provisions of the tax
        disaffiliation agreement may have the effect of discouraging or preventing
        an
        acquisition of Citadel or a disposition of Citadel’s businesses, which may in
        turn depress the market price for our shares.
 
 **FAILURE
        TO QUALIFY AS A TAX-FREE TRANSACTION COULD RESULT IN SUBSTANTIAL LIABILITY.**
 
 In
        May
        2002 Citadel was spun out of CT Holdings in a pro rata tax free distribution
        to
        shareholders. CT Holdings and Citadel intend for the distribution to be tax-free
        for U.S. federal income tax purposes. Neither CT Holdings nor Citadel requested
        an advance ruling from the Internal Revenue Service, or any opinion of their
        tax
        advisors, as to the tax consequences of the distribution. No assurance can
        be
        given that the Internal Revenue Service or the courts will agree that the
        distribution was tax-free.
 
 If
        the
        distribution does not qualify for tax-free treatment, a substantial corporate
        tax would be payable by the consolidated group of which CT Holdings is the
        common parent measured by the difference between (1) the aggregate fair market
        value of the Citadel shares distributed on the distribution date and (2)
        CT
        Holdings' adjusted tax basis in the distributed Citadel shares on the
        distribution date. The corporate level tax would be payable by CT Holdings.
        However, Citadel has agreed under certain circumstances to indemnify CT Holdings
        for all or a portion of this tax liability. This indemnification obligation,
        if
        triggered, could have a material adverse effect on the results of operations
        and
        financial position of Citadel. In addition, under the applicable treasury
        regulations, each member of CT Holdings' consolidated group (including Citadel)
        is severally liable for such tax liability. Furthermore, if the distribution
        does not qualify as tax-free, each CT Holdings stockholder who received Citadel
        shares in the distribution would be taxed as if he had received a cash dividend
        equal to the fair market value of his Citadel shares on the distribution
        date.
  33
 *Table
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  **ITEM
        2.  PROPERTIES**
 
 We
        occupy
        approximately 33,500 square feet of office space in Dallas, Texas, our
        headquarters, and 6,300 square feet of office space in Reston, Virginia.
        The
        average monthly rent over the term of the leases for this space is approximately
        $52,200 per month and $12,000 per month, respectively. We believe that both
        leases have commercially reasonable terms.
 
 During
        the year ended December 31, 2004 we completed the renovations to the Dallas
        office space. In 2004, the landlord paid for approximately $836,000 of the
        renovations as a lease incentive, which is being amortized to rent expense
        over
        the term of the lease. Renovation expenditures made by Citadel during the
        years
        ended December 31, 2005 and 2004 were approximately $53,000 and $387,000,
        respectively, and were paid from general working capital.
  We
        maintain fire and casualty insurance that we believe adequately covers our
        leased properties against loss. The current office space satisfies our current
        needs and we believe they will be adequate for our needs in 2006. There are
        no
        plans to open additional offices in 2006.
  **ITEM
        3.  LEGAL PROCEEDINGS**
 
 In
        January, February and March 2005, seven virtually identical lawsuits were
        filed
        against Citadel, Steven B. Solomon, our Chief Executive Officer and a Director,
        and Richard Connelly, our Chief Financial Officer. These suits have been
        consolidated in one action styled Ruth R. Lentz v. Citadel Security Software,
        Inc., et al., Civil Action No. 3:05-CV-0100-D, in the United States District
        Court for the Northern District of Texas. Each case was filed on behalf of
        a
        putative class of persons and/or entities who purchased our securities between
        February 12, 2004 and December 16, 2004, inclusive. The suits seek recovery
        of
        unspecified damages under Sections 10(b) and 20(a) of the Securities Exchange
        Act of 1934, as amended, and Rule 10b-5 promulgated thereunder. The suits
        were
        filed after our announcement on December 17, 2004 that our projection of
        revenue
        and earnings for the full year 2004 would be less than previously projected.
        On
        May 25, 2005, the court appointed a lead plaintiff and approved plaintiff's
        selection of lead counsel.  On August 19, 2005, the lead plaintiff filed a
        consolidated complaint. On October 18, 2005, the defendants filed a motion
        to
        dismiss this consolidated action, which motion is pending before the Court.
        We
        believe these suits are without merit and intend to vigorously defend them.
        Discovery has not yet commenced, and no trial date has been set.
  On
        April
        1, 2005, a shareholder derivative suit styled Harry Brantley, derivatively
        on
        behalf of Citadel Security Software Inc. v. Steven B. Solomon, Richard Connelly,
        Chris A. Economou, John Leide and Joe M. Allbaugh, Cause No. 05-03117-L,
        was
        filed in the 193 rd State
        District Court in Dallas County, Texas on behalf of Citadel against certain
        of
        the Company’s officers and directors: Steven B. Solomon, the Chief Executive
        Officer and a Director of the Company; Richard Connelly, the Company’s Chief
        Financial Officer; and Chris A. Economou, John Leide and Joe M. Allbaugh,
        Directors of the Company. The suit also names the Company as a nominal
        defendant. Based on allegations substantially similar to the federal securities
        action, the suit asserts claims for the defendants’ alleged violations of state
        law, including breaches of fiduciary duties, abuse of control, gross
        mismanagement, and waste of corporate assets, and unjust enrichment that
        allegedly occurred during the same period of time at issue in the federal
        securities action. The suit seeks the recovery of damages, fees, costs,
        equitable and/or injunctive remedies, and disgorgement of all profits, benefits
        and other compensation. On July 5, 2005, the Court entered an order staying
        and
        administratively closing this case subject to being reopened upon the motion
        of
        any party. We
        believe this suit is without merit and intend to vigorously defend the
        suit. The ultimate outcome is not currently
        predictable.
 
 On
        April
        28, 2005, a shareholder derivative suit styled *Hans
        J. Baier, derivatively on behalf of Nominal Defendant, Citadel Security Software
        Inc., v. Steven B. Solomon, Richard Connelly and Chris
        Economou,* Civil
        Action No. 3-05CV-0846-D, was filed in United States District Court for the
        Northern District of Texas, Dallas Division, against certain of the Company’s
        officers and directors: Steven B. Solomon, the Chief Executive Officer and
        a
        Director of the Company, Richard Connelly, the Company’s Chief Financial Officer
        and Chris Economou, a Director of the Company. The suit also names the Company
        as a nominal defendant. Based on allegations substantially similar to the
        federal securities action, the suit asserts claims for the defendants’ alleged
        violations of state law, including breaches of fiduciary duties, abuse of
        control, gross mismanagement, waste of corporate assets and unjust enrichment
        for the same period of time at issue in the federal securities action. The
        suit
        also purports to assert a claim against Steven B. Solomon and Richard Connelly
        pursuant to a federal statute for reimbursement of bonuses, profits and
        compensation. The suit seeks the recovery of damages, fees, costs, equitable
        and/or injunctive remedies, and disgorgement of all profits, benefits and
        other
        compensation. On September 12, 2005, the Court entered an order staying this
        case until thirty (30) days after the Court rules on the pending motion to
        dismiss filed by the defendants in the consolidated federal securities action
        described above. We
        believe this suit is without merit and intend to vigorously defend the
        suit. The ultimate outcome is not currently
        predictable.
  34
 *Table
            of Contents*
  On
        April
        8, 2005, Meyers Associates, L.P. f/k/a Roan/Meyers Associates, L.P. and f/k/a
        Janssen-Meyers Associates, L.P. (“Meyers”) filed a lawsuit in the Court of
        Chancery of the State of Delaware, in New Castle County, against the Company,
        CT
        Holdings, Inc. f/k/a Citadel Technology, Inc. and f/k/a Citadel Computer
        Systems, Inc. (“CT Holdings”) and certain current and former officers and
        directors of the Company and/or CT Holdings, including Steven B. Solomon,
        the
        Chief Executive Officer and a Director of the Company, Chris A. Economou,
        a
        Director of the Company, Lawrence Lacerte, a former Director of the Company,
        and
        Phillip J. Romano, a former Director of the Company (the “Individual
        Defendants”). The suit alleges that in connection with an action filed in the
        Supreme Court of New York, New York County, to enforce a Settlement Term
        Sheet
        executed on July 7, 2000 by Meyers and CT Holdings, Meyers was awarded a
        judgment against CT Holdings in the amount of $3 million plus interest on
        the
        judgment at the rate of 9% from October 31, 2000 until the date of entry
        of that
        judgment and thereafter at the statutory rate (the “Judgment”). The suit alleges
        that CT Holdings’ May 2002 spin-off of its interests in Citadel to CT Holdings’
shareholders rendered CT Holdings insolvent and constituted a fraudulent
        conveyance to defraud CT Holdings’ creditors, including Meyers. The suit asserts
        fraudulent conveyance claims against Citadel and CT Holdings pursuant to
        Delaware statutory and common law. The suit also asserts a claim against
        Citadel
        for successor liability as the alleged successor in interest or alter ego
        of
        Citadel. The suit alleges that the Individual Defendants who were officers
        and/or directors of CT Holdings at the time of the spin-off breached fiduciary
        duties allegedly owed to creditors of CT Holdings, including Meyers, by
        approving and allowing the spin-off transaction. The suit seeks to void the
        spin-off transaction, to hold Citadel liable for the Judgment including
        interest, to recover damages against the Individual Defendants in an amount
        not
        less than the Judgment including interest, plus an unspecified amount of
        punitive, consequential and incidental damages, as well as attorneys’ fees and
        costs. The Company believes that this suit is without merit and intends to
        vigorously defend this action. The ultimate outcome is not currently
        predictable.
 
 On
        February 14, 2006, the day the ‘247 Patent was issued, Secure Elements filed a
        declaratory judgment action in the United States District Court for the District
        of Delaware seeking a declaration from the Court that the ‘247 patent was both
        invalid and not infringed by Secure Elements. On March 6, 2006 Citadel answered
        Secure Element’s complaint, asserted counterclaims against Secure Elements for
        willful infringement of the ‘247 Patent, and sought an undisclosed amount of
        damages, costs and attorney’s fees, and an injunction barring Secure Elements
        from infringing the ‘247 Patent in the future. This case is in its infancy. The
        court has not yet entered a scheduling order and no discovery has been sought
        or
        obtained by either party. We believe this suit is without merit and we intend
        to
        vigorously defend the suit.
  From
        time
        to time, we may be subject to additional legal claims incidental to our
        business. We may suffer an unfavorable outcome as a result of one or more
        claims. We do not expect the final resolution of these claims to have a material
        adverse effect on our financial position, individually or in the aggregate.
        However, depending on the amount and timing of unfavorable resolutions of
        claims
        against us, or the costs of settlement or litigation, our future results
        of
        operations or cash flows could be materially adversely affected.
  **ITEM
        4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS**
 
 No
        matters were submitted to a vote of our security holders during the fourth
        quarter of 2005.
  35
 *Table
            of Contents*
  **PART
        II**
 
 **ITEM
        5.  MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED
        STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY
        SECURITIES**
 
 **MARKET
        INFORMATION**
 
 On
        May
        20, 2002 the Company’s stock began trading on the Over-The-Counter Bulletin
        Board under the symbol CDSS. In April, 2004 the Company's stock began trading
        on
        the NASDAQ Capital Market under the symbol CDSS. As of March 24, 2006, the
        last
        sales price per share of the Company’s common stock, as reported by The NASDAQ
        Capital Market, was $0.55. The following table presents the quarterly range
        of
        high and low closing prices for our common stock from January 1, 2004 through
        December 31, 2005, as reported by The NASDAQ Capital Market and the
        Over-The-Counter Bulletin Board prior to April 2004 (high and low quotations
        from the Over-The-Counter Bulletin Board reflect inter-dealer prices, and
        all
        prices do not reflect retail markup, markdown or commission, and may not
        necessarily represent actual transactions).
 
 HIGH
              
              LOWYEAR
                  ENDED DECEMBER 31, 20051stQuarter
              
              $
              2.55
              
              $
              1.022ndQuarter
              
              $
              1.40
              
              $
              0.753rdQuarter
              
              $
              1.09
              
              $
              0.604thQuarter
              
              $
              0.60
              
              $
              0.31YEAR
                  ENDED DECEMBER 31, 20041stQuarter
              
              $
              6.36
              
              $
              3.502ndQuarter
              
              $
              5.40
              
              $
              2.783rdQuarter
              
              $
              3.18
              
              $
              1.734thQuarter
              
              $
              5.00
              
              $
              2.28
 
 At
        December 31, 2005 there were approximately 822 holders of record of the
        Company’s outstanding common stock. Holders of common stock are entitled to
        dividends when and if declared by the Board of Directors out of legally
        available funds, subject to the limitations imposed by our shares of Series
        A
        Convertible Preferred Stock and Series B Convertible Preferred Stock. The
        Company has never paid cash dividends on its common stock, and management
        intends, for the immediate future, to retain any earnings for the operation
        and
        expansion of the Company’s business. Any future determination regarding the
        payment of dividends will depend upon results of operations, capital
        requirements, the financial condition of the Company, the limitations imposed
        by
        our preferred stock and loan agreement, and such other factors that the Board
        of
        Directors of the Company may consider. At December 31, 2005, the Company
        has
        1,000,000 shares of preferred stock authorized, of which 15,000 shares have
        been
        issued as Series A Convertible Preferred Stock and 7,000 shares have been
        issued
        as Series B Convertible Preferred Stock, which entitle the holders thereof
        to
        preferences as to payment of dividends and liquidation proceeds.
 
 On
        June
        23, 2005, we received a letter from The NASDAQ Stock Market (the "Notice")
        notifying us that for the 30 consecutive trading days preceding the date
        of the
        Notice, the bid price of our common stock had closed below the $1.00 per
        share
        minimum required for continued inclusion on The NASDAQ Capital Market pursuant
        to NASDAQ Marketplace Rule 4310(c)(4). The Notice further stated that we
        would
        be provided 180 calendar days, or until December 20, 2005, to regain compliance
        with the $1.00 per share bid price requirement in accordance with NASDAQ
        Marketplace Rule 4310(c)(8)(D). To regain compliance with the bid price
        requirement, the bid price of our common stock was required to close at or
        above
        $1.00 per share for a minimum of ten consecutive trading days prior to December
        20, 2005. On December 21, 2005, we received a letter from The NASDAQ Stock
        Market stating that we had not regained compliance with the NASDAQ's Marketplace
        Rule 4310(c)(4) within 180 days of the previously announced failure to comply
        with the Rule. As a result, Citadel's securities were subject to delisting
        from
        the NASDAQ Capital Market, unless we requested a hearing to appeal the
        decision.
  36
 *Table
            of Contents*
  We
        requested a hearing to appeal the NASDAQ Staff's determination to a NASDAQ
        Listing Qualifications Panel, in accordance with the Marketplace Rule 4800
        Series, and in February 2006, we participated in a hearing. On March 10,
        2006,
        Citadel received a letter from The NASDAQ Stock Market notifying Citadel
        that
        the NASDAQ Listing Qualifications Panel has granted Citadel’s request for
        continued listing, subject to the conditions that (1) on or before April
        13,
        2006, Citadel must have evidenced a closing bid price of at least $1.00 per
        share for a minimum of ten consecutive trading days, and (2) on or before
        May
        15, 2006, Citadel must report in its Quarterly Report on Form 10-Q for the
        period ending March 31, 2006, actual stockholders’ equity at March 31, 2006 of
        at least $2,500,000. In addition, Citadel must be able to demonstrate compliance
        with all requirements for continued listing on the NASDAQ Capital Market.
        Failure to meet any of these conditions may result in the delisting of Citadel’s
        common stock from The NASDAQ Stock Market. There can be no assurance that
        we
        will regain compliance with the NASDAQ listing requirements.
 
 We
        have
        scheduled a special stockholders meeting for March 29, 2006, at which our
        stockholders will vote on proposals for reverse stock splits ranging from
        1 for
        2 to 1 for 5. If the proposal is approved, there can be no assurance that
        the
        market price of our common stock will remain above $1 per share through April
        13, 2006, or that we will meet the other conditions required by the NASDAQ
        Stock
        Market for our continued listing on the NASDAQ Capital Market .
 
 **EQUITY
        COMPENSATION PLANS**
 
 The
        2002
        Stock Incentive Plan (the "Plan") was adopted by the board of directors and
        approved by the shareholders of Citadel prior to a spin out transaction of
        Citadel in May 2002. The plan authorizes the Board or a committee, which
        administers the plan, to grant stock options, stock appreciation rights,
        restricted stock and deferred stock awards to eligible officers, directors,
        employees and consultants. A total of 1,500,000 shares of common stock were
        originally reserved for issuance under the terms of the 2002 Stock Incentive
        Plan. In 2004 our Board and our stockholders approved amendments to the Plan,
        including an increase in the shares of common stock reserved for issuance
        thereunder by 1,500,000 shares of common stock to an aggregate of 3,000,000
        shares. In the event of any sale of assets, merger, reorganization,
        consolidation, recapitalization, stock dividend or other change in corporate
        structure affecting the stock, the Board or committee may make an equitable
        substitution or adjustment in the aggregate number of shares reserved for
        issuance under the plan. Since the inception of the plan we have granted
        4,301,000 awards under the Plan through December 31, 2005. Options cancelled
        since the inception of the Plan due to employee terminations amounted to
        1,636,776 and were added back to the options available for future grants
        under
        the Plan. Option holders under the Plan have exercised 337,224 options since
        the
        inception of the Plan through December 31, 2005 and hold 552,505 options
        which
        were exercisable at December 31, 2005. The options granted have a term of
        10
        years and generally vest over periods of up to three years. The underlying
        shares of the initial 1,500,000 shares of common stock in the Plan were
        registered on Form S-8 in July 2003, and we intend to register the additional
        1,500,000 shares on a Form S-8.
 
 The
        board
        of directors has also granted options outside of the Plan. These options
        are not
        covered under a plan approved by the stockholders. Options have been granted
        to
        officers, directors, employees, stockholders and consultants to the Company.
        The
        options granted have a term of 10 years or less. There were 6,516,250 options
        outside of the Plan outstanding at December 31, 2005 of which 5,525,834 are
        exercisable. The remaining options vest over periods of up to three years.
  Equity
                    Compensation Plan InformationPlan
                    category
                
                (a)
                  Number
                    of securities to be issued upon exercise of outstanding options,
                    warrants
                    and rights
                
                Weighted-average
                    exercise price of outstanding options, warrants and rights
                
                Number
                    of securities available for future issuance under equity compensation
                    plans [excluding securities reflected in column (a)]Equity
                    compensation plans approved by security holders
                
                
                2,327,000
                
                $
                1.59
                
                
                335,776Equity
                    compensation plans not approved by security holders
                
                
                6,516,250
                
                $
                0.99
                
                
                not
                    applicable
 **REPURCHASES
        OF SECURITIES**
 
 The
        Company made no repurchases of shares during the fourth quarter of
        2005.
  37
 *Table
            of Contents*
  **ITEM
        6.  SELECTED FINANCIAL DATA**
 
 You
        should read the following selected financial data with our consolidated
        financial statements and related notes and “Management’s Discussion and Analysis
        of Financial Conditions and Results of Operations”. Historical results may not
        be indicative of future results.
 
 **Years
                  Ended December 31,****2005**
              
              **2004**
              
              **2003**
              
              **2002****(1)**
              
              **2001****(1)****Statement
                  of Operations Data**Revenue
              
              $
              10,287,095
              
              $
              15,253,155
              
              $
              5,856,296
              
              $
              1,311,800
              
              $
              580,039Operating
                  loss
              
              
              (18,158,207
              )
              
              (7,873,594
              )
              
              (1,951,739
              )
              
              (2,608,135
              )
              
              (1,865,981
              )Net
                  loss
              
              
              (18,562,879
              )
              
              (7,839,025
              )
              
              (5,248,581
              )
              
              (2,346,895
              )
              
              (1,865,981
              )Net
                  loss to common shareholders
              
              
              (19,156,907
              )
              
              (8,719,362
              )
              
              (5,248,581
              )
              
              (2,346,895
              )
              
              (1,865,981
              )Net
                  loss per share -basic and diluted
              
              $
              (0.64
              )
              $
              (0.30
              )
              $
              (0.24
              )
              $
              (0.17
              )
              $
              (0.15
              )Shares
                  used in per share calculation
              
              
              29,976,179
              
              
              29,336,894
              
              
              22,134,040
              
              
              13,874,488
              
              
              12,433,427
 
 **Years
                  Ended December 31,****2005**
              
              **2004**
              
              **2003**
              
              **2002****(1)**
              
              **2001****(1)****Balance
                  Sheet Data**Cash
                  and cash equivalents
              
              $
              1,320,376
              
              $
              9,838,154
              
              $
              5,092,161
              
              $
              12,829
              
              $
              75,030Working
                  capital (deficit)
              
              
              (5,749,000
              )
              
              3,488,298
              
              
              2,042,601
              
              
              (3,428,158
              )
              
              (935,693
              )Total
                  assets
              
              
              14,465,419
              
              
              22,408,510
              
              
              9,734,130
              
              
              1,537,949
              
              
              413,721Deferred
                  revenue
              
              
              5,078,670
              
              
              2,943,023
              
              
              2,805,195
              
              
              150,193
              
              
              -Long-term
                  debt
              
              
              3,750,000
              
              
              1,989,393
              
              
              -
              
              
              -
              
              
              -Preferred
                  stock
              
              
              15,669,987
              
              
              10,701,847
              
              
              -
              
              
              -
              
              
              -Total
                  equity (deficit)
              
              
              (864,892
              )
              
              10,792,520
              
              
              4,770,761
              
              
              (2,326,900
              )
              
              (693,926
              )
 
 (1) Prior
        to
        May 17, 2002 certain of the Company's former parent’s, assets, liabilities and
        expenses were allocated to Citadel based on an estimate of the proportion
        of
        amounts allocable to Citadel, utilizing such factors as revenues, number
        of
        employees, and other relevant factors. In the opinion of management, the
        allocations have been made on a reasonable and consistent basis for the periods
        presented prior to May 17, 2002. Management believes that all amounts allocated
        to Citadel are a reasonable representation of the costs that would have been
        incurred if Citadel had performed these functions as a standalone
        company.
 
 **ITEM
        7.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL
        CONDITION AND RESULTS OF OPERATIONS**
 
 The
        following discussion should be read in conjunction with our audited consolidated
        financial statements and related notes included elsewhere in this Form 10-K .
        Our
        year ends on December 31, and each of our quarters end on the final day of
        a
        calendar quarter (each March 31, June 30 and September 30). The following
        discussion contains forward-looking statements. Please see "Risk Factors"
        and
        "Cautionary Statement Regarding Forward-Looking Statements" for a discussion
        of
        uncertainties, risks and assumptions associated with these statements.
 
 **OUR
        BUSINESS**
 
 The
        security software business of Citadel was formed in 1996 as the result of
        the
        acquisition of several technology businesses operated by a technology business
        incubator. Citadel was spun off as a standalone company in May 2002. We
        develop and market full life cycle vulnerability management software for
        enterprise level network security. Our computer software products include
        security and management solutions for networks and workstations which are
        designed to manage security on servers and personal computers (“PC”) attached to
        local area networks (“LAN”). Our products enable organizations to remediate
        their computer network’s security vulnerabilities that occur as a result of
        software application defects, unauthorized or weak access rights, or
        misconfigurations of systems. In some cases, security vulnerabilities are
        the
        result of leaving unnecessary services turned on in a PC or LAN, or the
        occurrence of a system backdoor that remains closed until exploited and opened
        by a hacker. Our software products can also be used to maintain compliance
        with
        security policies of the managed devices connected to the
        network.
  38
 *Table
            of Contents*
  With
        our
        products, companies and government agencies are able to more efficiently
        manage
        the security of computing environments and enforce security policies from
        a
        single point of control across Windows, Linux, Mac and UNIX platforms. Our
        products and services allow enterprises to secure confidential information,
        applications, and systems from unauthorized access, worms, and other security
        vulnerabilities. Our solutions are designed to reduce customer costs, improve
        accuracy of customer information, maintain the secure operations of workstations
        and servers, secure systems from fraud or unauthorized use, and generally
        enable
        IT professionals to devote more time to improving service rather than focusing
        on security policy details. Our products also allow customers to comply with
        internal and external security policies that are being driven by government
        or
        industry mandates.
 
 **CRITICAL
        ACCOUNTING POLICIES AND ESTIMATES**
 
 The
        discussion and analysis of our financial condition and results of operations
        are
        based on our consolidated financial statements, which have been prepared
        in
        accordance with accounting principles generally accepted in the United States
        of
        America (“GAAP”). The preparation of these financial statements requires us to
        make estimates, assumptions and judgments that affect the reported amounts
        of
        assets, liabilities, revenues and expenses, and related disclosures of
        contingent assets and liabilities. On an on-going basis, we evaluate these
        estimates, assumptions and judgments, including those related to bad debts,
        returns and allowances, software capitalization and technological obsolescence
        as well as litigation. We base our estimates on historical experience and
        on
        various other assumptions that are believed to be reasonable under the
        circumstances, the results of which form the basis for making judgments about
        the carrying value of assets and liabilities. Actual results may materially
        differ from these estimates under different assumptions or conditions. If
        actual
        results were to differ from these estimates materially, the resulting changes
        could have a material adverse effect on our financial statements.
 
 We
        have
        identified below the accounting policies for revenue recognition and software
        costs which we believe are most critical to our business operations. These
        policies are discussed throughout Management's Discussion and Analysis, where
        such policies affect our reported and expected financial results.
 
 **REVENUE
        RECOGNITION**
 
 Significant
        management judgment and estimates must be made and used in connection with
        the
        revenue recognized in any accounting period. Material differences may result
        in
        the amount and timing of our revenue for any period if our management made
        different judgments or utilized different estimates. Our customers consist
        of
        large and small corporations, healthcare organizations, financial institutions
        and government and educational agencies. Our revenue recognition policies
        have
        been designed to follow the guidance provided by Statement of Position (SOP)
        97-2, "Software Revenue Recognition," as amended by SOP 98-9 and Staff
        Accounting Bulletin (SAB) 104, "Revenue Recognition." Revenue from license
        fees
        is generally recognized when a fixed fee order has been received and delivery
        has occurred to the customer. If software media and documentation are shipped
        FOB “Origin”, license fee revenue is recognized when shipped. If software and
        media documentation are shipped FOB “Destination”, license fee revenue is
        recognized when delivered. In addition, revenue is recognized only when the
        collectibility of the invoiced amounts is probable and acceptance criteria,
        if
        any, have been met. Customer support contracts provide the customer the right
        to
        telephone support, software updates, point releases of new features and
        functionality, and content subscriptions provide the customer with vulnerability
        remediation updates on a when and if available basis. Content and customer
        support contracts are sold separately from the license and the related revenue
        is recognized ratably over the term of the support contract. Professional
        services revenue is recognized as the services are performed assuming all
        other
        revenue recognition criteria are met. In arrangements that include multiple
        elements, including perpetual software licenses and maintenance and/or services,
        revenue is allocated to the undelivered components based on vendor specific
        objective evidence (“VSOE”) and recognized based on management’s estimate of the
        fair value of each undelivered component as described in SOP 97-2, SOP 98-9
        and
        SAB 104.
  39
 *Table
            of Contents*
  Customers
        may obtain a license from our direct sales organization, or license products
        through promotions or agreements with independent third party resellers and
        strategic partners. Our products are not licensed through retail distribution
        channels. Once properly licensed for an evaluation or permanent installation
        the
        customer has the media and documentation shipped directly to them. A customer
        may return a product only under very limited circumstances during the first
        thirty to ninety days from the date of shipment for a replacement if the
        media
        is damaged or for a full refund if the software does not perform in accordance
        with written specifications. Accordingly, we record a provision for returns
        against license revenue in the same period the revenue is recorded. The
        provision is subject to estimation by management and has been based on
        historical product returns, the average invoice size, revenue volume and
        other
        known data as well as market and economic conditions. An allowance for returns,
        allowances and bad debts of $209,000 was recorded at December 31, 2005. The
        estimate of the allowance for returns, allowances and bad debts may fluctuate
        from period to period due to factors including but not limited to the value
        of
        actual returns, the average dollar value of licenses granted during the period,
        the relative license revenue volume for the period and changes in financial
        condition of individual customers.
 
 Citadel
        utilizes a sell-through business model for distributors and resellers under
        which revenue is recognized on products sold through distributors and resellers
        at the time the distributors and resellers liscense the products to the
        end-user. When distributor and resellers agreements provide for a contractual right of
        return, future price concessions, or minimum purchase commitments, we record
        an
        estimated allowance for returns and allowances based on historical returns
        and
        other facts and circumstances known at the time the estimate is made. When
        payment is contingent upon the distributor’s future licensing of products
        we defer revenue until payment is received. Revenue generated from products
        licensed through various marketing channels where the right of return might
        expressly or implicitly exist is reduced by reserves for estimated product
        returns. Such reserves are estimates developed by management based on returns
        history and current economic and market trends. Management determined that
        no
        reserve for returns from distributors was required at December 31, 2005.
 
 A s
        a
        convenience to government customers, our products may be licensed through
        government contractors, including systems integrators. These government
        contractors and systems integrators hold the preferred purchasing and
        contracting vehicles for use by the various government agencies to purchase
        information technology products and services including our products and
        services. Our contracts with these government contractors generally do not
        contain an express right of return, however, these government contractors
        may
        order products in advance of receiving the order from the government agency.
        Under the sell-through method of accounting we defer revenue recognition
        until
        the government contractor has received the authorization to deliver the products
        to the end user government agency and any contingencies have lapsed.
 
 We
        also
        offer our products to customers under subscription licenses with one-year
        to
        three-year terms. The customer may renew the subscription at the end of the
        subscription term or may convert the subscription into a perpetual use license
        at any time for an additional fee. Under a subscription license the customer
        receives the right to use the product, to post sale customer support and
        to
        content (i.e., the vulnerability remedy updates) for the term of the
        subscription and for as long as the customer meets its payment obligation.
        The
        subscription fee payment is generally due in equal payments at the beginning
        of
        the subscription term and then on each anniversary date thereafter. Revenue
        from
        subscriptions is recognized ratably over the term of the subscription. If
        a
        customer fails to adhere to the payment terms of the subscription, the revenue
        recognized is limited to the ratable recognition of the amount of payments
        actually received. At December 31, 2005, we had $109,000 of annual value
        of
        subscription contracts in force and during the year, we recognized approximately
        $44,000 of subscription revenue. No subscription revenue was recognized for
        the
        years ended December 31, 2004 and 2003.
 
 In
        June
        2005 we announced the availability of our Hercules product under a usage
        based
        pricing model which provides the end-user customer a method to pay for the
        use
        of the product on a transaction-by-transaction basis. Assuming all other
        requirements for revenue recognition have been met, the revenue from the
        transaction fees are accounted for based upon the transaction fees earned
        during
        a reporting period. No transaction fee revenue was recorded during the year
        period ended December 31, 2005.
 
 **SOFTWARE
        DEVELOPMENT COSTS**
 
 We
        follow
        the guidance provided in Statement of Financial Accounting Standards No.
        86
“Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise
        Marketed” (“SFAS No. 86”) regarding the accounting for the costs of developing
        our products. Purchased software (i.e., software acquired from a third party)
        is
        recorded at the lower of acquisition cost or net realizable value. We develop
        software for licensing to our customers and capitalize software development
        costs when technological feasibility has been established. Technological
        feasibility generally occurs at the time a detailed design and analysis plan
        is
        completed and programming of the software code begins. Software development
        costs that qualify for capitalization include the salaries and benefits of
        the
        software engineers assigned to the projects, internal and external quality
        assurance testing costs, overhead allocations primarily associated with
        facilities costs, the costs of outsourced development activities and costs
        of
        independent product testing and certification labs. Software development
        costs
        not qualifying for capitalization are expensed and classified as product
        development expense in the statements of operations. Product development
        expense
        and the capitalization rate will fluctuate from period to period depending
        upon
        the number and status of software development projects that are in process
        and
        the related number of people assigned to those projects.
  40
 *Table
            of Contents*
  Purchased
        software and capitalized software development costs are amortized using the
        greater of the revenue method or the straight-line method with useful lives
        ranging from one to three years. Amortization expense is classified in costs
        of
        revenue in the statements of operations. Our products operate on or with
        other
        third party operating systems and software. When determining the useful life
        of
        a product, we consider factors such as the current state of the technology,
        operating systems upon which our products run, competitive products and the
        potential use of our products by the end user. Technological advances in
        software operating systems and other software technologies upon which our
        products rely may shorten the expected life cycle of some versions of our
        products. We make an assessment of the useful lives of our products at each
        balance sheet date. If that assessment determines that a shortened product
        life
        has occurred, we amortize the remaining unamortized balances over the new
        estimated useful life of the product and provide disclosure regarding a change
        in estimate in the notes to the financial statements pursuant to FASB Statement
        of Financial Accounting Standard No. 154 “Accounting for Changes and Error
        Corrections”.
 
 Our
        product development strategy has been architected for the current and future
        releases of Microsoft Windows, UNIX, Linux, Mac and other well established
        operating systems. We believe that this cross platform strategy reduces the
        potential exposure to product obsolescence due to rapid changes in customer
        preferences or technological obsolescence due to the introduction of new
        operating systems or competing products. However, it is possible that these
        factors may change in the future as our business model is adapted to changes
        in
        technology, changes in customer buying patterns and changes in the software
        industry's revenue licensing models.
 
 We
        evaluate the estimated net realizable value of each software product at each
        balance sheet date. Our estimate is based on historical and forecasted net
        revenue for each product. Net revenue is the product revenue reduced by the
        estimated costs of revenue and, if in development, the estimated cost to
        complete the development of the product. When the net book value exceeds
        the
        estimate of net realizable value, we record a write-down to net realizable
        value
        on each product affected. Management’s ability to achieve its revenue forecast
        is subject to judgment, competitive pressures, market and economic conditions
        and management’s ability to successfully license the Company’s products to its
        customers. A change in one or more of these factors may influence management’s
        estimates. Accordingly, currently estimated net realizable values are subject
        to
        reductions in corresponding charges for impairment in the future.
  STOCK-BASED
        COMPENSATION
 
 On
          December 16, 2004, the Financial Accounting Standards Board issued SFAS
          No. 123
          (revised 2004), Share-Based Payment (“SFAS No. 123R”), which is a revision of
          SFAS No. 123, “Accounting for Stock-Based Compensation”. SFAS No. 123R
          supersedes APB Opinion No. 25, and amends SFAS No. 95, “Statement of Cash
          Flows”. Generally, the approach in SFAS No. 123R is similar to the approach
          described in SFAS No. 123. However, SFAS 123R requires all share-based
          payments
          to employees, including grants of employee stock options, to be recognized
          in
          the income statement based on their fair values. Pro forma disclosure is
          no
          longer an alternative. The Company will adopt the modified prospective
          method of
          SFAS No. 123R on January 1, 2006.
 
 The
          adoption of SFAS No. 123R will require the Company to record substantial
          non-cash stock compensation expenses. While the adoption of SFAS 123R is
          not
          expected to have a significant effect on the Company's financial condition
          or
          cash flows, it is expected to have a significant effect on the Company's
          results
          of operations. The future impact of the adoption of SFAS 123R cannot be
          predicted at this time because it will depend on the levels of share-based
          payments granted by the Company in the future. However, had the Company
          adopted
          SFAS 123R in prior periods, the impact of the standard would have approximated
          the impact of SFAS 123 as described in the pro forma net loss attributable
          to
          common shareholders.


**RESULTS
        OF OPERATIONS FOR YEAR ENDED DECEMBER 31, 2005 AS COMPARED WITH THE YEAR
        ENDED
        DECEMBER 31, 2004**
 
 **REVENUE**
 
 The
        components of revenue for the years ended December 31, 2005 and 2004 are
        as
        follows.
  Year
                    Ended December 31,
                
                Increase
                    (Decrease)2005
                
                2004
                
                Amount
                
                PercentRevenue
                    from:-License
                    feesHercules
                
                $
                2,541,451
                
                $
                9,491,667
                
                $
                (6,950,216
                )
                
                (73%
                )SecurePC
                
                
                53,548
                
                
                432,208
                
                
                (378,660
                )
                
                (88%
                )NetOFF
                
                
                19,169
                
                
                2,506,264
                
                
                (2,487,095
                )
                
                (99%
                )Provision
                    for returns and allowances
                
                
                (45,715
                )
                
                (68,554
                )
                
                22,839
                
                
                33
                %2,568,453
                
                
                12,361,585
                
                
                (9,793,132
                )
                
                (79
                %)-Content,
                    subscription, and customer support services
                
                
                4,867,542
                
                
                2,786,937
                
                
                2,080,605
                
                
                75
                %-Other
                    services
                
                
                2,851,100
                
                
                104,633
                
                
                2,746,467
                
                
                2625
                %Total
                    revenue
                
                $
                10,287,095
                
                $
                15,253,155
                
                $
                (4,966,060
                )
                
                (33
                %)
 41
 *Table
                of Contents*
 During
        2005 we received orders of $11.3 million for software, content, support and
        professional services versus orders of $19.4 million in 2004. Of the $19.4
        million in orders received during 2004, four orders represented $15.3 million
        or
        79% of the total orders; $8.6 million from Department of Defense ("DoD"),
        $5.0
        million across two orders from the Department of Veteran Affairs ("VA") and
        $1.7
        million from MCI. Our average dollar order by customer fell from $167 thousand
        per customer in 2004 to $110 thousand per customer in 2005. Included in the
        2005
        orders is $6.9 million of orders from new customers and $4.4 million in repeat
        orders for software, content, support and services from existing customers
        including $2.4 million from DoD, $1.6 million from VA and $325 thousand from
        MCI. This compares to $17.1 million in new orders in 2004 (primarily the
        DoD and
        VA) and $2.3 million in repeat orders from existing customers, $2.2 million
        of
        which was the VA.
 
 DoD,
        VA
        and MCI represented 62% and 89% of total revenue for the years ended December
        31, 2005 and 2004, respectively. The decrease in this percentage reflects
        the
        expansion of our customer base into industry segments outside the public
        sector
        such as financial services companies and retail companies. Revenue from the
        commercial sector market segment grew $1.6 million or 63% in 2005 over 2004
        driven primarily by financial services companies. Revenue from public sector
        market segment, primarily federal government agencies was $6.1 million in
        2005
        versus $12.7 million in 2004 representing a decline of $6.6 million or 52%.
        Excluding the revenue from the DoD and the VA, revenue from the public sector
        grew $91 thousand or 20% in 2005 over 2004.
 
 Revenue
        from license fees for the year ending December 31, 2005 was $2,568,453 versus
        $12,361,585 for the same period in 2004, representing a decrease of $9,793,132
        or 79%. As mentioned, revenue in 2004 benefited from large contract awards
        from
        the DoD, VA and MCI. Excluding the effect of approximately $11.2 million
        of
        license fee revenue related to these three customers in 2004, license fee
        revenue increased approximately $1.4 million, or 114% in 2005. This increase
        represents an increase in the average license revenue per customer and a
        wider
        distribution of software licenses across more customers in 2005 than in
        2004.
 
 We
        require all customers to enter into a separate contract for customer support
        services when licensing our products. In addition to support services, Hercules
        customers receive content, or access to the Hercules remedies available via
        the Hercules content service known as V-Flash. Our Remediation Security Group
        researches new vulnerabilities, writes the remedies for the new vulnerabilities
        and tests the remedies to assure that the remedies function as expected.
        The
        remedies are then made available to our customers via the V-Flash content
        database. Customers are encouraged to update their remediation content database
        frequently by performing the update actions within Hercules which accesses
        the
        V-Flash content database over the Internet. It is recommended that customers
        access the content database frequently to remain secure from newly identified
        vulnerabilities.
 
 Revenue
        recognized from content, subscription, and customer support services contracts
        is recognized ratably over the term of the contract, which is generally one
        year, and amounted to $4,867,542 and $2,786,937 for the years ended December
        31,
        2005 and 2004, respectively. The increase of $2,080,605, or 75%, is primarily
        due to content and customer support revenue recognized from the rollout of
        the
        DISA renewal of its content and customer support contract that began its
        initial
        one year term in the third quarter of 2004. This rollout accompanied by the
        DISA
        renewal of its content and customer support contract in the third quarter
        of
        2005, accounts for approximately $1,500,000 of the $2,080,605 increase in
        content, subscription, and customer support services revenue from 2004 to
        2005.
 
 Professional
        services revenue also rose to $2,851,100 in 2005 due to the completion of
        work
        performed under professional services engagements with higher total contract
        value during the year versus the same period of 2004. Of this amount $832,261
        was for training, $364,563 for implementation services and $1,654,276 for
        consulting services. This compares to $45,200 for training, $30,000 for
        implementation services and $29,433 for consulting services during
        2004.
 
 The
        provision for product returns and allowances for the year ended December
        31,
        2005 was $45,715 versus $68,554 for the year ended December 31, 2004. The
        provision for returns and allowances is an estimate based upon historical
        trends
        and the increase in the average invoice size in 2005. We do not expect product
        returns, if any, related to 2005 revenue to exceed the estimated allowance
        of
        $209,000 at December 31, 2005 due to the nature of our licensing terms and
        product quality, however, there can be no assurance that returns will not
        exceed
        the allowance.
 
 During
        2005 we continued to focus our licensing efforts on the government, healthcare,
        financial institutions and general corporate market segments. This is due
        in
        part to the mandates of the Health Insurance Portability and Accountability
        Act
        for healthcare, Gramm-Leach-Bliley Act for financial services, Federal
        Information Security
  42
 *Table
            of Contents*
  Management
        Act for government and the Sarbanes Oxley Act of 2002 for publicly traded
        companies, and Presidential Decision Directive 63 for government, each of
        which
        require certain industries to meet minimum security requirements for the
        protection of personal, financial and government data. The revenue distribution
        by industry segments for the years ended December 31, 2005 and 2004 was as
        follows:
 
 Years
                  Ended December 31,2005
              
              2004Industry
                  Segment:Government
              
              
              58
              %
              
              82
              %Corporate
              
              
              25
              %
              
              12
              %Financial
                  institutions
              
              
              13
              %
              
              4
              %Education
              
              
              1
              %
              
              1
              %All
                  other, primarily health
              
              
              3
              %
              
              1
              %
  Revenue
        from customers representing 10% or more of total revenue during the years
        ended
        December 31, 2005 and 2004, respectively, was as follows:
 
 Years
                  Ended December 31,2005
              
              2004End
                  User Customer:Defense
                  Information Systems Agency
              
              
              32
              %
              
              39
              %Department
                  of Veteran Affairs
              
              
              21
              %
              
              41
              %
 
 Although
        the existing customers listed above represent 53% of the 2005 revenue, we
        do not
        expect to rely on any one existing customer, group of existing customers
        or
        industry segment for a significant source of recurring revenue. We anticipate
        that revenue from government agencies will continue to be focused on large
        purchases and high value orders, and if those orders are received we foresee
        that revenue from government agencies will continue to be a large portion
        of the
        future revenue composition by industry segment. In addition, revenue from
        Hercules is expected to be the primary source of our total license fee, customer
        support and services revenue. We expect that future revenue from the licensing
        of Hercules will be derived from multiple orders primarily from large
        enterprises consisting of Fortune 2000 companies and large government agencies.
        Therefore any one customer or groups of customers in the same industry segment
        could become a material component of total revenue in any future quarter
        or
        year. However, there is no assurance that the distribution of revenue by
        industry segment or customer for the quarters presented is representative
        of
        future revenue projections and we expect that our revenue by industry segment
        and customer will vary markedly from period to period.
 
 **COSTS
        OF REVENUE**
 
 The
        components of costs of revenue for the years ended December 31, 2005 and
        2004
        are as follows:
  Year
                    Ended December 31,
                
                Increase2005
                
                2004
                
                Amount
                
                PercentCosts
                    of revenueSoftware
                    amortization
                
                $
                2,192,115
                
                $
                1,287,927
                
                $
                904,188
                
                
                70
                %Content,
                    subscription, and customer support services costs
                
                
                1,667,581
                
                
                1,478,633
                
                
                188,948
                
                
                13
                %Professional
                    services costs
                
                
                645,202
                
                
                29,028
                
                
                616,174
                
                
                2123
                %Shipping
                    and other costs
                
                
                161,805
                
                
                36,496
                
                
                125,309
                
                
                343
                %Total
                    costs of revenue
                
                $
                4,666,703
                
                $
                2,832,084
                
                $
                1,834,619
                
                
                65
                %
  *Software
          Amortization*
 
 Software
        amortization begins at the time a new product or new version of a product
        is
        available for licensing. The estimated useful life used to amortize the
        capitalized value of released products is three years or less. Approximately
        $2.6 million of capitalized software costs have become amortizable since
        December 31, 2004 primarily due to new releases of Hercules during that period.
        As a result of this increase in the average balance of capitalized software
        costs, software amortization expense increased $904,188, or 70%, in the year
        ended December 31, 2005 versus the year ended December 31, 2004. We expect
        that
        software amortization will increase in the quarters of 2006 due to the
        amortization of the capitalized software development costs associated with
        planned new releases of Hercules.
  43
 *Table
            of Contents*
  The
        comparison of unamortized capitalized software development costs to the net
        realizable value of the capitalized software at December 31, 2005 of $4,431,322
        and December 31, 2004 of $4,048,452 indicated that the unamortized capitalized
        software balances at December 31, 2005 and December 31, 2004 did not exceed
        net
        realizable value. Accordingly, no write-down was required during the year
        ended
        December 31, 2005 or the year ended December 31, 2004. The net realizable
        value
        analysis involves assumptions as to future product revenue and as a result,
        there can be no assurance that we will successfully achieve those future
        revenue
        forecasts or that an unexpected technological change in operating systems
        or
        other technologies will not impair the recorded values or require us to change
        our estimated useful lives in the future.
 
 *Content,
        Subscription and Customer Support Services Costs*
 
 Under
        our
        post sale customer support services agreements, customers receive the right
        to
        telephone support as well as the right to software point releases and software
        updates on a when and if available basis. In addition to these services,
        Hercules customers receive frequent updates to the vulnerability remedies
        via
        Internet access to our V-Flash content remediation database. The costs
        associated with these contractual obligations are classified as costs of
        revenue.
 
 The
        content, subscription, and customer support services costs for the years
        ended
        December 31, 2005 and 2004 of $1,667,581 and $1,478,633, respectively, include
        the salaries, benefits and other direct and indirect expenses of the personnel
        assigned to the post sale customer support function plus similar expenses
        associated with the remediation security engineers that write the vulnerability
        remedies and manage the remedy content database. The total increase in customer
        support services costs of $188,948 or 13% over the year ended December 31,
        2004
        is primarily attributable to increases in direct costs and higher year over
        year
        insurance costs associated with the customer support and remediation security
        engineer personnel and additional costs for database services incurred in
        2005
        but not in 2004. At December 31, 2005 and 2004, we had 12 and 23 full time
        personnel assigned to customer support services, respectively. We
        anticipate that the cost associated with these functions will vary from quarter
        to quarter based on the number of personnel assigned to the customer support
        and
        remediation database functions and their associated compensation expense.
 
 The
        security engineers monitor various security intelligence sites, IRC channels
        and
        our associated scanning partners for new vulnerabilities and exploits. As
        vulnerabilities and their exploits are discovered, the remediation security
        engineers quickly respond by writing a remedy to counteract the discovered
        vulnerability and prevent its exploit. The remedy is tested against the known
        affected platforms and delivered to the customer site electronically through
        the
        V-Flash mechanism. In addition to delivering new remedies, the security
        engineers continually monitor and update research information and URL links
        for
        vulnerabilities and related content to ensure that all links and research
        information and research material are timely and relevant. The costs associated
        with the customer support and security remediation group are largely dependent
        upon the number of people assigned to these functions. We believe that these
        functions are adequately staffed and therefore we do not expect to incur
        significant increases in the quarter-to-quarter costs for these functions
        in
        future periods, however, there can be no assurance that costs will remain
        constant at these expected staffing levels.
 
 *Professional
        Services Costs*
 
 For
        the
        year ending December 31, 2005, costs associated with professional services
        engagements were $645,202 compared with $29,028 for the same period in 2004.
        These costs include the direct costs and indirect overhead costs associated
        with
        the personnel performing the service engagements. The increase in professional
        services costs during the year ended December 31, 2005 is directly attributed
        to
        an increase in the number of consulting and training services engagements
        performed during 2005 over 2004. At December 31, 2005, we had six dedicated
        full-time professionals providing professional services versus four
        professionals providing similar services at December 31, 2004. In addition,
        to
        meet demand, services engagements may be supplemented with personnel from
        other
        functions within the Company or with outside third party consultants. When
        this
        occurs, the direct costs and overhead associated with these personnel in
        the
        performance of services engagements are charged to professional services
        costs.
  44
 *Table
            of Contents*
  *Shipping
        and Other Costs*
 
 Shipping
        and other costs include freight costs, preparation of media and documentation,
        costs of third party products shipped with Hercules and third party royalties
        for technology embedded in Hercules. Shipping and other costs during the
        year
        2005 also included costs related to the Hercules Security Appliance, which
        was
        not available in 2004. Shipping and other costs for the years ended December
        31,
        2005 and 2004 were $161,805 and $36,496, respectively. The $125,309 increase
        was
        primarily due to increases in costs associated with third party software
        royalties and appliance hardware purchases.
 
 **SELLING,
        GENERAL AND ADMINISTRATIVE EXPENSES******
 
 We
        incurred selling, general and administrative expenses ("SG&A") of
        $19,577,780 and $17,550,485 for the years ended December 31, 2005 and 2004,
        respectively, representing an increase of $2,027,295, or 12%. The increase
        was
        composed of higher pay and benefits costs, travel and entertainment expenses,
        marketing expenses, professional fees and higher rent and other infrastructure
        costs.
 
 At
        December 31, 2005, we employed 45 sales and marketing professionals, including
        pre-sales security engineers and professional services consultants, and we
        employed 14 people in finance, internal information technology, administration
        and general management including our CEO and CFO. At December 31, 2004, we
        employed 61 people as sales and marketing professionals, including pre-sales
        security engineers and professional services consultants, and 14 people in
        finance, internal information technology, administration and general management
        including our CEO and CFO. However, during 2005, overall SG&A headcount was
        higher than in 2004. Personnel reduction actions taken in the third quarter
        of
        2005 resulted in lower year-end 2005 headcount as compared to year-end 2004.
 
 The
        increase in SG&A professionals employed during 2005 resulted in an increase
        in pay and benefits costs of approximately $1.3 million in 2005 and an
        approximate $625 thousand increase in travel and entertainment expenses in
        pursuit of new sales in 2005. The approximate $1.9 million increase in pay,
        benefits and travel related costs during 2005 was offset by a decline in
        incentive related pay of $1.0 million versus 2004 due to the lower sales
        attained during 2005.
 
 Marketing
        expenses increased approximately $475 thousand in 2005 compared to 2004 because
        of additional expenditures needed for the marketing launch of Hercules 4.0,
        the
        Hercules Security Appliance, the 2-Minute Warning internet news service and
        for
        trade shows, advertising and other lead generation activities to drive increased
        sales opportunities for the sales organization. Professional fees increased
        approximately $470 thousand in 2005 primarily because of legal defense costs
        associated with lawsuits not yet reimbursed by insurance coverage. Rent and
        telecommunications costs increased approximately $250 thousand as a direct
        result of the increase in the technology infrastructure and the office expansion
        during the year.
 
 We
        expect
        total SG&A to vary from quarter-to-quarter primarily related to variable
        commission expense on changes in revenue, but we do not expect any significant
        increases in any other individual expense category.
 
 **PRODUCT
        DEVELOPMENT EXPENSE**
 
 We
        capitalize software development costs at the time technological feasibility
        is
        established, which generally occurs at the time the design and analysis plan
        is
        completed and software code programming begins. The costs and expenses that
        qualify for capitalization primarily consist of salaries, benefits and the
        direct and indirect costs associated with the development staff or with the
        specific development projects. Costs and expenses that do not qualify for
        capitalization and all costs and expenses incurred prior to technological
        feasibility are expensed and classified as product development expense in
        the
        statement of operations. A summary of gross product development expense,
        product
        development expense net of capitalized development costs and the capitalization
        rate for the years ended December 31, 2005 and 2004 are presented in the
        table
        below.
 
 2005
              
              2004Product
                  development expense, net of capitalized software development
                  costs
              
              $
              2,443,864
              
              $
              1,995,612Software
                  development costs capitalized
              
              $
              2,574,984
              
              $
              3,261,210Gross
                  product development expense
              
              $
              5,018,848
              
              $
              5,256,822Capitalized
                  costs as a percentage of gross product development expense
              
              
              51
              %
              
              62
              %
  45
 *Table
            of Contents*
  The
        decrease in gross product development expense of $237,973, or 5%, is primarily
        due to lower pay and benefits expenses associated with the decrease in the
        number software development engineers and quality assurance engineers employed
        during the respective periods presented *.* At
        December 31, 2005, we employed 23 software development and quality assurance
        engineers versus 39 software development and quality assurance engineers
        at
        December 31, 2004.
 
 The
        increase in product development expense, net of capitalized software development
        costs is due to lower gross costs as well as a lower capitalization rate
        of
        overall development expenses. The capitalization rate is the percentage of
        capitalized costs to total gross product development costs for the period.
        The
        capitalization rate was 51% for the year 2005 versus 62% for the year 2004.
        The
        decrease in the capitalization rate is primarily due to higher levels of
        non-capitalizable costs and expenses that had not reached technological
        feasibility and therefore were not capitalizable.
 
 Factors
        that affect the amount of software development costs capitalized or expensed
        include the stage of development of each project, the number of employees
        assigned to capitalizable projects, and the existence of significant third
        party
        costs, such as Common Criteria or other certification costs. Following a
        product
        release there is a period of time when maintenance development is performed
        and
        new product planning and analysis occurs. The costs associated with these
        activities are not capitalizable and as a result, the capitalization rate
        is
        expected to decline following a product release. The capitalization rate
        may
        increase once the new product planning and analysis phases are completed
        and the
        product has been determined to have reached technological feasibility.
        Therefore, product development expense and the capitalization rate historically
        have fluctuated from period to period, and may continue to fluctuate from
        period
        to period in the future. The capitalization rate is highly dependent upon
        the
        number and stage of software development projects that are in process, the
        length of time planned or incurred on each project, and the related number
        of
        employees assigned to those projects. In addition, third party testing and
        certification costs may be significant from time-to-time and are dependent
        upon
        the cost requirements of the testing or certification laboratory. We expect
        that
        the capitalization rate will average approximately 50% of gross product
        development expense in future projects but due to the factors discussed above,
        there can be no assurance that the capitalization rate will achieve this
        average
        consistently from period to period. Gross product development expense is
        expected to remain constant at the current staffing and spending levels from
        quarter to quarter during 2006. We plan to release new products and new versions
        of our products during 2006.
  **DEPRECIATION
        AND AMORTIZATION OF PROPERTY AND EQUIPMENT**
 
 Depreciation
        and amortization of property and equipment for the year ended December 31,
        2005
        was $1,756,955, compared to $670,782 for the year ended December 31, 2004,
        representing an increase of $1,086,173 or 162%. The increase is due to the
        increase in depreciable property, equipment and leasehold improvement purchases
        in the last six months of 2004 of approximately $4.1 million and in the first
        six months of 2005 of approximately $1.2 million. The estimated useful lives
        of
        the property and equipment range from one to eight years. Depreciation expense
        is not expected to change materially in future periods.
 
 **INTEREST
        EXPENSE**
 
 Interest
        expense for the years ended December 31, 2005 and 2004 was $472,260 and $82,612,
        respectively. The $389,648 increase in interest expense was the result of
        higher
        levels of average long-term debt balances outstanding during 2005 versus
        2004.
        The average long-term debt balance outstanding in 2005 was approximately
        $3.1
        million compared to $1.2 million in 2004.
 
 Also
        in
        2005, we incurred interest expense of approximately $63,000 related to factored
        accounts receivable balances and we amortized approximately $130,000 of debt
        issuance costs primarily related to the settlement of the Comerica debt in
        October 2005. During 2004 interest expense primarily related to interest
        on bank
        debt of approximately $61,000 and the amortization of deferred debt issuance
        costs of approximately $16,000. Interest expense paid in 2005 was approximately
        $256,000 compared to approximately $55,000 paid in 2004.
  46
 *Table
            of Contents*
  **INTEREST
        INCOME**
 
 Cash
        in
        excess of funds required for operating expenses is invested in a money market
        fund which generates interest income. Interest income for the years ending
        December 31, 2005 and 2004 was $67,588 and $107,261, respectively. The decrease
        in interest income is primarily due to lower average balances of invested
        cash.
 
 **PREFERRED
        STOCK DIVIDENDS AND OTHER NON CASH ITEMS INCLUDED IN NET LOSS TO COMMON
        SHAREHOLDERS**
 
 The
        statements of operations present preferred stock dividends, the accretion
        of the
        beneficial conversion feature of the Series A Convertible Preferred Stock
        (the
“Series A Shares”), the non-cash fair value adjustments related to the
        modifications to the terms of the Series A Shares and related warrants, and
        the
        non-cash fair value adjustments related to modification to the terms of the
        Series B Convertible Preferred Stock (the “Series B Shares”) warrants as
        adjustments to the net loss so as to arrive at net loss to common
        shareholders.
 
 At
        the
        shareholders meeting in July 2005 the shareholders approved the modifications
        to
        the terms of the Series A Shares which included waiving of the dividend payments
        effective on May 9, 2005. The estimated fair value of the benefit related
        to the
        waived dividends of $1,826,000 resulted in an increase to additional paid
        in
        capital and a decrease to the net loss to common shareholders for the year
        ended
        December 31, 2005. Through May 9, 2005 the Series A Preferred Stock accrued
        dividends at a rate of 5% if paid in cash, or 6% if paid in shares of our
        common
        stock. The dividends were payable on April 1, July 1, October 1 and January
        1 of
        each year. For the year ended December 31, 2005 we accrued $268,750 of
        dividends, which are shown as an increase to the loss to common shareholders,
        and paid $456,250. No dividends accrue on the Series B Shares. During the
        year
        ended December 31, 2004, we had accrued dividends of $187,500 and paid $477,439
        of dividends.
 
 The
        Series A Shares were issued along with warrants for 1.2 million shares of
        common
        stock. The relative fair values of the Series A Shares and the warrants were
        computed and as a result, it was determined that the relative fair value
        of the
        beneficial conversion feature of the Series A Shares was approximately $985,000,
        which was being accreted to additional paid in capital over the four year
        term
        of the preferred stock and shown as an increase to the loss to common
        shareholders. For the year ended December 31, 2005 $141,145 of the beneficial
        conversion feature was accreted to loss to common shareholders. At September
        30,
        2005 the Company determined that the beneficial conversion feature no longer
        existed due to the relationship between the new preferred conversion price
        ($3/common share) and Citadel’s stock price; thus, we reversed the unaccreted
        balance of the conversion feature of $628,107, resulting in a decrease to
        additional paid in capital and an increase to the net loss to common
        shareholders for the year ended December 31, 2005. For the year ended December
        31, 2004, accretion related to the beneficial conversion feature was
        $215,397.
 
 In
        May
        2005, in connection with the issuance of the Series B Shares, we entered
        into an
        Exchange Agreement with Satellite to exchange the Series A Warrants for Exchange
        Warrants to purchase up to 1.2 million shares of common stock at an initial
        exercise price of $1.75. The fair value of the Series A Warrants on May 9,
        2005
        was estimated and compared to the estimated fair value of the Exchange Warrants
        and the excess in the fair value of the Exchange Warrants over the Series
        A
        Warrants resulted in a net increase to additional paid in capital and a net
        increase to the net loss to common shareholders of $274,800 for the year
        ended
        December 31, 2005.
 
 At
        the
        shareholders meeting in July 2005 the shareholders also approved an amendment
        to
        the Series A Shares to reduce the conversion price from $5 to $3. The fair
        value
        of the Series A Shares immediately prior to the conversion price change was
        estimated using a Black-Scholes options pricing model and compared to the
        fair
        value of the Series A Shares immediately following the approval of the
        conversion price change, resulting in a decrease to additional paid in capital
        and an increase to the net loss to common shareholders of $1,064,000 for
        the
        year ended December 31, 2005.
 
 In
        October 2005, Satellite agreed to permit Citadel to issue a senior security
        in
        consideration for a reduction in the exercise price of their 4,038,710 Exchange
        and Series B warrants from $1.75 per share to $1.56 per share. The fair value
        of
        the warrants immediately prior to the conversion price change was estimated
        and
        compared to the fair value of the warrants immediately following the conversion
        price change, resulting in an increase to additional paid in capital and
        an
        decrease to the net loss to common shareholders of $43,226.
  47
 *Table
            of Contents*
  **NET
        LOSS AND INCOME TAX VALUATION ALLOWANCE**
 
 For
        the
        year ended December 31, 2005 we reported a net loss to common shareholders
        of
        $19,156,907 versus a net loss to common shareholders of $8,719,362 for the
        year
        ended December 31, 2004. Due to the uncertainty of realization, we recorded
        a
        valuation allowance equal to the net deferred tax asset associated with income
        tax benefit ascribed to the loss before income taxes for the years ended
        December 31, 2005 and 2004. At December 31, 2005 we had a net loss carryforward
        of approximately $33,200,000 which due to the uncertainty of realization
        has
        been fully reserved. The net operating loss carryforward is subject to annual
        limitations as prescribed in the Internal Revenue Code and is available to
        offset future taxable income and begins to expire in 2023.
 
 **LIQUIDITY
        AND CAPITAL RESOURCES**
 
 At
        December 31, 2005 the Company had cash and cash equivalents of approximately
        $1.3 million, a net working capital deficiency of approximately $5.7 million
        and
        a stockholders’ deficit of approximately $865 thousand. In
        addition, the Company used cash in its operating activities totaling
        approximately $12.6 million and incurred a net los of approximately $18.6
        million during the year ended December 31, 2005.
 
 On
        May 9,
        2005, we entered into agreements with funds affiliated with Satellite Asset
        Management (“Satellite”) related to a private placement for up to $11 million,
        consisting of up to 11,000 shares of Series B Convertible Preferred Stock
        (the
“Series B Shares”), convertible into approximately 7.1 million shares of common
        stock at the initial conversion price of $1.55, and warrants (“Series B
        Warrants”) to purchase approximately 2.8 million shares of common stock at an
        initial exercise price of $1.75 per share, in a private placement to accredited
        investors under Regulation D of the Securities Act of 1933, as amended. In
        addition, Citadel and Satellite entered into an Exchange Agreement where
        we
        agreed to exchange warrants to purchase 1.2 million shares of common stock
        issued to Satellite in connection with the sale of Series A convertible
        preferred stock with an exercise price of $5.15 per share for new warrants
        (the
“Exchange Warrants”) to purchase up to 1.2 million shares of our common stock at
        an initial exercise price of $1.75 per share.
 
 On
        May 9,
        2005, we closed the first tranche of the private placement for $7 million
        of
        Series B Shares (convertible into approximately 4.5 million shares of our
        common
        stock at the initial conversion price) and Series B Warrants to purchase
        approximately 1.8 million shares of our common stock. In addition, 1 million
        Exchange Warrants became immediately exercisable and the remaining 200,000
        Exchange Warrants became exercisable upon shareholder approval in July 2005.
        The
        proceeds from the preferred stock financing were used for working capital
        and
        general corporate purposes.
 
 Citadel
        had a put option to sell up to an additional $4 million of Series B Shares
        (convertible into approximately 2.6 million common shares) and Series B Warrants
        to purchase approximately 1 million shares of common stock at an exercise
        price
        of $1.75 per share, upon satisfaction of certain milestones, including
        shareholder approval, which was obtained at our annual meeting in July 2005,
        effectiveness of the registration statement covering the resale of the
        securities issued in the first tranche and a minimum bid price. The registration
        statement became effective in September 2005, however, the minimum bid
        requirement was not met and the put option expired. Pursuant to the requirements
        of the put option, we issued approximately 1 million Series B Warrants to
        Satellite in August 2005.
 
 On
        September 15, 2005, we borrowed $750,000 pursuant to an additional revolving
        credit line provided by a Fifth Amendment to the Loan and Security Agreement
        with Comerica Bank (“Comerica”) bringing the total principal amounts due to
        Comerica to approximately $3.1 million. On October 10, 2005 Citadel and Lawrence
        Lacerte (“Lacerte”) entered into a Loan and Security Agreement and Intellectual
        Property Security Agreement (the “Agreements”). Under the Agreements, Lacerte
        agreed to advance $3.75 million to Citadel with a maturity date of October
        10,
        2007 and an interest rate of 12%. The proceeds of the loan were used to retire
        principal amounts due to Comerica Bank on October 10, 2005 of approximately
        $2.9
        million and for general working capital purposes. As a result of the retirement
        of the Comerica notes payable, the loan and security agreement, as amended,
        between Citadel and Comerica, including debt covenants, was terminated. The
        terms of the Agreements require quarterly interest payments and payment of
        the
        principal balance at maturity. The loan from Lacerte is secured by a security
        interest in our assets except trade accounts receivable. We have agreed to
        pay a
        five percent (5%) premium to Lacerte upon early repayment of the loans or
        upon a
        change in control, and paid a one percent (1%) loan origination fee. The
        obligations under the Agreements may be accelerated in the event of a default
        under the Agreements, including a failure to pay amounts when due or a breach
        of
        the Agreements by Citadel.
  48
 *Table
            of Contents*
  Satellite,
        holder of the Series A and Series B convertible preferred stock, agreed to
        permit us to issue the senior security to Lacerte in consideration for a
        reduction in the exercise price of their warrants to purchase approximately
        4.0
        million shares of the Company’s common stock issued in conjunction with the
        Series A and Series B convertible preferred stock from $1.75 per share to
        $1.56
        per share.
 
 On
        October 31, 2005, Citadel and Allied Capital Partners, L.P. (“Allied”) entered
        into a factoring agreement and related agreements including a personal guarantee
        from our CEO (the “Allied Agreements”). Under the Allied Agreements, we may
        offer certain accounts receivable to Allied. Allied will factor the accepted
        accounts receivable and pay us approximately 80% of the face amount. The
        discount rate is 1.5% of the face amount for the first 30 days after Allied
        has
        purchased an account and 0.050% for each day that the account remains unpaid
        after the initial 30 day period. The Allied Agreements have a term of one
        year
        and contain no operating ratio covenants. During 2005 we transferred $3,514,248
        of our accounts receivable to Allied, for which we received $2,864,112 in
        cash
        proceeds. The proceeds were used for working capital purposes. The December
        31,
        2005 balance sheet includes $1,177,916 of uncollected trade receivables
        transferred to Allied and a balance due to Allied of $924,777, presented
        on the
        balance sheet as “Factoring line of credit”.
  During
          2005 the Company took actions to improve financial performance including
          reductions in costs and expenses, the hiring of new sales management and
          the
          reorganization of the sales team. We also began offering new ways for our
          customers to license our software solution including usage based pricing,
          subscription pricing and Hercules on an appliance. Some of the benefits
          of these
          actions began to be realized during the third and fourth quarters of 2005.
 
 We
          believe that the current sales management, the reorganization of the sales
          team,
          the new selling models introduced in 2005 and selling models that may be
          introduced in 2006 can continue the trend in increased orders for the next
          twelve months, although any one quarter's total orders could be skewed
          upward or
          downward resulting from the timing of the booking of large contracts that
          are in
          the pipeline. The expected increase in orders is expected to cause a
          corresponding increase in cash inflows to the Company.
 
 During
          the third and fourth quarters of 2005 we took actions to reduce costs and
          expenses. A substantial portion of these actions was a reduction in force.
          We
          expect to replace key positions as necessary and will add additional personnel
          to support additional contract order opportunities. In addition discretionary
          spending has been reduced. As a result of these cost and expense reduction
          actions taken in 2005, we expect that the total of our fixed costs and
          discretionary expenses will be reduced as much as $1.5 million to $2 million
          per
          quarter in 2006.
 
 Historically
          the Company has had access to additional capital and has raised money through
          both equity and debt financings. We believe that we will continue to have
          access
          to capital to fund the operations but the Company has no plans as of the
          filing
          date of this report to raise additional funds. From time-to-time in 2005
          the
          Company's CEO has advanced funds to the Company to meet short-term working
          capital needs. The total amounts advanced during 2005 were approximately
          $881,000, all of which was repaid to the CEO by February 1, 2006. The Company's
          CEO has committed to advance the Company up to three million dollars in
          funding
          should it be necessary for short term working capital needs through March
          2007.
          The terms and conditions of any advance to the Company from the CEO will
          be
          established by the Company's Board of Directors.
 
 The
          Company believes that the execution of its business plan including strategies
          to
          grow revenue and control costs and expenses, combined with liquidity available
          from our Factoring Agreement and the commitment from the Company's CEO,
          is
          sufficient to fund operations for the next twelve months. If needed, Citadel
          may
          also consider raising additional debt or equity capital under the right
          circumstances. However, there can be no assurance that the Company will
          be able
          to raise debt or equity capital at terms it considers reasonable and prudent
          or
          that the Company will be able to fully execute its business plan in
          2006.
  *Cash
        Used in Operating Activities*
 
 The
        net
        cash used in operating activities was $12,566,483 for the year ended December
        31, 2005. Our net loss of $18,562,879 was adjusted for net non-cash charges
        of
        $4,192,441 and a net increase to cash for changes in operating assets and
        liabilities of $1,803,955. Non-cash charges include depreciation and software
        amortization of $3,949,070, provision for returns, allowances and bad debts
        of
        $46,233, amortization of deferred debt issue costs of $130,192, and stock
        compensation expense of $171,500, and were offset by the amortization of
        a
        credit related to a tenant incentive of $104,554. Cash decreased due to a
        change
        in operating assets of $1,491,553 primarily due to a $2,000,574 increase
        in
        accounts receivable partially offset by a $533,764 decrease in prepaid expenses
        related to the recognition of deferred commission expense. Operating
        liabilities, including deferred revenue, increased $3,295,508. An increase
        of
        $1,328,130 in accounts payable was offset by decreases in accrued compensation
        and payroll taxes totaling $168,269. Total deferred revenue at December 31,
        2005
        was $5,078,670 and represents revenue to be earned from customer support
        contracts in force at December 31, 2005 and professional services contracts
        for
        which the services had not been performed at December 31, 2005. Of the total
        deferred revenue $398,342 is for prepaid services expected to be performed
        more
        than twelve months from the balance sheet date and accordingly has been
        classified as long-term deferred revenue. Total deferred revenue of $5,078,670
        at December 31, 2005 increased $2,135,647 from total deferred revenue of
        $2,943,023 at December 31, 2004 primarily due to higher levels of contracts
        in
        force at December 31, 2005 than at December 31, 2004.
 
 The
        net
        cash used in operating activities was $4,100,422 during the year ended December
        31, 2004. Our net loss of $7,839,025 was adjusted for non-cash charges of
        $2,313,042 and a net increase in cash from changes in operating assets and
        liabilities of $1,425,561. Non-cash charges include depreciation and
        amortization of $1,958,709, provision for returns, allowances and bad debts
        of
        $130,500, stock compensation expense of $129,995, a $77,786 write-off of
        fixed
        assets and the amortization of debt issuance costs of $16,052. Cash decreased
        due to a change in operating assets of $256,103 during the year ended December
        31, 2004 primarily due to the increase in prepaid commissions on higher levels
        of deferred revenue offset by the collection of accounts receivable during
        the
        year ended December 31, 2004. Operating liabilities, except for deferred
        revenue, increased $1,543,836 primarily due to higher activity levels from
        a
        higher number of employees during 2004 than in 2003. Deferred revenue increased
        $137,828 resulting from a net increase in deferred maintenance and services
        revenue of $1,847,828 related to a higher level of post sale customer support
        and services contracts in force at December 31, 2004 than at December 31,
        2003
        and offset by the reversal of $1,710,000 related to the deferred revenue
        associated with a December 2003 product shipment to a systems integrator.
        Total
        deferred revenue at December 31, 2004 was $2,943,023 and represented revenue
        to
        be earned from customer support contracts in force at December 31, 2004 and
        professional services contracts for which the services had not been performed
        at
        December 31, 2004. Of the total deferred revenue $480,172 is for prepaid
        services expected to be performed more than twelve months from the balance
        sheet
        date and accordingly has been classified as long-term deferred revenue. The
        increase in deferred revenue of $137,828 from December 31, 2003 to December
        31,
        2004 is the result of higher levels of orders during 2004 than in 2003 for
        customer support services and professional services net of a $1.7 million
        cancellation of an order from a government systems integrator discussed
        above.
  49
 *Table
            of Contents*
  *Cash
        Used in Investing Activities*
 
 Cash
        flows used in investing activities during the year ended December 31, 2005
        were
        $3,749,051, representing $1,174,067 for purchases of computer equipment,
        software licenses and the completion of improvements to our information
        technology infrastructure and $2,574,984 of additions to capitalized software
        development costs related to our Hercules product development. This compares
        to **** cash
        flows used in investing activities during the year ended December 31, 2004
        of
        $8,299,403, representing $5,038,193 related to purchases of computer equipment
        for newly hired employees, improvements to our information technology
        infrastructure and leasehold improvements to new office space occupied in
        November 2004, and $3,261,210 of additions to capitalized software development
        costs. **** Our
        development plans include new product releases, new features, and functionality
        additions to existing products. Gross expenditures for product development
        are
        largely dependent upon the number of software engineers employed and assigned
        to
        the software development projects. We believe that at December 31, 2005 we
        were
        fully staffed in product development therefore, gross expenditures are expected
        to remain stable from quarter to quarter during 2006. However, the
        capitalization rate may fluctuate from quarter to quarter in the future,
        depending upon the number and stage of software development projects that
        are in
        process and the related number of employees assigned to those
        projects.
 
 *Cash
        Provided by Financing Activities*
 
 Cash
        flows provided by financing activities for the year ended December 31, 2005
        were
        $7,797,756 and consisted primarily of proceeds from the preferred stock
        transaction in May 2005. On May 9, 2005, in return for net proceeds of
        $6,902,396 (net of transaction fees of $97,604), we completed the issuance
        of
        7,000 shares of Series B Convertible Preferred Stock with warrants to purchase
        approximately 1.8 million shares of common stock. During 2005 we paid $456,250
        of preferred stock dividends. In connection with the approval of the Series
        B
        transaction by the shareholders at the July 2005 annual shareholders meeting,
        the dividend on the Series A Preferred Stock was waived beginning on May
        9,
        2005. In September 2005, we borrowed $750,000 pursuant to an additional
        revolving credit line provided by Comerica Bank. On October 10, 2005 Lawrence
        Lacerte advanced us $3,750,000 pursuant to a Loan and Security Agreement
        and
        Intellectual Property Security Agreement executed on that date. We used the
        proceeds of the Lacerte loan to retire principal amounts due to Comerica
        Bank on
        October 10, 2005 of $2,918,183 and for general working capital purposes.
        In
        addition to the approximate $2.9 million payment to Comerica, during 2005
        we
        made principal payments to Comerica Bank of $1,148,484. During 2005, pursuant
        to
        our factoring agreement with Allied, we transferred $3,514,248 of the Company’s
        accounts receivable to Allied, for which we received $2,864,112 in cash proceeds
        and repaid $1,939,335. Also in 2005, we received $36,000 from the exercise
        of
        employee stock options.
 
 Cash
        flows provided by financing activities for the year ended December 31, 2004
        were
        $17,145,818 and consisted primarily of proceeds from the Series A preferred
        stock transaction in February 2004 and borrowings on our bank lines of credit
        to
        partially fund capital expenditures during 2004. On February 10, 2004, in
        return
        for net proceeds of $13,797,283 (net of placement fees of $1,125,000 plus
        legal,
        accounting and registration fees of $77,717), we completed the issuance of
        15,000 shares of Series A Convertible Preferred Stock with warrants to purchase
        1,200,000 shares of common stock. During 2004, we paid $477,439 of preferred
        dividends and at December 31, 2004, we had accrued preferred dividends of
        $187,500 which were subsequently paid in January 2005. During 2004 we borrowed
        $3,500,000 against our bank lines of credit to partially fund capital
        approximately $5,000,000 expenditures related to the technology infrastructure
        project and the build out of new office space. Payments against borrowings
        began
        in November 2004 and through December 31, 2004 we had made payments of $183,334
        against the borrowings. We also received proceeds of $336,057 from the exercise
        of employee stock options, $216,550 from the exercise of warrants and we
        repaid
        $16,903 of advances made to us by our CEO.
 
 As
        a
        result of the aforementioned factors, cash and cash equivalents decreased
        $8,517,778 during the year ended December 31, 2005, versus an increase of
        $4,745,993 for the year ended December 31, 2004.
  50
 *Table
            of Contents*
  **RESULTS
        OF OPERATIONS FOR YEAR ENDED DECEMBER 31, 2004 AS COMPARED WITH THE YEAR
        ENDED
        DECEMBER 31, 2003**
 
 **REVENUE**
 
 The
        components of revenue for the years ended December 31, 2004 and 2003 are
        as
        follows.
  Year
                    Ended December 31,
                
                Increase
                    (Decrease)2004
                
                2003
                
                Amount
                
                PercentRevenue
                    from:-License
                    feesHercules
                
                $
                9
                    ,491,667
                
                $
                4
                    ,686,801
                
                $
                4,804,866
                
                
                103
                %SecurePC
                
                
                432,208
                
                
                439,468
                
                
                (7,260
                )
                
                (2
                %)NetOFF
                
                
                2,506,264
                
                
                112,666
                
                
                2,393,598
                
                
                2125
                %Provision
                    for returns and allowances
                
                
                (68,554
                )
                
                (40,925
                )
                
                (27,629
                )
                
                67
                %12,361,585
                
                
                5,198,010
                
                
                7,163,575
                
                
                138
                %-Content,
                    subscription and customer support services
                
                
                2,786,937
                
                
                617,651
                
                
                2,169,265
                
                
                351
                %-Other
                    services
                
                
                104,633
                
                
                40,635
                
                
                64,019
                
                
                158
                %Total
                    revenue
                
                $
                15,253,155
                
                $
                5,856,296
                
                $
                9,396,859
                
                
                160
                %
 During
        the year ended December 31, 2004 we received gross orders for approximately
        $19.4 million of product and services. After applying revenue recognition
        criteria, total revenue, net of a provision for product returns, for the
        year
        ended December 31, 2004 was $15,253,155 versus $5,856,296 for the year ended
        December 31, 2003, an increase of $9,396,859 or 160%. The increase in revenue
        was primarily the result of the increase in orders for Hercules and NetOFF.
 
 The
        increase in orders resulted in an increase in revenue from license fees,
        net of
        a provision for returns and allowances, of $7,163,575 or 138%. Revenue from
        Hercules license fees grew $4,804,866 or 103% to $9,491,667 for the year
        ended
        December 31, 2004 versus $4,686,801 for the year ended December 31, 2003.
        License fee revenue for NetOFF was up $2,393,598 primarily due to a $2.3
        million
        order from the Department of Veteran Affairs. SecurePC license fee revenue
        was
        flat in 2004 as compared to the year 2003.
 
 Typically
        we have little or no backlog of unfilled orders at the end of a reporting
        period. However, at December 31, 2004 we had received an order for $2.2 million
        dollars for renewal maintenance and professional services from one customer.
        The
        renewal period for the maintenance began on January 1, 2005 and the services
        were scheduled to be performed beginning in the first quarter of 2005. At
        December 31, 2004 we had not been paid in advance for these services therefore,
        no amounts were reflected in the financial statements for accounts receivable
        and unearned deferred revenue at December 31, 2004 because this entry would
        gross up accounts receivable and deferred revenue on the balance sheet. The
        revenue from this order for customer support was recognized ratably and
        professional services were earned and recognized as performed during 2005.
 
 Revenue
        recognized from customer support services contracts recognized ratably over
        the
        term of the contract, which is generally one year, amounted to $2,786,916
        and
        $617,651 for the years ended December 31, 2004 and 2003, respectively. The
        increase of $2,169,265 or 351% is primarily due to the increase in the delivery
        of customer support services related to Hercules.
 
 During
        2004 we began offering optional services to our customers including Hercules
        training, implementation services and security system architecture expertise.
        Other services revenue for the year ended December 31, 2004 included training
        and implementation services revenue of $104,654. Other services revenue for
        the
        year ended December 31, 2003 includes training revenue of approximately $32,000
        and approximately $8,000 of custom development services.
  51
 *Table
            of Contents*
  The
        provision for product returns and allowances for the years ended December
        31,
        2004 was $68,554 versus $40,925 for the year ended December 31, 2003. The
        provision for returns and allowances is an estimate based upon historical
        trends
        and the increase in the average invoice size in 2004.
 
 During
        2004 we continued to focus our licensing efforts on market segments including
        government, healthcare, financial institutions and corporations in all other
        market segments. This is due in part to the mandates of the Health Insurance
        Portability and Accountability Act (“HIPAA”) for healthcare, Gramm-Leach-Bliley
        Act for financial services (“GLB”), Federal Information Security Management Act
        (“FISMA”) for government, the Sarbanes Oxley Act of 2002 ("SOX") for publicly
        traded companies, and Presidential Decision Directive 63 (“PDD-63”) for
        government, each of which require certain industries to meet minimum security
        requirements for the protection of personal, financial and government data.
        The
        revenue distribution by industry segments for the years ended December 31,
        2004
        and 2003 was as follows:
 
 Years
                  Ended December 31,2004
              
              2003Industry
                  Segment:Government
              
              
              82
              %
              
              80
              %Corporate
              
              
              12
              %
              
              3
              %Financial
                  institutions
              
              
              4
              %
              
              8
              %Education
              
              
              1
              %
              
              2
              %All
                  other, primarily health
              
              
              1
              %
              
              7
              %
  Revenue
        from customers representing 10% or more of total revenue during the years
        ended
        December 31, 2005 and 2004, respectively, was as follows:
  Years
                    Ended December 31,2004
                
                2003End
                    User Customer:Defense
                    Information Systems Agency
                
                
                39
                %
                
                -Department
                    of Veteran Affairs
                
                
                41
                %
                
                67
                %
 **COSTS
        OF REVENUE**
 
 The
        components of costs of revenue for the years ended December 31, 2004 and
        2003
        are as follows:
  Year
                    Ended December 31,
                
                Increase
                    (Decrease)2004
                
                2003
                
                Amount
                
                PercentCosts
                    of revenueSoftware
                    amortization
                
                $
                1,287,927
                
                $
                473,881
                
                $
                814,046
                
                
                172
                %Content,
                    subscription, and customer support services costs
                
                
                1,478,633
                
                
                288,323
                
                
                1,190,310
                
                
                413
                %Professional
                    services costs
                
                
                29,028
                
                
                -
                
                
                29,028
                
                
                100
                %Shipping
                    and other costs
                
                
                36,496
                
                
                56,544
                
                
                (20,048
                )
                
                (35
                %)Total
                    costs of revenue
                
                $
                2,832,084
                
                $
                818,748
                
                $
                2,013,336
                
                
                246
                %
 *Software
        Amortization*
 
 Software
        amortization begins at the time a new product or new version of a product
        is
        released from development and is made generally available to potential customers
        for licensing. Software amortization expense increased $814,046, or 172%,
        in the
        year ended December 31, 2004 versus the year ended December 31, 2003 due
        to
        higher average balances of amortizable capitalized software development costs
        related to new releases of Hercules versions in 2004 versus 2003.
 
 The
        comparison of unamortized capitalized software development costs to the net
        realizable value of the capitalized software at December 31, 2004 of $4,048,452
        and December 31, 2003 of $2,075,169 indicated that the unamortized capitalized
        software balances at December 31, 2004 and December 31, 2003 did not exceed
        net
        realizable value. Accordingly, no write-down was required during the year
        ended
        December 31, 2004 or the year ended December 31, 2003.
  52
 *Table
            of Contents*
  *Content,
        Subscription, and Customer Support Services Costs*
 
 The
        content, subscription, and customer support costs for the years ended December
        31, 2004 and 2003 of $1,478,633 and $288,323, respectively, include the
        salaries, benefits and other direct expenses of the personnel assigned to
        the
        post sale customer support function plus similar expenses associated with
        the
        remediation security engineers that write the vulnerability remedies and
        manage
        the V-Flash remedy database. The increase in the content, subscription, and
        customer support costs of $1,190,310 or 413% over the year ended December
        31,
        2003 is directly attributable to the increase in personnel performing these
        functions in 2004 over 2003.
 
 At
        December 31, 2004, we had 7 full time personnel assigned to the support
        organization versus 3 full time employees assigned to customer support at
        December 31, 2003. Included in customer support and other services costs
        are the
        costs and expenses associated with our V-Flash remediation security engineering.
        At December 31, 2004, we employed 16 security engineers versus 11 security
        engineers at December 31, 2003.
 
 *Professional
        Services Costs***
 
 For
        the
        year ended December 31, 2004, costs associated with professional services
        engagements was approximately $29,000 Professional services costs include
        the
        direct costs of the personnel assigned to training and implementation services.
        The increase in professional services costs in the year ended December 31,
        2004
        is due to an increase in the of volume services engagements in 2004 over
        2003.
        At December 31, 2004 there was approximately $899,000 of services revenue
        in
        deferred revenue and unfilled order backlog.
 
 *Shipping
        and Other Costs*
 
 Shipping
        and other costs include freight costs, preparation of media and documentation,
        costs of third party products shipped with Hercules and third party royalties
        for technology embedded in Hercules. Shipping and other costs for the years
        ended December 31, 2004 and 2003 were $36,496 and $56,544, respectively.
        Of
        these costs, third party royalties were approximately $14,000 for the year
        ended
        December 31, 2004, compared to approximately $13,000 of third party royalties
        for the year ended December 31, 2003. The costs of shipping and media
        preparation were immaterial in the years ended December 31, 2004 and 2003.
 
 **SELLING,
        GENERAL AND ADMINISTRATIVE EXPENSES******
 
 We
        incurred selling, general and administrative expenses ("SG&A") of
        $17,550,485 and $6,388,396 for the years ended December 31, 2004 and 2003,
        respectively, representing an increase of $11,162,089, or 175%. The increase
        in
        SG&A as more fully described below is primarily due to the increase in the
        number of employees performing SG&A functions resulting in higher
        compensation expense, increased infrastructure support costs and increased
        professional fees incurred for the execution of the marketing and public
        relations efforts surrounding the marketing and licensing of our vulnerability
        management product, Hercules.
 
 At
        December 31, 2004, we employed 61 sales and marketing professionals, including
        pre-sales security engineers and professional services consultants, and we
        employed 14 people in finance, internal information technology, administration
        and general management including our CEO and CFO. At December 31, 2003, we
        employed 24 people as sales and marketing professionals, including pre-sales
        security engineers, and 9 people in finance, administration and general
        management including our CEO and CFO. This is an increase of 42 personnel
        in
        SG&A functions since December 31, 2003 creating corresponding increases in
        the expense categories discussed below.
 
 As
        noted
        above the increases in SG&A expense during the year ended December 31, 2004
        over the year ended December 31, 2003 were approximately $11,162,000. Increases
        in salaries and benefits of approximately $4,530,000 associated with the
        increase in employees accounted for 41% of the total increase in SG&A in
        2004. Increases of approximately $3,140,000 in incentive compensation associated
        with higher revenue in 2004 accounted for 28% of the total increase in SG&A
        in 2004. Travel and entertainment associated with increases in employees
        and
        customer sales activities increased approximately $724,000; direct marketing
        expense primarily related to trade shows and advertising increased approximately
        $913,000; professional fees, including accounting, legal, public relations
        and
        recruiting fees increased approximately $928,000; rents and telecommunication
        expenses increased approximately $423,000; and expenses related to insurance,
        maintenance fees, supplies, business taxes and other office support increased
        approximately $504,000 in 2004 compared to 2003.
  53
 *Table
              of Contents*
  Compensation
        expense included in SG&A for 2004 included non-cash stock compensation
        expense for estimated fair value of approximately $130,000 related to the
        extension of the time to exercise a stock option grant by a former employee.
        This is considered a modification of the terms of the option agreement and
        accordingly the fair value of the option was estimated and expensed. In 2003,
        compensation expense included in SG&A for 2003 included non-cash stock
        compensation expense for the estimated fair value of $82,500 for shares of
        common stock issued to an officer upon his employment with the Company.
 
 **PRODUCT
        DEVELOPMENT EXPENSE**
  A
        summary
        of gross product development expense, product development expense net of
        capitalized development costs and the capitalization rate for the years ended
        December 31, 2004 and 2003 are presented in the table below.
  2004
              
              2003Product
                  development expense, net of capitalized software development
                  costs
              
              $
              1,995,612
              
              $
              392,967Software
                  development costs capitalized
              
              $
              3,261,210
              
              $
              1,897,497Gross
                  product development expense
              
              $
              5,256,822
              
              $
              2,290,464Capitalized
                  costs as a percentage of gross product development expense
              
              
              62
              %
              
              83
              %
 
 The
        increase in development expense is primarily due to the increase in pay and
        benefits expenses associated with the increase in the number software
        development engineers and quality assurance engineers employed during the
        respective periods presented as well as the costs of third party development
        projects and the Common Criteria certification testing. At December 31, 2004,
        we
        employed 40 software development and quality assurance engineers versus 27
        software development and quality assurance engineers at December 31, 2003.
 
 The
        capitalization rate is the percentage of capitalized costs to total gross
        product development costs for the period. The capitalization rate was 62%
        for
        the year 2004 versus 83% for the year 2003. The decrease in the capitalization
        rate is primarily due to the expensing of higher levels of non-capitalizable
        costs and expenses including development projects that had not reached
        technological feasibility, software hotfixes and product maintenance releases
        during the years presented.
 
 **DEPRECIATION
        AND AMORTIZATION OF PROPERTY AND EQUIPMENT**
 
 Depreciation
        and amortization of property and equipment for the year ended December 31,
        2004
        was $670,782, compared to $207,924 for the year ended December 31, 2003,
        representing an increase of $462,858 or 223%. We attribute this increase
        to
        higher average depreciable balances of property, equipment and leasehold
        improvements. During the year ended December 31, 2004, we purchased $5,038,193
        of depreciable property and equipment for the expansion of office facilities
        and
        the build out of our technology infrastructure supporting the growth in
        employees, new products, quality assurance test labs and our remediation
        signature and software development initiatives, compared to similar purchase
        totaling $411,211made during 2003. Net property and equipment balances at
        December 31, 2004 and 2003 were $6,356,362 and $635,748,
        respectively.
  54
 *Table
            of Contents*
  **INTEREST
        EXPENSE**
 
 Interest
        expense for the years ended December 31, 2004 and 2003 was $82,612 and
        $3,036,342, respectively, reflecting a decrease in interest expense of
        $2,953,730. During 2003 we completed a number of equity and debt financings
        that
        due to the type and estimated fair value of the securities and debt instruments
        issued, approximately $2.8 million of non-recurring, non-cash charges were
        recorded as interest expense. The non-cash interest charges are listed in
        the
        table below. During 2004 interest expense primarily related to the interest
        on
        the bank debt and the amortization of the deferred debt issuance costs related
        to the estimated fair value of warrants issued to the bank in conjunction
        with
        obtaining the lines of credit. Interest expense paid during 2004 was
        approximately $55,000 versus approximately $38,000 paid during 2003. The
        components of interest expense for the years ended December 31, 2004 and
        2003
        are summarized as follows:
  Years
                    Ended December 31,2004
                
                2003Non-cash
                    interest charges:Fair
                    value of common stock issued in conjunction with convertible
                    debt
                
                $
                -
                
                $
                1,067,928Fair
                    value of beneficial conversion feature of convertible debt
                
                
                -
                
                
                1,543,310Fair
                    value of warrants issued to placement agent
                
                
                -
                
                
                121,725Interest
                    payable converted to common stock
                
                
                -
                
                
                68,131Amortization
                    of fair value of warrants as debt issuance costs
                
                
                16,052
                
                
                -Sub-total
                    non-cash interest expense
                
                
                16,052
                
                
                2,801,094Cash
                    interest charges:Amortization
                    of debt issue costs
                
                
                -
                
                
                212,000Interest
                    on notes payable
                
                
                -
                
                
                23,248Interest
                    on bank lines of credit
                
                
                60,908
                
                
                -Other
                    interest bearing obligations
                
                
                5,652
                
                
                -Total
                    interest expense
                
                $
                82,612
                
                $
                3,036,342
 **WRITE-OFF
        OF PROPERTY AND EQUIPMENT**
 
 In
        May
        2004, we signed an 8 year lease for approximately 33,500 square feet of office
        space in Dallas, Texas. We moved into the new office space on November 18,
        2004
        and at that time wrote off the remaining net book value of $77,786 of leasehold
        improvements and equipment at the old facility that we would no longer use
        in
        our operations.
 
 **WRITE-OFF
        OF NOTE RECEIVABLE FROM RELATED PARTY**
 
 In
        April
        2003, a CT Holdings legal claim associated with a lawsuit was settled for
        $225,000 in cash. Citadel advanced $225,000 to CT Holdings in return for
        a
        demand note payable bearing interest at 12% per year and a release for any
        potential claims pertaining to the CT Holdings litigation. Because CT Holdings
        has a significant cash deficiency and stockholder's deficit this demand note
        receivable was fully reserved in the second quarter of 2003 as there can
        be no
        assurance that this note will be collected.
 
 **PREFERRED
        DIVIDENDS AND ACCRETION OF BENEFICIAL CONVERSION FEATURE OF PREFERRED
        STOCK**
 
 The
        statement of operations presents preferred dividends and the accretion of
        the
        beneficial conversion feature of the Series A Shares as an increase to the
        net
        loss to arrive at net loss to common shareholders. During 2004, the Series
        A
        Shares accrued dividends at a rate of 5% if paid in cash, or 6% if paid in
        shares of our common stock. During the year ended December 31, 2004 we accrued
        $187,500 and paid $477,439 of preferred stock dividends in cash.
 
 The
        Series A Shares were issued along with warrants for 1.2 million shares of
        common
        stock. The relative fair values of the Series A Shares and the warrants were
        computed and as a result, it was determined that the relative fair value
        of the
        beneficial conversion feature of the Series A Shares was approximately $985,000,
        which was being accreted to additional paid in capital over the four year
        term
        of the preferred stock and shown as an increase to the loss to common
        shareholders. For the year ended December 31, 2004, $215,307 of the beneficial
        conversion feature was accreted to loss to common shareholders.
  55
 *Table
            of Contents*
  **NET
        LOSS AND INCOME TAX VALUATION ALLOWANCE**
 
 For
        the
        year ended December 31, 2004 we reported a net loss to common shareholders
        of
        $8,719,362 versus a net loss to common shareholders of $5,248,581 for the
        year
        ended December 31, 2003. Due to the uncertainty of realization, we recorded
        a
        valuation allowance equal to the net deferred tax asset associated with income
        tax benefit ascribed to the loss before income taxes for the years ended
        December 31, 2004 and 2003. At December 31, 2004 we had a net loss carryforward
        of approximately $14,000,000 which due to the uncertainty of realization
        has
        been fully reserved. The net operating loss carryforward is subject to annual
        limitations as prescribed in the Internal Revenue Code and is available to
        offset future taxable income and begins to expire in 2023.
 
 **LIQUIDITY
        AND CAPITAL RESOURCES**
 
 At
        December 31, 2004 we had cash and cash equivalents of approximately $9.8
        million, a net working capital position of approximately $3.5 million and
        stockholders’ equity of approximately $10.8 million. On February 10, 2004, in
        return for gross proceeds of $15,000,000, we issued 15,000 shares of the
        Preferred Stock (convertible into 3,000,000 shares of common stock at the
        initial conversion price of $5.00 per share) and warrants to purchase 1,200,000
        shares of common stock. The net proceeds from the preferred stock financing,
        were approximately $13,800,000, after placement agent fees, as well as
        accounting and legal fees and were used to fund the expansion of our sales
        and
        marketing team to accelerate the execution of our 2004 revenue plan, and
        to
        increase our engineering team to implement our product development initiatives,
        grow market share through product innovation and establish Citadel as a provider
        of quality products in the life cycle vulnerability management market. In
        April
        2004, we secured a revolving credit line from a bank of $750,000 for operations
        and term loan credit facilities totaling $2,750,000 for use to acquire the
        capital equipment necessary to support our business plan. The $750,000 revolving
        line of credit was later converted by the bank as a term loan line of credit
        for
        the acquisition of equipment. The total $3,500,000 in proceeds from the credit
        facilities has been used to partially fund approximately $5,000,000 of capital
        expenditures during 2004, and the loans were refinanced in 2005 with loans
        from
        Mr. Lacerte.
 
 *Cash
        Used in Operating Activities*
 
 The
        net
        cash used in operating activities was $4,100,422 during the year ended December
        31, 2004. Our net loss of $7,839,025 was adjusted for non-cash charges of
        $2,313,042 and a net increase in cash from changes in operating assets and
        liabilities of $1,425,561. Non-cash charges include depreciation and
        amortization of $1,958,709, provision for returns, allowances and bad debts
        of
        $130,500, stock compensation expense of $129,995, a $77,786 write-off of
        fixed
        assets and the amortization of debt issuance costs of $16,052. Cash decreased
        due to a change in operating assets of $256,103 during the year ended December
        31, 2004 primarily due to the increase in prepaid commissions on higher levels
        of deferred revenue offset by the collection of accounts receivable during
        the
        year ended December 31, 2004. Operating liabilities except for deferred revenue,
        increased $1,543,836 primarily due to higher activity levels from a higher
        number of employees during 2004 than in 2003. Deferred revenue increased
        $137,828 resulting from a net increase in deferred maintenance and services
        revenue of $1,847,828 related to a higher level of post sale customer support
        and services contracts in force at December 31, 2004 than at December 31,
        2003
        and offset by the reversal of $1,710,000 million related to the deferred
        revenue
        associated with a December 2003 product shipment to a systems integrator.
 
 Total
        deferred revenue at December 31, 2004 and 2003 was $2,943,023 and $2,805,195,
        respectively, and represented revenue to be earned from customer support
        contracts in force at December 31, 2004 and professional services contracts
        for
        which the services had not been performed at December 31, 2004. Of the total
        deferred revenue, $480,172 was for prepaid services expected to be performed
        more than twelve months from the balance sheet date and accordingly has been
        classified as long-term deferred revenue. The increase in deferred revenue
        of
        $137,828 was the result of higher levels of orders during 2004 than in 2003
        for
        customer support services and professional services net of a $1.7 million
        cancellation of an order from a government systems integrator discussed
        below.
  56
 *Table
            of Contents*
  Deferred
        revenue at December 31, 2003 was $2,805,195, of which approximately $1,400,000
        related to deferred license fees and approximately $1,400,000 related to
        customer support services deferred revenue. At
        December 31, 2003 deferred revenue included the invoiced value of a December
        2003 product shipment for an order received from a government systems integrator
        of approximately $1.7 million and consisting of approximately $1.4 million
        in
        license fees and $0.3 million for post sale customer support services. Although
        the order was fixed-fee order and shipment had occurred in December 2003
        and the
        Company determined that the collection of the revenue was probable, the Company
        deferred revenue recognition because the government systems integrator had
        not
        concluded negotiations with the end user government agency and had not delivered
        the software licenses to the government agency. During the quarter ended
        June
        30, 2004, the systems integrator cancelled the order to the Company because,
        according to the cancellation notice, the systems integrator and the government
        agency had not concluded contract negotiations and the eventual terms of
        the
        systems integrator’s order from the government agency would most likely be
        different than the terms originally proposed in December 2003. Accordingly,
        the
        Company reduced deferred revenue and accounts receivable by approximately
        $1.7
        million in June 2004.
 
 The
        net
        cash used in operating activities was $272,093 for the year ended December
        31,
        2003. The net loss of $5,248,581 was adjusted for non-cash charges of $4,257,979
        and changes in operating assets and liabilities of $718,509. Non-cash charges
        include depreciation and amortization of $681,806, provision for returns,
        allowances and bad debts of $58,500, non-cash interest charges of $2,944,963
        related to the convertible notes issued during the year, stock compensation
        expense of $82,500, the estimated fair value of $265,210 for common stock,
        stock
        options and warrants issued to consultants in lieu of cash payments for
        services, and the $225,000 write-off of the note receivable from CT Holdings.
        Operating assets increased $1,749,447 during the year ended December 31,
        2003
        primarily due to the increase in licensing fees and support services related
        to
        the increased orders for Hercules. Operating liabilities except for deferred
        revenue decreased $187,046 due to the payment of the payroll tax liability,
        which is no longer in arrears and the payment of accounts payable due to
        the
        availability of cash to meet our current obligations.
 
 *Cash
        Used in Investing Activities*
 
 Cash
        flows used in investing activities during the year ended December 31, 2004
        were
        $8,299,403. Of that amount $5,038,193 was expended for purchases of computer
        equipment for newly hired employees, improvements to our information technology
        infrastructure and the leasehold improvements to new office space. Similar
        expenditures during the year 2003 were $411,211.
 
 We
        also
        had expenditures during 2004 of $3,261,210 for additions to capitalized software
        development costs related to the Hercules product development costs. This
        compares to $1,897,497 for similar expenditures during 2004. Our development
        plans include new product releases, new features and functionality additions
        to
        existing products.
 
 Cash
        flows from investing activities during the year ended December 31, 2003 in
        addition to capital expenditures and capitalized software development costs,
        included the issuance of a $225,000 note receivable to CT Holdings.
 
 *Cash
        Provided by Financing Activities*
 
 Cash
        flows provided by financing activities for the year ended December 31, 2004
        were
        $17,145,818 and were primarily due to the proceeds received from a preferred
        stock transaction in February 2004 and borrowings of on our prior bank lines
        of
        credit. On February 10, 2004, in return for net proceeds of $13,797,283 (net
        of
        placement fees of $1,125,000 plus legal, accounting and registration fees
        of
        $77,717), we completed the issuance of 15,000 shares of Series A Convertible
        Preferred Stock (convertible into 3,000,000 shares of common stock at the
        initial conversion price of $5.00 per share) with warrants to purchase 1,200,000
        shares of common stock. Preferred dividends of $477,439 were paid during
        the
        year ended December 31, 2004. At December 31, 2004, we had accrued preferred
        dividends of $187,500 which were subsequently paid in January 2005. During
        2004
        we borrowed $3,500,000 against our prior bank lines of credit to partially
        fund
        capital approximately $5,000,000 of capital expenditures related to the
        technology infrastructure project and the build out of new office space.
        Payments against the borrowings began in November 2004 and through December
        31,
        2004 we had made payments of $183,334 against the borrowings. We also received
        proceeds of $336,057 from the exercise of employee stock options, $216,550
        from
        the exercise of warrants and we repaid $16,903 of advances made to us by
        our
        CEO.
  57
 *Table
            of Contents*
  Cash
        flows provided by financing activities for the year ended December 31, 2003
        were
        $7,885,133. During January 2003, we received net proceeds of approximately
        $2,397,467 from the issuance of 3,275,000 shares of common stock plus warrants
        to purchase 1,637,500 shares of common stock. In May 2003 we received net
        proceeds of $1,122,814 from the exercise of warrants for 1,560,559 shares
        of
        common stock. During the fourth quarter of 2003 warrants for 1,974,336 shares
        of
        common stock were exercised providing net proceeds of $2,506,430. Proceeds
        of
        $199,060 were received during 2003 from the exercise of stock options for
        393,660 shares of common stock. In September 2003, we closed a bridge loan
        financing transaction, receiving gross proceeds of approximately $2,570,000
        and
        issued convertible notes payable to a limited number of accredited investors.
        The principal amount of the bridge loans plus accrued interest, totaling
        $2,810,881, was converted into 2,348,079 shares of common stock during the
        fourth quarter of 2003. The placement agent for this transaction converted
        their
        fee of $212,000 and $50,000 of our payables to them into a note payable with
        the
        same terms and conversion features as the Notes. This note was repaid in
        cash in
        December 2003.
 
 In
        addition, we received advances and proceeds from notes payable from related
        parties of $888,522 and made payments to related parties of $1,463,160 to
        pay
        down the advances and notes payable from related parties. During the year
        ended
        December 31, 2003, a former director exercised stock options for 862,500
        shares
        of the Company’s common stock using a $250,000 note payable to the former
        director plus accrued interest of $26,000 through the date of exercise as
        payment of the aggregate exercise price of $276,000. Notes payable to
        stockholders at December 31, 2002 plus new notes issued to stock holders
        during
        the year 2003, aggregating $537,000, were repaid during the year ended December
        31, 2003. At December 31, 2003, as a result of the culmination of all the
        financing activities, we had no amounts owed under notes payable.
 
 **CONTRACTUAL
        OBLIGATIONS**
 
 A
        summary
        of our contractual obligations at December 31, 2005 is as follows:
 
 Contractual
                  Obligations
              
              Total
              
              Less
                  than 1 year
              
              1
                  -
                  3 years
              
              3
                  -
                  5 years
              
              More
                  than 5 yearsLong-Term
                  Debt Obligations
              
              $
              3,750,000
              
              $
              -
              
              $
              3,750,000
              
              $
              -
              
              $
              -Capital
                  Lease Obligations
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Operating
                  Lease Obligations(1)
              
              
              4,964,944
              
              
              759,907
              
              
              1,319,273
              
              
              1,505,616
              
              
              1,380,148Purchase
                  Obligations
              
              
              424,879
              
              
              424,879
              
              
              -
              
              
              -
              
              
              -Preferred
                  Stock Dividends
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Other
                  Contractual Obligations Reflected on the Registrant’s Balance Sheet under
                  GAAP
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Total
              
              $
              9,139,823
              
              $
              1,184,786
              
              $
              5,069,273
              
              $
              1,505,616
              
              $
              1,380,148
 
 (1) Operating
        leases are for office space and office equipment. The operating lease
        commitments above reflect contractual and reasonably assured rent escalations
        under the lease arrangements. The majority of our lease contractual obligations
        relate to the lease for our Dallas headquarters.
 
 In
        addition to the contractual obligations above and as permitted under Delaware
        law, we have agreements whereby we indemnify our officers and directors for
        certain events of occurrences while the officer or director is, or was, serving
        at our request in such capacity. The maximum potential amount of future payments
        we could be required to make under these indemnification agreements is not
        limited; however, we have director and officer insurance coverage that reduces
        our exposure and may enable us to recover a potion of any amounts paid.
 
 **OFF-BALANCE
        SHEET ARRANGEMENTS**
 
 The
        Company has no off-balance sheet arrangements that have had, or are reasonably
        likely to have, a current or future effect on the Company’s financial condition,
        changes in financial condition, revenues or expenses, results of operations,
        liquidity, capital expenditures or capital resources that is material to
        investors.
  58
 *Table
            of Contents*
  **ITEM
        7A.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
        MARKET RISK**
 
 **Interest
        Rate Risk**
  We
        have
        limited exposure to financial market risks, including changes in interest
        rates.
        We consider all highly liquid investments purchased with a maturity of three
        months or less to be cash equivalents. Cash in excess of operating funds
        is
        invested in a money market fund. For the year ended December 31, 2005, we
        had
        interest income of $67,588 earned on funds invested in the money market
        investments.
 
 **ITEM
        8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY
        DATA**
 
 The
        Financial Statements for the years ended December 31, 2005, 2004 and
        2003 and supplementary data are found following the signature page of this
        report.
 
 **ITEM
        9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
        ACCOUNTING AND FINANCIAL DISCLOSURE ITEM**
 
 None.
 
 **ITEM
        9A.  CONTROL AND PROCEDURES**
 
 The
        Company’s management, including the Company’s principal executive officer and
        principal financial officer, has evaluated the effectiveness of the Company’s
        disclosure controls and procedures (as defined in Rules 13(a) - 15(e) and
        15(d)
        - 15(e) under the Securities Exchange Act of 1934) as of the year ended December
        31, 2005, the period covered by the Annual Report on Form 10-K .
        Based
        upon that evaluation, the Company’s principal executive officer and principal
        financial officer have concluded that the disclosure controls and procedures
        were effective as of December 31, 2005 to provide reasonable assurance that
        material information relating to the Company is made known to management
        including the CEO and CFO.
 
 There
        were no changes in the Company’s internal control over financial reporting that
        occurred during the Company’s last fiscal quarter that have materially affected,
        or are reasonably likely to materially affect, the Company’s internal control
        over financial reporting.
 
 **Inherent
        Limitation on the Effectiveness of Internal Controls**
  The
        effectiveness of any system of internal control over financial reporting,
        including Citadel’s, is subject to inherent limitations, including the exercise
        of judgment in designing, implementing, operating, and evaluating the controls
        and procedures, and the inability to eliminate misconduct completely.
        Accordingly, any system of internal control over financial reporting, including
        Citadel’s, can only provide reasonable, not absolute assurances. In addition,
        projections of any evaluation of effectiveness to future periods are subject
        to
        the risk that controls may become inadequate because of changes in conditions,
        or that the degree of compliance with the policies or procedures may
        deteriorate. We intend to continue to monitor and upgrade our internal controls
        as necessary or appropriate for our business, but cannot assure you that
        such
        improvements will be sufficient to provide us with effective internal control
        over financial reporting.
 
 **ITEM
        9B.  OTHER INFORMATION**
 
 None.
  59
 *Table
            of Contents*
  **PART
        III**
 
 **ITEM
        10.  DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT**
 
 Information
        with respect to this Item may be found in the section captioned “Directors and
        Executive Officers,” and “Section 16(a) Beneficial Ownership Reporting
        Compliance” appearing in the definitive Proxy Statement that we will deliver to
        stockholders in connection with our Annual Meeting of Stockholders for 2006.
        Such information is incorporated herein by reference.
 
 Our
        Board
        of Directors adopted a Code of Business Conduct for all of our directors,
        officers and employees and a Code of Ethics for our CEO and Senior Financial
        Executives in March 2004. Stockholders may view our Code of Business Conduct
        and
        Code of Ethics on our website at www.citadel.com or request a free copy:
 
 Citadel
        Security Software, Inc.
 Attention:
        Investor Relations
 Two
        Lincoln Centre, Suite 1600
 5420
        LBJ
        Freeway
 Dallas,
        Texas 75240
 (214)520-9292
 
 To
        date,
        there have been no waivers under our Code of Business Conduct and Ethics.
        We
        will post any waivers, if and when granted, of our Code of Business Conduct
        and
        Ethics on our website at www.citadel.com.
 
 **ITEM
        11.  EXECUTIVE
        COMPENSATION******
 
 Information
        with respect to this Item may be found in the section captioned “Executive
        Compensation” appearing in the definitive Proxy Statement that we will deliver
        to stockholders in connection with our Annual Meeting of Stockholders for
        2006.
        Such information is incorporated herein by reference.
 
 **ITEM
        12.  SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
        AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS**
 
 Information
        with respect to this Item may be found in the section captioned “Directors and
        Management—Security Ownership of Certain Beneficial Owners and Management,” and
“Equity Compensation Plan Information” appearing in the definitive Proxy
        Statement that we will deliver to stockholders in connection with our Annual
        Meeting of Stockholders for 2006. Such information is incorporated herein
        by
        reference.
 
 **ITEM
        13.  CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS**
 
 Information
        with respect to this Item may be found in the section captioned “Related Party
        Transactions” appearing in the definitive Proxy Statement that we will deliver
        to stockholders in connection with our Annual Meeting of Stockholders for
        2006.
        Such information is incorporated herein by reference.
 
 **ITEM
        14.  PRINCIPAL ACCOUNTANT FEES AND SERVICES**
 
 Information
        with respect to this Item may be found in the section captioned “Principal
        Accountant Fees and Services” appearing in the definitive Proxy Statement that
        we will deliver to stockholders in connection with our Annual Meeting of
        Stockholders for 2006. Such information is incorporated herein by
        reference.
  60
 *Table
            of Contents*
  **PART
        IV**
 
 **ITEM
        15.  EXHIBITS AND FINANCIAL STATEMENT
        SCHEDULE**
 
 The
        exhibits listed in the accompanying index to exhibits are filed or incorporated
        by reference as part of this Annual Report.
  **Financial
          Statements**
 
 The
          following financial statements are filed as a part of this report under
          "Item 8
          -Financial Statements and Supplementary Data" following the signature page
          of
          this report.
 
 Report
                    of Independent Registered Public Accounting Firm
                
                F-2Consolidated
                    Balance Sheets as of December 31, 2005 and 2004
                
                F-3Consolidated
                    Statements of Operations for the years ended December 31, 2005,
                    2004 and
                    2003
                
                F-4Consolidated
                    Statement of Stockholders' Equity for the year ended December
                    31,
                    2003
                
                F-5Consolidated
                    Statement of Stockholders' Equity for the year ended December
                    31,
                    2004
                
                F-6Consolidated
                    Statement of Stockholders' Equity (Deficit) for the year ended
                    December
                    31, 2005
                
                F-7Consolidated
                    Statements of Cash Flows for the years ended December 31, 2005,
                    2004 and
                    2003
                
                F-8Notes
                    to Consolidated Financial Statements
                
                F-10
  **Consolidated
          Financial Statement Schedule**
  The
        following consolidated financial statement schedule
        for the years ended December 31, 2005, 2004 and 2003 is filed as part of
        this
        Form 10K and should be read in conjunction with Citadel Security Software
        Inc.'s
        Consolidated Financial Statements. Schedules not included below have been
        omitted because they are not applicable or are not required or because the
        required information is included in the Consolidated Financial Statements
        or
        Notes thereto.
  **Schedule
        II - Valuation and Qualifying
        Accounts**
 
 **Description**
              
              Balance
                  at Beginning of Period
              
              Additions
                  Charged to Costs and Expenses
              
              Charged
                  to Other
              
              Deductions
              
              Balance
                  at End of Period**Year
                  Ended December 31, 2005**Allowance
                  for doubtful accounts
              
              $
              100,000
              
              $
              2,496
              
              $
              -
              
              $
              (2,496
              )
              $
              100,000Allowance
                  for returns
              
              
              109,000
              
              
              -
              
              
              46,233
              
              
              (46,233
              )
              
              109,000Valuation
                  allowance for deferred tax assets
              
              
              3,489,000
              
              
              6,369,000
              
              
              -
              
              
              -
              
              
              9,858,000**Year
                  Ended December 31, 2004**Allowance
                  for doubtful accounts
              
              
              27,575
              
              
              61,946
              
              
              10,479
              
              
              -
              
              
              100,000Allowance
                  for returns
              
              
              50,925
              
              
              -
              
              
              68,554
              
              
              (10,479
              )
              
              109,000Valuation
                  allowance for deferred tax assets
              
              
              1,032,000
              
              
              2,457,000
              
              
              -
              
              
              -
              
              
              3,489,000**Year
                  Ended December 31, 2003**Allowance
                  for doubtful accounts
              
              
              10,000
              
              
              17,575
              
              
              -
              
              
              -
              
              
              27,575Allowance
                  for returns
              
              
              10,000
              
              
              -
              
              
              40,925
              
              
              -
              
              
              50,925Valuation
                  allowance for deferred tax assets
              
              
              354,000
              
              
              678,000
              
              
              -
              
              
              -
              
              
              1,032,000
  61
 *Table
            of Contents*
  **SIGNATURES**
 
 Pursuant
        to the requirements of Section 13 or 15(d) of the Securities Exchange Act
        of
        1934, as amended, the Registrant has duly caused this Annual Report on Form 10-K to be
        signed on its behalf by the undersigned, thereunto duly authorized.
  Date:
                  March 27, 2006
              CITADEL
                  SECURITY SOFTWARE INC.By:
                  /s/ STEVEN B. SOLOMONSteven
                  B. Solomon, President and Chief Executive
                  Officer
 
 **POWER
        OF ATTORNEY**
 
 KNOW
        ALL
        PERSONS BY THESE PRESENTS, that each person whose signature appears below
        constitutes and appoints Steven B. Solomon his true and lawful attorney-in-fact
        and agent, with full power of substitution and resubstitution, to sign any
        and
        all amendments to this Annual Report on Form 10-K and to
        file the same, with all exhibits thereto and other documents in connection
        therewith, with the Securities and Exchange Commission, granting unto said
        attorney-in-fact and agent full power and authority to do and perform each
        and
        every act and thing requisite and necessary to be done in connection therewith,
        as fully to all intents and purposes as he might or could do in person, hereby
        ratifying and confirming all that said attorney-in-fact and agent, or his
        substitute or substitutes, or any of them, shall do or cause to be done by
        virtue hereof.
 
 Pursuant
        to the requirements of the Securities Exchange Act of 1934, as amended, this
        report has been signed below by the following persons on behalf of the
        Registrant and in the capacities and on the dates indicated:
 
 SIGNATURE
              
              TITLE
              
              DATE/s/
                  STEVEN B. SOLOMON
              
              President,
                  Chief Executive Officer
                (Principal
                  Executive Officer)
              
              March
                  27, 2006Steven
                  B. Solomon/s/
                  RICHARD CONNELLY
              
              Chief
                  Financial Officer
                (Principal
                  Financial and Accounting Officer)
              
              March
                  27, 2006Richard
                  Connelly/s/
                  JOHN LEIDE
              
              Director
              
              March
                  27, 2006Major
                  General (Ret) John Leide/s/
                  CHRIS A. ECONOMOU
              
              Director
              
              March
                  27, 2006Chris
                  A. EconomouDirectorMark
                  Rogers/s/
                  JOE M. ALLBAUGH
              
              Director
              
              March
                  27, 2006Joe
                  M. Allbaugh
  62
 *Table
            of Contents*
  **INDEX
        TO EXHIBITS**
 **EXHIBIT****NUMBER**
                    
                    **DESCRIPTION**3.1
                    
                    Amended
                        and Restated Certificate of Incorporation of the Registrant
                        (filed as
                        Exhibit 3.1 to the Registrant’s Registration Statement on Form 10-SB,
                        Registration No. 000-33491, filed with the Commission on
                        January 11, 2002
                        (the “Form 10-SB”) and incorporated by reference herein)3.2
                    
                    Amended
                        and Restated By-laws of the Registrant (filed as Exhibit
                        3.2 to the Form
                        10-SB and incorporated by reference herein)3.3
                    
                    Certificate
                        of Designation, Rights and Preferences of Series A Convertible
                        Preferred
                        Stock (filed as
                      Exhibit
                        3.1 to the Form 8-K filed by the Company on February 10,
                        2004 and
                        incorporated by reference herein)3.4
                    
                    Certificate
                        of Designation, Rights and Preferences of Series B Convertible
                        Preferred
                        Stock (filed as
                      Exhibit
                        3.1 to the Form 8-K filed by the Company on May 10, 2005
                        and incorporated
                        by reference herein)3.5
                    
                    Certificate
                        of Amendment of Amended and Restated Certificate of Incorporation
                        (filed
                        as Exhibit 3.1 to the Form S-3/A filed by the Company on
                        August 1, 2005
                        and incorporated herein by reference)4.1
                    
                    Form
                        of Certificate of Common Stock of the Registrant (filed as
                        Exhibit 4.1 to
                        the Form 10-SB and incorporated by reference herein)4.2
                    
                    Form
                        of Warrant to Purchase Common Stock (filed as Exhibit 4.1
                        to the Form 8-K
                        filed by the Company on February 10, 2004 and incorporated
                        by reference
                        herein)4.3
                    
                    Registration
                        Rights Agreement, dated as of February 9, 2004 by and among
                        Citadel and
                        the entities whose names appear on the signature pages thereof
                        (filed as
                        Exhibit 4.2 to the Form 8-K filed by the Company on February
                        10, 2004 and
                        incorporated by reference herein)4.4
                    
                    Form
                        of Senior Promissory Note (filed as exhibit 4.1 to the Form
                        8-K filed by
                        the Company on
                      September
                        8, 2004 and incorporated by reference herein)4.5
                    
                    Loan
                        and Security Agreement between Citadel and Comerica Bank
                        (filed as Exhibit
                        10.1 to the Form
                      10-QSB
                        filed by the Company on May 13, 2004 and incorporated by
                        reference
                        herein)4.6
                    
                    Intellectual
                        Property Security Agreement between Citadel and Comerica
                        Bank (filed as
                        Exhibit 10.2 to the Form 10-QSB filed by the Company on May
                        13, 2004 and
                        incorporated by reference herein)4.7
                    
                    Form
                        of Warrant to Purchase Stock (filed as Exhibit 10.3 to the
                        Form 10-QSB
                        filed by the Company on May 13, 2004 and incorporated by
                        reference herein)4.8
                    
                    First
                        Amendment to Loan and Security Agreement between Comerica
                        and Comerica
                        Bank (filed as Exhibit 99.1 to the Form 8-K filed by the
                        Company on
                        December 30, 2004 and incorporated by reference herein)4.9
                    
                    Second
                        Amendment to Loan and Security Agreement between Comerica
                        and Comerica
                        Bank (filed as Exhibit 4.9 to the Form 10-KSB filed by the
                        Company on
                        March 31,2005 and incorporated by reference herein)4.10
                    
                    Commitment
                        Letter dated February 28, 2006 between Citadel and Comerica
                        Bank (filed as
                        Exhibit 99.1 to the Form 8-K filed by the Company on February
                        28, 2005 and
                        incorporated herein by reference)4.11
                    
                    Form
                        of Warrant to Purchase Common Stock issued to Satellite (filed
                        as Exhibit
                        4.1 to the Form 8-K filed by the Company on May 10, 2005
                        and incorporated
                        herein by reference)
  63
  4.12
                    
                    Registration
                        Rights Agreement dated as of May 9, 2005 between Citadel
                        and Satellite
                        entities whose names appear on the signature pages thereof
                        (filed as
                        Exhibit 4.2 to the Form 8-K filed by the Company on May 10,
                        2005 and
                        incorporated herein by reference)4.13
                    
                    Exchange
                        Agreement dated as of May 9, 2005 between Citadel and Satellite
                        Strategic
                        Finance Associates, LLC (filed as Exhibit 4.3 to the Form
                        8-K filed by the
                        Company on May 10, 2005 and incorporated herein by
                        reference)4.14
                    
                    Form
                        of Series C Warrant to Purchase Common Stock (filed as Exhibit
                        4.4 to the
                        Form 8-K filed by the Company on May 10, 2005 and incorporated
                        herein by
                        reference)4.15
                    
                    Third
                        Amendment to Loan and Security Agreement dated as of June
                        30, 2005 between
                        Citadel and Comerica Bank (filed as Exhibit 99.1 to the Form
                        8-K filed by
                        the Company on July 1, 2005 and incorporated herein by
                        reference)4.16
                    
                    Certificate
                        of Amendment of Certificate of Designations, Preferences
                        and Rights of
                        Series A Convertible Preferred Stock (filed as Exhibit 4.12
                        to the Form
                        S-3/A filed by the Company on August 1, 2005 and incorporated
                        herein by
                        reference)4.17
                    
                    Fourth
                        Amendment to Loan and Security Agreement dated as of August
                        22, 2005
                        between Citadel and Comerica Bank (filed as Exhibit 4.1 to
                        the Form 8-K
                        filed by the Company on August 26, 2005 and incorporated
                        herein by
                        reference)4.18
                    
                    Warrant
                        (filed as Exhibit 4.2 to the Form 8-K filed by the Company
                        on August 26,
                        2005 and incorporated herein by reference)4.19
                    
                    Fifth
                        Amendment to Loan and Security Agreement dated as of September
                        15, 2005
                        between Citadel and Comerica Bank (filed as Exhibit 4.1 to
                        the Form 8-K
                        filed by the Company on September 16, 2005 and incorporated
                        herein by
                        reference)4.20
                    
                    Warrant
                        to Purchase Stock (filed as Exhibit 4.2 to the Form 8-K filed
                        by the
                        Company on September 16, 2005 and incorporated herein by
                        reference)4.21
                    
                    Loan
                        and Security Agreement dated as of October 10, 2005 between
                        Citadel and
                        Lawrence Lacerte (filed as Exhibit 4.1 to the Form 8-K filed
                        by the
                        Company on October 12, 2005 and incorporated herein by
                        reference)4.22
                    
                    Intellectual
                        Property Security Agreement dated as of October 10, 2005
                        between Citadel
                        and Lawrence Lacerte (filed as Exhibit 4.2 to the Form 8-K
                        filed by the
                        Company on October 12, 2005 and incorporated herein by
                        reference)10.1
                    
                    Form
                        of Plan and Agreement of Distribution between CT Holdings
                        and Registrant
                        (filed as Exhibit 10.1 to the Form 10-SB and incorporated
                        by reference
                        herein)10.2
                    
                    Form
                        of Tax Disaffiliation Agreement between CT Holdings and the
                        Registrant
                        (filed as Exhibit 10.2 to the Form 10-SB and incorporated
                        by reference
                        herein)10.3
                    
                    Form
                        of Transition Services Agreement between CT Holdings and
                        Registrant (filed
                        as Exhibit 10.3 to the Form 10-SB and incorporated by reference
                        herein)10.4
                    
                    Form
                        of Indemnification Agreement between Registrant and its directors
                        and
                        officers (filed as Exhibit 10.4 to the Form 10-SB and incorporated
                        by
                        reference herein)10.5
                    
                    Employment
                        Agreement dated as of January 1, 2002 by and between Registrant
                        and Steven
                        B. Solomon (filed as Exhibit 10.5 to the Form 10-SB and incorporated
                        by
                        reference herein)
  64
  10.6
                    
                    2002
                        Stock Incentive Plan of the Registrant (filed as Exhibit
                        10.6 to the Form
                        10-SB and incorporated by reference herein)10.7
                    
                    Master
                        Services Agreement, dated as of December 19, 2001, between
                        CT Holdings and
                        SBC Services (filed as Exhibit 10.7 to Amendment No. 1 to
                        the Form 10-SB
                        filed with the Commission on March 6, 2002 and incorporated
                        by reference
                        herein)10.8
                    
                    Office
                        Lease Agreement between Citadel and Metropolitan Life Insurance
                        Company
                        (filed as Exhibit 10.1 to the Form 10-QSB filed with the
                        Commission on
                        August 16, 2004 and incorporated by reference herein)10.8
                    
                    Sublease
                        Agreement, dated March 22, 2002, between the Registrant and
                        SWS
                        Securities, Inc. (filed as Exhibit 10.8 to Amendment No.
                        2 to the Form
                        10-SB filed with the Commission on April 5, 2002 and incorporated
                        by
                        reference herein)10.9
                    
                    Form
                        of Subscription Agreement between the Registrant and certain
                        accredited
                        investors (filed as Exhibit 99.2 to the Registrant’s Current Report on
                        Form 8-K filed with the Commission February 13, 2003 and
                        incorporated by
                        reference herein)10.10
                    
                    Form
                        of Warrant issued by the Registrant to certain accredited
                        investors (filed
                        as Exhibit 99.3 to the Registrant’s Current Report on Form 8-K filed with
                        the Commission February 13, 2003 and incorporated by reference
                        herein)10.11
                    
                    Form
                        of Amendment No. 1 to Stock Purchase Warrant issued by the
                        Registrant to
                        certain accredited investors (filed as Exhibit 99.1 to the
                        Registrant’s
                        Current Report on Form 8-K filed with the Commission April
                        21, 2003 and
                        incorporated by reference herein)10.12
                    
                    Form
                        of Stock Purchase Warrant issued by the Registrant to certain
                        accredited
                        investors (filed as Exhibit 99.2 to the Registrant’s Current Report on
                        Form 8-K filed with the Commission April 21, 2003 and incorporated
                        by
                        reference herein)10.13
                    
                    Engagement
                        letter, dated December 10, 2002, between DHR International
                        Inc. and the
                        Registrant. (filed as Exhibit 10.13 to the Company’s Registration
                        Statement on Form SB-2 (registration number 333- 104777)
                        filed with the
                        Commission on June 30, 2003 and incorporated by reference
                        herein)10.14
                    
                    Advisory
                        Agreement, dated November 11, 2002, between Merriman Curhan
                        Ford & Co.
                        (formerly known as RTX Securities Corporation) and the Registrant.
                        (filed
                        as Exhibit 10.14 to the Company’s Registration Statement on Form SB-2
                        (registration number 333- 104777) filed with the Commission
                        on June 30,
                        2003 and incorporated by reference herein)10.15
                    
                    Engagement
                        letter related to private placement dated December 9, 2002
                        between
                        Merriman Curhan Ford & Co. (formerly known as RTX Securities
                        Corporation) and the Registrant. (filed as Exhibit 10.15
                        to the Company’s
                        Registration Statement on Form SB-2 (registration number
                        333- 104777)
                        filed with the Commission on June 30, 2003 and incorporated
                        by reference
                        herein)10.16
                    
                    Warrant
                        Agreement between the Registrant and Merriman Curhan Ford
& Co. dated
                        January 29,2003. (filed as Exhibit 10.16 to the Company’s Registration
                        Statement on Form SB-2 (registration number 333- 104777)
                        filed with the
                        Commission on June 30, 2003 and incorporated by reference
                        herein)10.17
                    
                    Promissory
                        Note, dated September 11, 2002, payable by the Registrant
                        to the order of
                        Eagle Equity I, L.P. (filed as Exhibit 10.17 to the Company’s Registration
                        Statement on Form SB-2 (registration number 333- 104777)
                        filed with the
                        Commission on June 30, 2003 and incorporated by reference
                        herein)10.18
                    
                    Stock
                        Purchase Agreement, dated September 11, 2002, among the Registrant,
                        Lawrence E. Steinberg, Michael A. Hershman, and Ari Reubin.
                        (filed as
                        Exhibit 10.18 to the Company’s Registration Statement on Form SB-2
                        (registration number 333- 104777) filed with the Commission
                        on June 30,
                        2003 and incorporated by reference herein)
  65
  10.19
                    
                    Promissory
                        Note, dated December 9, 2002, payable by the Registrant to
                        the order of
                        Ken Schnitzer, including Guaranty by Steven B. Solomon, Chief
                        Executive
                        Officer of the Registrant in favor of Ken Schnitzer. (filed
                        as Exhibit
                        10.19 to the Company’s Registration Statement on Form SB-2 (registration
                        number 333- 104777) filed with the Commission on June 30,
                        2003 and
                        incorporated by reference herein)10.20
                    
                    Notice
                        of Conversion, dated April 23, 2003, by Kenneth Schnitzer.
                        (filed as
                        Exhibit 10.20 to the Company’s Registration Statement on Form SB-2
                        (registration number 333- 104777) filed with the Commission
                        on June 30,
                        2003 and incorporated by reference herein)10.21
                    
                    Option
                        agreement dated November 4, 2002 between the registrant and
                        Marc Still.
                        (filed as Exhibit 10.21 to the Company’s Registration Statement on Form
                        SB-2 (registration number 333- 104777) filed with the Commission
                        on June
                        30, 2003 and incorporated by reference herein)10.22
                    
                    Promissory
                        Note dated June 5, 2002 payable by the Registrant to Aspen
                        Advisors, LP.
                        (filed as Exhibit 10.22 to the Company’s Registration Statement on Form
                        SB-2 (registration number 333- 104777) filed with the Commission
                        on June
                        30, 2003 and incorporated by reference herein)10.23
                    
                    Consultant
                        Agreement dated April 24, 2003 between the Registrant and
                        CEOcast, Inc.
                        (filed as Exhibit 10.23 to the Company’s Registration Statement on Form
                        SB-2 (registration number 333- 104777) filed with the Commission
                        on June
                        30, 2003 and incorporated by reference herein)10.24
                    
                    Warrant
                        Agreement between the Registrant and Merriman Curhan Ford
& Co. dated
                        April 21, 2003. (filed as Exhibit 10.24 to the Company’s Registration
                        Statement on Form SB-2 (registration number 333- 104777)
                        filed with the
                        Commission on June 30, 2003 and incorporated by reference
                        herein)10.25
                    
                    Securities
                        Purchase Agreement, dated as of February 9, 2004 by and among
                        Citadel and
                        the entities whose names appear on the signature pages thereof
                        (filed as
                        Exhibit 10.1 to the Form 8-K filed by the Company on February
                        10, 2004 and
                        incorporated by reference herein)10.26
                    
                    Employment
                        Agreement dated as of November 17, 2003 between Registrant
                        and Ed Krupa
                        (filed as Exhibit 10.26 to the Form 10-KSB filed with the
                        Commission on
                        March 15, 2004 and incorporated by reference)10.27
                    
                    Employment
                        Agreement dated as of April 1, 2003 between Registrant and
                        Richard
                        Connelly (filed as Exhibit 10.27 to the Form 10-KSB filed
                        with the
                        Commission on March 15, 2004 and incorporated by
                        reference)10.28
                    
                    Amendment
                        No. 1 to Employment Agreement dated as of October 1, 2003
                        between
                        Registrant and Steven B. Solomon (filed as Exhibit 10.28
                        to the Form
                        10-KSB filed with the Commission on March 15, 2004 and incorporated
                        by
                        reference)10.29
                    
                    Amendment
                        No. 1 to Employment Agreement dated as of October 1, 2003
                        between
                        Registrant and Richard Connelly (filed as Exhibit 10.29 to
                        the Form 10-KSB
                        filed with the Commission on March 15, 2004 and incorporated
                        by
                        reference)10.30
                    
                    Software
                        License and Service Agreement between Citadel and DigitalNet
                        Government
                        Solutions, LLC (filed as Exhibit 10.1 the Form 10-QSB filed
                        with the
                        Commission on November 15, 2004 and incorporated herein by
                        reference)10.31
                    
                    Securities
                        Purchase Agreement dated as of May 9, 2005 between Citadel
                        and entities
                        whose names appear on the signature pages thereof (filed
                        as Exhibit 10.1
                        to the Form 8-K filed by the Company on May 10, 2005 and
                        incorporated
                        herein by reference)10.32
                    
                    Consultant
                        Agreement dated as of April 24, 2005 between Citadel and
                        CEOcast, Inc.
                        (filed as Exhibit 10.2 to the Form S-3 filed by the Company
                        on June 8,
                        2005 and incorporated herein by reference)10.33
                    
                    Factoring
                        Agreement between the Company and Allied Capital Partners,
                        L.P. (filed as
                        Exhibit 4.1 to the Form 8-K filed by the Company on October
                        31, 2005 and
                        incorporated herein by reference)
  66
  10.34
                    
                    Software
                        License and Service Agreement between Citadel and DigitalNet
                        Government
                        Solutions, LLC (filed as Exhibit 10.1 the Form 10-QSB filed
                        with the
                        Commission on November 15, 2004 and incorporated herein by
                        reference)10.35
                    
                    Form
                        of Change of Control Agreement for each of Messrs. Carl Banzhof,
                        Richard
                        Connelly, Robert Dix, Dave Helffrich, Robert Humphrey and
                        Randy Schirman
                        (filed as Exhibit 10.1 to the Form 8-K filed by the Company
                        on December
                        21, 2005 and incorporated herein by reference)10.36
                    
                    Form
                        of Change of Control Agreement for Steven B. Solomon (filed
                        as Exhibit
                        10.2 to the Form 8-K filed by the Company on December 21,
                        2005 and
                        incorporated herein by reference)10.37
                    
                    Form
                        of Restricted Stock Award Agreement for Executives (filed
                        as Exhibit 10.3
                        to the Form 8-K filed by the Company on December 21, 2005
                        and incorporated
                        herein by reference)21
                    
                    Subsidiaries
                      of the Registrant23.1
                    
                    Consent
                        of KBA Group LLP, Independent Registered Public Accounting Firm,
                        filed herewith.24.1
                    
                    Power
                        of Attorney (included as part of the signature page of this
                        Annual Report
                        on Form 10-K).31.1
                    
                    Certification
                        of Principal Executive Officer, filed herewith.31.2
                    
                    Certification
                        of Principal Financial Officer, filed herewith.32.1
                    
                    Certification
                        of Chief Executive Officer and Chief Financial Officer Pursuant
                        to 18
                        U.S.C. Section 1350, As Adopted Pursuant to Section 906 of
                        the
                        Sarbanes-Oxley Act of 2002, filed herewith.
 
 67
  CITADEL
        SECURITY SOFTWARE INC.
 DECEMBER
        31, 2005
 TABLE
        OF
        CONTENTS
 
 PageReport
                  of Independent Registered Public Accounting Firm
              
              F-2Consolidated
                  Balance Sheets as of December 31, 2005 and 2004
              
              F-3Consolidated
                  Statements of Operations for the years ended December 31, 2005,
                  2004 and
                  2003
              
              F-4Consolidated
                  Statement of Stockholders' Equity for the year ended December 31,
                  2003
              
              F-5Consolidated
                  Statement of Stockholders' Equity for the year ended December 31,
                  2004
              
              F-6Consolidated
                  Statement of Stockholders' Equity (Deficit) for the year ended
                  December
                  31, 2005
              
              F-7Consolidated
                  Statements of Cash Flows for the years ended December 31, 2005,
                  2004 and
                  2003
              
              F-8Notes
                  to Consolidated Financial Statements
              
              F-10
  F-1
 *Table
            of Contents*
  **REPORT
        OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**
 
 
 The
        Board
        of Directors and Stockholders
 Citadel
        Security Software Inc.
 
 We
        have
        audited the accompanying consolidated balance sheets of Citadel Security
        Software Inc. and subsidiary (the “Company”) as of December 31, 2005 and 2004
        and the related consolidated statements of operations, stockholders’ equity
        (deficit) and cash flows for each of the years in the three-year period ended
        December 31, 2005. Our audits also included the financial statement schedule
        appearing under Item 15. These consolidated financial statements and schedule
        are the responsibility of the Company's management. Our responsibility is
        to
        express an opinion on these financial statements and schedule based on our
        audits.
 
 We
        conducted our audits in accordance with the standards of the Public Company
        Accounting Oversight Board (United States). Those standards require that
        we plan
        and perform the audits to obtain reasonable assurance about whether the
        financial statements are free of material misstatement. The Company is not
        required to have, nor were we engaged to perform, an audit of their internal
        control over financial reporting. Our audits included consideration of internal
        control over financial reporting as a basis for designing audit procedures
        that
        are appropriate in the circumstances, but not for the purpose of expressing
        an
        opinion on the effectiveness of the Company’s internal control over financial
        reporting. Accordingly, we express no such opinion. An audit includes examining,
        on a test basis, evidence supporting the amounts and disclosures in the
        financial statements, assessing the accounting principles used and significant
        estimates made by management, as well as evaluating the overall financial
        statement presentation. We believe that our audits provide a reasonable basis
        for our opinion.
 
 In
        our
        opinion, the consolidated financial statements referred to above present
        fairly,
        in all material respects, the consolidated financial position of Citadel
        Security Software Inc. and subsidiary as of December 31, 2005 and 2004 and
        the
        consolidated results of their operations and their cash flows for each of
        the
        years in the three-year period ended December 31, 2005 in conformity with
        accounting principles generally accepted in the United States of America.
        Also,
        in our opinion, the related financial statement schedule, when considered
        in
        relation to the consolidated financial statements as a whole, presents fairly,
        in all material respects, the information set forth therein.
  /s/
        KBA
        Group LLP
 KBA
        Group
        LLP
 Dallas,
        Texas
 February
        10, 2006, except for Note P to which the date is March 6, 2006
  F-2
 *Table
            of Contents*
  CITADEL
        SECURITY SOFTWARE INC.
 CONSOLIDATED
        BALANCE SHEETS
 DECEMBER
                  31,2005
              
              2004ASSETSCURRENT
                  ASSETSCash
                  and cash equivalents
              
              $
              1,320,376
              
              $
              9,838,154Accounts
                  receivable-trade, less allowance of $209,000 at December 31, 2005
                  and
                  2004
              
              
              2,570,090
              
              
              615,749Prepaid
                  expenses and other current assets
              
              
              932,591
              
              
              1,466,354Total
                  current assets
              
              
              4,823,057
              
              
              11,920,257PROPERTY
                  AND EQUIPMENT, net of accumulated depreciation of $2,483,398 and
                  $726,444
              
              
              5,126,228
              
              
              6,356,362CAPITALIZED
                  SOFTWARE DEVELOPMENT COSTS, net of accumulated amortization of
                  $6,625,180
                  and $4,433,065
              
              
              4,431,322
              
              
              4,048,452OTHER
                  ASSETS
              
              
              84,812
              
              
              83,439TOTAL
                  ASSETS
              
              $
              14,465,419
              
              $
              22,408,510LIABILITIES
                  AND STOCKHOLDERS’ EQUITY (DEFICIT)CURRENT
                  LIABILITIESFactoring
                  line of credit
              
              $
              924,777
              
              $
              -Current
                  portion of long-term debt
              
              
              -
              
              
              1,327,273Accounts
                  payable and accrued expenses
              
              
              3,721,551
              
              
              3,040,665Accrued
                  compensation and payroll tax obligations
              
              
              1,245,401
              
              
              1,413,670Preferred
                  stock dividends payable
              
              
              -
              
              
              187,500Current
                  portion of deferred revenue
              
              
              4,680,328
              
              
              2,462,851Total
                  current liabilities
              
              
              10,572,057
              
              
              8,431,959LONG-TERM
                  DEBT, LESS CURRENT PORTION
              
              
              3,750,000
              
              
              1,989,393DEFERRED
                  REVENUE, LESS CURRENT PORTION
              
              
              398,342
              
              
              480,172OTHER
                  NON-CURRENT LIABILITIES
              
              
              609,912
              
              
              714,466COMMITMENTS
                  AND CONTINGENCIESCONVERTIBLE
                  PREFERRED STOCK, $1,000 stated value per share; 1,000,000 shares
                  authorized;Series
                  A Preferred Stock, 15,000 shares issued and outstanding at December
                  31,
                  2005 and 2004, liquidation preference of $15,000,000
              
              
              10,422,299
              
              
              10,701,847Series
                  B Preferred Stock, 7,000 shares issued and outstanding at December
                  31,
                  2005, liquidation preference of $7,000,000
              
              
              5,247,688
              
              
              -COMMON
                  STOCK, $.01 par value per share; 100,000,000 shares authorized;
                  30,518,230
                  and 29,845,730 shares issued and outstanding at December 31, 2005
                  and
                  2004
              
              
              305,182
              
              
              298,457ADDITIONAL
                  PAID-IN CAPITAL
              
              
              46,179,211
              
              
              44,248,609ACCUMULATED
                  DEFICIT
              
              
              (63,019,272
              )
              
              (44,456,393
              )Total
                  Stockholders’ Equity (Deficit)
              
              
              (864,892
              )
              
              10,792,520TOTAL
                  LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
              
              $
              14,465,419
              
              $
              22,408,510
 
 The
        accompanying notes are an integral part of these consolidated financial
        statements.
  F-3
 *Table
            of Contents*
 
 CITADEL
        SECURITY SOFTWARE INC.
 CONSOLIDATED
        STATEMENTS OF OPERATIONS
 
 YEARS
                  ENDED DECEMBER 31,2005
              
              2004
              
              2003RevenueLicense
                  fees
              
              $
              2,568,453
              
              $
              12,361,585
              
              $
              5,198,010Content,
                  subscription, and customer support services
              
              
              4,867,542
              
              
              2,786,937
              
              
              617,651Professional
                  services
              
              
              2,851,100
              
              
              104,633
              
              
              40,635Total
                  revenue
              
              
              10,287,095
              
              
              15,253,155
              
              
              5,856,296Costs
                  of revenueSoftware
                  amortization
              
              
              2,192,115
              
              
              1,287,927
              
              
              473,881Content,
                  subscription, and customer support services costs
              
              
              1,667,581
              
              
              1,478,633
              
              
              288,323Professional
                  services costs
              
              
              645,202
              
              
              29,028
              
              
              -Shipping
                  and other costs
              
              
              161,805
              
              
              36,496
              
              
              56,544Total
                  costs of revenue
              
              
              4,666,703
              
              
              2,832,084
              
              
              818,748Operating
                  expensesSelling,
                  general and administrative expense
              
              
              19,577,780
              
              
              17,550,485
              
              
              6,388,396Product
                  development expense
              
              
              2,443,864
              
              
              1,995,612
              
              
              392,967Depreciation
                  and amortization of property and equipment
              
              
              1,756,955
              
              
              670,782
              
              
              207,924Write-off
                  of property and equipment
              
              
              -
              
              
              77,786
              
              
              -Total
                  operating expenses
              
              
              23,778,599
              
              
              20,294,665
              
              
              6,989,287Operating
                  loss
              
              
              (18,158,207
              )
              
              (7,873,594
              )
              
              (1,951,739
              )Interest
                  income
              
              
              67,588
              
              
              107,261
              
              
              -Interest
                  expense
              
              
              (472,260
              )
              
              (82,612
              )
              
              (3,036,342
              )Other
                  income (expense)
              
              
              -
              
              
              9,920
              
              
              (35,500
              )Write-off
                  of note receivable from related party
              
              
              -
              
              
              -
              
              
              (225,000
              )Loss
                  before income taxes
              
              
              (18,562,879
              )
              
              (7,839,025
              )
              
              (5,248,581
              )Provision
                  for income taxes
              
              
              -
              
              
              -
              
              
              -Net
                  loss
              
              
              (18,562,879
              )
              
              (7,839,025
              )
              
              (5,248,581
              )Preferred
                  stock dividends
              
              
              (268,750
              )
              
              (664,940
              )
              
              -Non-cash
                  fair value adjustment for exchanged warrants
              
              
              (274,800
              )
              
              -
              
              
              -Non-cash
                  fair value adjustment for Series A preferred stock dividend
                  waiver
              
              
              1,826,000
              
              
              -
              
              
              -Non-cash
                  fair value adjustment for change in Series A preferred stock conversion
                  price
              
              
              (1,064,000
              )
              
              -
              
              
              -Non-cash
                  accretion of preferred stock beneficial conversion feature
              
              
              (769,252
              )
              
              (215,397
              )
              
              -Non-cash
                  fair value adjustment for change in exercise price of
                  warrants
              
              
              (43,226
              )
              
              -
              
              
              -Net
                  loss to common shareholders
              
              $
              (19,156,907
              )
              $
              (8,719,362
              )
              $
              (5,248,581
              )Net
                  loss per share to common shareholders - basic and diluted
              
              $
              (0.64
              )
              $
              (0.30
              )
              $
              (0.24
              )Weighted
                  average common shares outstanding - basic and diluted
              
              
              29,976,179
              
              
              29,336,894
              
              
              22,134,040
 
 The
        accompanying notes are an integral part of these consolidated financial
        statements.
  F-4
 *Table
            of Contents*
 CITADEL
            SECURITY SOFTWARE INC.
 CONSOLIDATED
            STATEMENT OF STOCKHOLDERS' EQUITY
 ****
                Common
                    StockNumber
                    ofShares
                
                Amount
                
                AdditionalPaid-in
                    Capital
                
                AccumulatedDeficit
                
                TotalBalances
                    at December 31, 2002
                
                
                15,255,577
                
                $
                152,555
                
                $
                28,889,332
                
                $
                (31,368,787
                )
                $
                (2,326,900
                )Issuance
                    of common stock for cash net of transaction fees
                
                
                3,275,000
                
                
                32,750
                
                
                2,364,717
                
                
                
                
                
                2,397,467Common
                    stock issued with convertible notes payable, recorded as debt
                    discount
                
                
                1,082,800
                
                
                10,828
                
                
                1,010,017
                
                
                
                
                
                1,020,845Beneficial
                    conversion feature of convertible notes payable, recorded as
                    debt discount
                
                
                
                
                
                
                
                
                1,543,310
                
                
                
                
                
                1,543,310Fair
                    value of warrants issued as transaction fee in conjunction with
                    issuance
                    of convertible notes payable, recorded as debt issuance costs
                
                
                
                
                
                
                
                
                121,725
                
                
                
                
                
                121,725Common
                    stock issued upon conversion of convertible notes payable and
                    accrued
                    interest
                
                
                2,348,079
                
                
                23,481
                
                
                2,787,399
                
                
                
                
                
                2,810,880Fair
                    value of warrants issued in lieu of cash for services
                
                
                
                
                
                
                
                
                64,140
                
                
                
                
                
                64,140Common
                    stock issued pursuant to the exercise of stock options
                
                
                393,660
                
                
                3,937
                
                
                195,124
                
                
                
                
                
                199,061Common
                    stock issued pursuant to the exercise of stock options in exchange
                    for
                    reduction of a note payable to a former director
                
                
                862,500
                
                
                8,625
                
                
                267,375
                
                
                
                
                
                276,000Common
                    stock issued pursuant to the exercise of warrants
                
                
                3,534,895
                
                
                35,349
                
                
                3,593,895
                
                
                
                
                
                3,629,244Issuance
                    of common stock held in reserve at Distribution Date for settlement
                    of CT
                    Holdings liabilities
                
                
                250,000
                
                
                2,500
                
                
                (2,500
                )
                
                
                
                
                -Issuance
                    of common stock per commitment upon conversion of CT Holdings
                    convertible
                    note payable
                
                
                675,000
                
                
                6,750
                
                
                (6,750
                )
                
                
                
                
                -Issuance
                    of common stock in settlement of liability to former employee
                
                
                25,000
                
                
                250
                
                
                35,250
                
                
                
                
                
                35,500Common
                    stock issued as compensation
                
                
                50,000
                
                
                500
                
                
                82,000
                
                
                
                
                
                82,500Fair
                    value of common stock and stock options issued to consultants
                    in lieu of
                    cash for services
                
                
                78,000
                
                
                780
                
                
                164,790
                
                
                
                
                
                165,570Net
                    loss
                
                
                -
                
                
                -
                
                
                -
                
                
                (5,248,581
                )
                
                (5,248,581
                )Balances
                    at December 31, 2003
                
                
                27,830,511
                
                $
                278,305
                
                $
                41,109,824
                
                $
                (36,617,368
                )
                $
                4,770,761
 
 The
          accompanying notes are an integral part of this consolidated financial
          statement.
  F-5
 *Table
              of Contents*
 CITADEL
            SECURITY SOFTWARE INC.
 CONSOLIDATED
            STATEMENT OF STOCKHOLDERS' EQUITY
 
 Series
                      A Preferred Stock
                  
                  Common
                      StockNumber
                      ofShares
                  
                  Amount
                  
                  Number
                      ofShares
                  
                  Amount
                  
                  AdditionalPaid-in
                      Capital
                  
                  AccumulatedDeficit
                  
                  TotalBalances
                      at December 31, 2003
                  
                  
                  -
                  
                  $
                  -
                  
                  
                  27,830,511
                  
                  $
                  278,305
                  
                  $
                  41,109,824
                  
                  $
                  (36,617,368
                  )
                  $
                  4,770,761Issuance
                      of comvertible preferred stock net of transcation fees
                  
                  
                  15,000
                  
                  
                  13,797,283
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  13,797,283Fair
                      value of warrants issued in conjunction with preferred stock
                  
                  
                  
                  
                  
                  (2,326,184
                  )
                  
                  
                  
                  
                  
                  
                  
                  2,326,184
                  
                  
                  
                  
                  
                  -Fair
                      value of beneficial conversion feature of convertible preferred
                      stock
                  
                  
                  
                  
                  
                  (984,649
                  )
                  
                  
                  
                  
                  
                  
                  
                  984,649
                  
                  
                  
                  
                  
                  -Accretion
                      of beneficial conversion feature
                  
                  
                  
                  
                  
                  215,397
                  
                  
                  
                  
                  
                  
                  
                  
                  (215,397
                  )
                  
                  
                  
                  
                  -Preferred
                      dividends
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (664,939
                  )
                  
                  
                  
                  
                  (664,939
                  )Common
                      stock issued pursuant to the exercise of stock options
                  
                  
                  
                  
                  
                  
                  
                  
                  350,219
                  
                  
                  3,502
                  
                  
                  332,555
                  
                  
                  
                  
                  
                  336,057Common
                      stock issued pursuant to the exercise of warrants
                  
                  
                  
                  
                  
                  
                  
                  
                  165,000
                  
                  
                  1,650
                  
                  
                  214,900
                  
                  
                  
                  
                  
                  216,550Exercise
                      of conversion right
                  
                  
                  
                  
                  
                  
                  
                  
                  1,500,000
                  
                  
                  15,000
                  
                  
                  (15,000
                  )
                  
                  
                  
                  
                  -Fair
                      value of warrants issued in conjunction with bank lines of
                      credit
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  45,838
                  
                  
                  
                  
                  
                  45,838Fair
                      value of stock options with modified terms issued to employee
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  129,995
                  
                  
                  
                  
                  
                  129,995Net
                      loss
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (7,839,025
                  )
                  
                  (7,839,025
                  )Balances
                      at December 31, 2004
                  
                  
                  15,000
                  
                  $
                  10,701,847
                  
                  
                  29,845,730
                  
                  $
                  298,457
                  
                  $
                  44,248,609
                  
                  $
                  (44,456,393
                  )
                  $
                  10,792,520
 
 The
            accompanying notes are an integral part of this financial
            statement.
  F-6
 *Table
                of Contents*
 
 CITADEL
            SECURITY SOFTWARE INC.
 CONSOLIDATED
            STATEMENT OF STOCKHOLDERS' EQUITY (DEFICIT)
 
 Preferred
                      StockSeries
                      A
                  
                  Series
                      B
                  
                  Common
                      StockNumber
                      ofShares
                  
                  Amount
                  
                  Number
                      ofShares
                  
                  Amount
                  
                  Number
                      ofShares
                  
                  Amount
                  
                  AdditionalPaid-in Capital
                  
                  AccumulatedDeficit
                  
                  TotalBalances
                      at December 31, 2004
                  
                  
                  15,000
                  
                  $
                  10,701,847
                  
                  
                  
                  
                  $
                  -
                  
                  
                  29,845,730
                  
                  $
                  298,457
                  
                  $
                  44,248,609
                  
                  $
                  (44,456,393
                  )
                  $
                  10,792,520Fair
                      value adjustment for issuance of exchanged warrants
                  
                  
                  
                  
                  
                  (274,800
                  )
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  274,800
                  
                  
                  
                  
                  
                  -Fair
                      value adjustment for Series A preferred stock dividend waiver
                  
                  
                  
                  
                  
                  (1,826,000
                  )
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  1,826,000
                  
                  
                  
                  
                  
                  -Fair
                      value adjustment for change in Series A preferred stock conversion
                      price
                  
                  
                  
                  
                  
                  1,064,000
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (1,064,000
                  )
                  
                  
                  
                  
                  -Fair
                      value adjustment for change in exercise price of warrants issued
                      in
                      conjunction with preferred stock
                  
                  
                  
                  
                  
                  (12,000
                  )
                  
                  
                  
                  
                  (31,226
                  )
                  
                  
                  
                  
                  
                  
                  
                  43,226
                  
                  
                  
                  
                  
                  -Issuance
                      of Series B convertible preferred stock, net of transcation
                      fees
                  
                  
                  
                  
                  
                  
                  
                  
                  7,000
                  
                  
                  6,902,396
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  6,902,396Fair
                      value of warrants issued in conjunction with Series B preferred
                      stock
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (1,623,482
                  )
                  
                  
                  
                  
                  
                  
                  
                  1,623,482
                  
                  
                  
                  
                  
                  -Accretion
                      of preferred stock beneficial conversion feature
                  
                  
                  
                  
                  
                  769,252
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (769,252
                  )
                  
                  
                  
                  
                  -Fair
                      value of warrants issued in conjunction with bank covenants
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  64,321
                  
                  
                  
                  
                  
                  64,321Preferred
                      stock dividends
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (268,750
                  )
                  
                  
                  
                  
                  (268,750
                  )Common
                      stock issued pursuant to the exercise of stock options
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  112,500
                  
                  
                  1,125
                  
                  
                  34,875
                  
                  
                  
                  
                  
                  36,000Common
                      stock issued in lieu of cash for director's fee
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  110,000
                  
                  
                  1,100
                  
                  
                  86,900
                  
                  
                  
                  
                  
                  88,000Common
                      stock issued in lieu of cash for services
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  50,000
                  
                  
                  500
                  
                  
                  46,000
                  
                  
                  
                  
                  
                  46,500Restricted
                      common stock issued as compensation to directors and officers
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  400,000
                  
                  
                  4,000
                  
                  
                  144,000
                  
                  
                  
                  
                  
                  148,000Deferred
                      compensation to officers
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (111,000
                  )
                  
                  
                  
                  
                  (111,000
                  )Net
                      loss
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  
                  (18,562,879
                  )
                  
                  (18,562,879
                  )Balances
                      at December 31, 2005
                  
                  
                  15,000
                  
                  $
                  10,422,299
                  
                  
                  7,000
                  
                  $
                  5,247,688
                  
                  
                  30,518,230
                  
                  $
                  305,182
                  
                  $
                  46,179,211
                  
                  $
                  (63,019,272
                  )
                  $
                  (864,892
                  )
  The
            accompanying notes are an integral part of this consolidated financial
            statement.
 
 F-7
 *Table
                  of Contents*
 
 CITADEL
            SECURITY SOFTWARE INC
 CONSOLIDATED
            STATEMENTS OF CASH FLOWS
  YEARS
                      ENDED DECEMBER 31,2005
                  
                  2004
                  
                  2003CASH
                      FLOWS FROM OPERATING ACTIVITIESNet
                      loss
                  
                  $
                  (18,562,879
                  )
                  $
                  (7,839,025
                  )
                  $
                  (5,248,581
                  )Adjustments
                      to reconcile net loss to net cash used in operating
                      activities:Depreciation
                      and amortization
                  
                  
                  3,949,070
                  
                  
                  1,958,709
                  
                  
                  681,806Write-off
                      of property and equipment
                  
                  
                  -
                  
                  
                  77,786
                  
                  
                  -Provision
                      for returns, allowances and bad debts
                  
                  
                  46,233
                  
                  
                  130,500
                  
                  
                  58,500Stock-based
                      compensation expense
                  
                  
                  37,000
                  
                  
                  129,995
                  
                  
                  82,500Amortization
                      of deferred credit for tenant incentive recorded as leasehold
                      improvements
                  
                  
                  (104,554
                  )
                  
                  -
                  
                  
                  -Amortization
                      of debt issuance costs recorded as interest expense
                  
                  
                  130,192
                  
                  
                  16,052
                  
                  
                  333,725Beneficial
                      conversion feature of convertible debt recognized as interest
                      expense
                  
                  
                  -
                  
                  
                  -
                  
                  
                  1,543,310Common
                      stock issued in conjunction with convertible debt recognized
                      as interest
                      expense
                  
                  
                  -
                  
                  
                  -
                  
                  
                  1,067,928Common
                      stock issued in lieu of cash for director’s fee
                  
                  
                  46,500
                  
                  
                  -
                  
                  
                  -Common
                      stock, warrants and stock issued in lieu of cash for
                      services
                  
                  
                  88,000
                  
                  
                  -
                  
                  
                  265,210Write-off
                      of note receivable from related party
                  
                  
                  -
                  
                  
                  -
                  
                  
                  225,000Changes
                      in operating assets and liabilities:Accounts
                      receivable - trade
                  
                  
                  (2,000,574
                  )
                  
                  952,905
                  
                  
                  (1,590,989
                  )Prepaid
                      expenses and other current assets
                  
                  
                  533,764
                  
                  
                  (1,198,994
                  )
                  
                  (158,458
                  )Other
                      assets
                  
                  
                  (24,743
                  )
                  
                  (10,014
                  )
                  
                  -Accounts
                      payable and accrued expenses
                  
                  
                  1,328,130
                  
                  
                  898,611
                  
                  
                  98,511Accrued
                      compensation and payroll tax obligations
                  
                  
                  (168,269
                  )
                  
                  645,225
                  
                  
                  (285,557
                  )Deferred
                      revenue
                  
                  
                  2,135,647
                  
                  
                  137,828
                  
                  
                  2,655,002NET
                      CASH USED IN OPERATING ACTIVITIES
                  
                  
                  (12,566,483
                  )
                  
                  (4,100,422
                  )
                  
                  (272,093
                  )CASH
                      FLOWS FROM INVESTING ACTIVITIESPurchases
                      of property and equipment
                  
                  
                  (1,174,067
                  )
                  
                  (5,038,193
                  )
                  
                  (411,211
                  )Capitalized
                      software development costs
                  
                  
                  (2,574,984
                  )
                  
                  (3,261,210
                  )
                  
                  (1,897,497
                  )Issuance
                      of note receivable to CT Holdings
                  
                  
                  -
                  
                  
                  -
                  
                  
                  (225,000
                  )NET
                      CASH USED IN INVESTING ACTIVITIES
                  
                  
                  (3,749,051
                  )
                  
                  (8,299,403
                  )
                  
                  (2,533,708
                  )CASH
                      FLOWS FROM FINANCING ACTIVITIESNet
                      proceeds from issuance of preferred stock
                  
                  
                  6,902,396
                  
                  
                  13,797,283
                  
                  
                  -Borrowings
                      of long-term debt
                  
                  
                  4,500,000
                  
                  
                  3,500,000
                  
                  
                  -Payments
                      of long-term debt
                  
                  
                  (4,066,667
                  )
                  
                  (183,334
                  )
                  
                  -Debt
                      issue costs
                  
                  
                  (42,500
                  )
                  
                  (26,396
                  )
                  
                  -Payment
                      of preferred stock dividends
                  
                  
                  (456,250
                  )
                  
                  (477,439
                  )
                  
                  -Proceeds
                      of notes and advances from related parties
                  
                  
                  -
                  
                  
                  -
                  
                  
                  888,522Payments
                      on notes and advances from related parties
                  
                  
                  -
                  
                  
                  (16,903
                  )
                  
                  (1,463,160
                  )Proceeds
                      from notes payable to shareholders
                  
                  
                  -
                  
                  
                  -
                  
                  
                  2,570,000Payments
                      on notes payable to shareholders
                  
                  
                  -
                  
                  
                  -
                  
                  
                  (537,000
                  )Proceeds
                      from issuance of common stock
                  
                  
                  -
                  
                  
                  -
                  
                  
                  2,397,467Net
                      advances from factoring accounts receivable
                  
                  
                  924,777
                  
                  
                  -
                  
                  
                  -Proceeds
                      from exercise of warrants
                  
                  
                  -
                  
                  
                  216,550
                  
                  
                  3,629,244Proceeds
                      from exercise of stock options
                  
                  
                  36,000
                  
                  
                  336,057
                  
                  
                  199,060Proceeds
                      on notes receivable from issuance of common stock
                  
                  
                  -
                  
                  
                  -
                  
                  
                  201,000NET
                      CASH PROVIDED BY FINANCING ACTIVITIES
                  
                  
                  7,797,756
                  
                  
                  17,145,818
                  
                  
                  7,885,133Net
                      (decrease) increase in cash and cash equivalents
                  
                  
                  (8,517,778
                  )
                  
                  4,745,993
                  
                  
                  5,079,332Cash
                      and cash equivalents at the beginning of the year
                  
                  
                  9,838,154
                  
                  
                  5,092,161
                  
                  
                  12,829Cash
                      and cash equivalents at the end of the year
                  
                  $
                  1,320,376
                  
                  $
                  9,838,154
                  
                  $
                  5,092,161
 
 The
            accompanying notes are an integral part of these consolidated financial
            statements.
 
 F-8
 *Table
                  of Contents*
 
 CITADEL
            SECURITY SOFTWARE INC
 CONSOLIDATED
            STATEMENTS OF CASH FLOWS (continued)
 
 YEARS
                      ENDED DECEMBER 31,2005
                  
                  2004
                  
                  2003Supplemental
                      cash flow information:Interest
                      paid
                  
                  $
                  256,417
                  
                  $
                  54,989
                  
                  $
                  38,252Income
                      taxes paid
                  
                  $
                  -
                  
                  $
                  -
                  
                  $
                  -Non-cash
                      investing items:Leasehold
                      improvements funded by landlord
                  
                  $
                  -
                  
                  $
                  836,448
                  
                  $
                  -Note
                      payable issued as settlement of accounts payable
                  
                  $
                  -
                  
                  $
                  -
                  
                  $
                  50,000Non-cash
                      financing items:Accretion
                      of convertible preferred stock beneficial conversion
                      feature
                  
                  $
                  769,252
                  
                  $
                  215,397
                  
                  $
                  -Fair
                      value of warrants issued in connection with sale of preferred
                      stock
                  
                  $
                  1,623,482
                  
                  $
                  2,326,184
                  
                  $
                  -Fair
                      value of warrants issued in conjunction with bank lines of
                      credit recorded
                      as deferred financing costs
                  
                  $
                  64,321
                  
                  $
                  45,838
                  
                  $
                  -Fair
                      value adjustment for exchanged warrants
                  
                  $
                  274,800
                  
                  $
                  -Fair
                      value adjustment for Series A preferred stock dividend
                      waiver
                  
                  $
                  1,826,000
                  
                  $
                  -Fair
                      value adjustment for change in Series A preferred stock conversion
                      price
                  
                  $
                  1,064,000
                  
                  $
                  -Fair
                      value adjustment for change in exercise price of warrants issued
                      in
                      conjunction with preferred stock
                  
                  $
                  43,226
                  
                  $
                  -Preferred
                      stock dividend accrued
                  
                  $
                  -
                  
                  $
                  187,500
                  
                  $
                  -Beneficial
                      conversion feature of convertible preferred stock
                  
                  $
                  -
                  
                  $
                  984,649
                  
                  $
                  -Issuance
                      of common stock through exercise of exchange right by
                      officer
                  
                  $
                  -
                  
                  $
                  15,000
                  
                  $
                  -Exercise
                      of stock options in exchange for note payable plus accrued
                      interest due
                      former director
                  
                  $
                  -
                  
                  $
                  -
                  
                  $
                  276,000Conversion
                      of note payable plus accrued interest into shares of common
                      stock
                  
                  $
                  -
                  
                  $
                  -
                  
                  $
                  2,810,881Note
                      payable issued for financing fees recorded as debt issuance
                      costs
                  
                  $
                  -
                  
                  $
                  -
                  
                  $
                  212,000Warrants
                      to purchase common stock issued with convertiblenote payable
                      recorded as
                      debt issuance costs
                  
                  $
                  -
                  
                  $
                  -
                  
                  $
                  121,725Beneficial
                      conversion feature of convertible notes payable recorded as
                      debt
                      discount
                  
                  $
                  -
                  
                  $
                  -
                  
                  $
                  1,543,310Common
                      stock issued with convertible notes payable recorded as debt
                      discount
                  
                  $
                  -
                  
                  $
                  -
                  
                  $
                  1,020,845
 
 The
            accompanying notes are an integral part of these consolidated financial
            statements.
 
 F-9
 *Table
                  of Contents*
 
 CITADEL
            SECURITY SOFTWARE INC.
 NOTES
            TO
            CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
            31, 2005
 
 NOTE
            A -
            NATURE OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
 *Basis
            of Presentation*
 
 The
            accompanying consolidated financial statements of Citadel Security Software
            Inc.
            ( “Citadel”) and its wholly-owned subsidiary, Citadel Security Software
            International LLC, (collectively referred to as the “Company”) have been
            prepared in accordance with generally accepted accounting principles.
            All
            significant intercompany accounts and transactions have been eliminated
            in
            consolidation. Certain prior year amounts have been reclassified to conform
            to
            current year presentation.
 
 *Description
            of Business*
 
 Citadel
            provides enterprise vulnerability management and policy compliance and
            enforcement solutions that enable organizations to reduce the risk associated
            with computer network vulnerabilities. Citadel develops and markets full
            life
            cycle vulnerability management software solutions including Citadel’s patented
            technology included in its Hercules®, product, powered by automated
            vulnerability remediation technology which allows enterprises to neutralize
            security vulnerabilities across Windows, Linux, Mac and Unix platforms.
            In June
            2005 the Company released its latest version of the Hercules solution,
            Hercules
            4.0 and reconfigured the product into three components, Compliance Manager,
            Remediation Manager and Enterprise Reporting. AssetGuard, which provides
            the ability to collect detailed workstation and server device information
            and
            store that information in the Hercules database repository, and ConnectGuard,
            which provides
            endpoint security by quarantining remote and local machines before allowing
            them
            to reconnect to the network, checking for security policy compliance,
            and
            applying remedies to out of compliance machines before releasing the
            quarantine
            and allowing network access, are
            contained within the components of Hercules and may still be licensed
            separately
            to customers with older version of the Hercules product. In addition,
            Hercules
            4.0 is available in two formats, as traditional enterprise software or
            as
            software pre-installed on a hardware appliance. SecurePCTM and NetOFFTM are
            security management solutions for networks and personal workstations
            which are
            designed to secure and manage personal computers as well as local area
            networks.
            With Citadel’s solutions, enterprises are able to realize cost and process
            efficiencies, proactively manage the latest threats and vulnerabilities,
            and
            demonstrate compliance with corporate mandates or government legislation.
 
 The
            Company's security software business was formed in 1996 as the result
            of the
            acquisition of several technology businesses operated by a business incubator
            from 1996 through May 17, 2002 at which time Citadel was spun out from
            its
            former parent as a stand alone company in a pro
            rata dividend distribution to the shareholders of the former parent company
            (the
            "Distribution") .
            The
            Company is a Delaware corporation and is headquartered in Dallas, Texas
            with an
            additional office in Reston, Virginia. On April 30, 2004 the Company’s stock
            moved from the OTCBB to the NASDAQ Capital Market and trades under the
            symbol
“CDSS”. In October 2005 the Company formed a wholly owned subsidiary, Citadel
            Security Software International LLC for the purposes of managing the
            Company’s
            international operations. Citadel’s website can be found at
            www.citadel.com.
 
 *Liquidity
            and Plan of Operations*
 
 At
            December 31, 2005 the Company had cash and cash equivalents of approximately
            $1.3 million, a net working capital deficiency of approximately $5.7
            million and
            a stockholders’ equity deficit of approximately $865 thousand. In addition, the
            Company used cash in its operating activities totaling approximately
            $12.6
            million and incurred a net loss of approximately $18.6 million during
            the year
            ended December 31, 2005.
 
 F-10
 *Table
                  of Contents*
 During
              2005 the Company took actions to improve financial performance including
              reductions in costs and expenses, the hiring of new sales management
              and the
              reorganization of the sales team. The Company also began offering new
              ways for
              its customers to license its software solution including usage based
              pricing,
              subscription pricing and Hercules on an appliance. Some of the benefits
              of these
              actions began to be realized during the third and fourth quarters of
              2005.
 
 The
              Company believes that the current sales management, the reorganization
              of the
              sales team, the new selling models introduced in 2005 and selling models
              that
              may be introduced in 2006 can continue the trend in increased orders
              for the
              next twelve months, although any one quarter's total orders could be
              skewed
              upward or downward resulting from the timing of the booking of large
              contracts
              that are in the pipeline. The expected increase in orders is expected
              to cause a
              corresponding increase in cash inflows to the Company.
 
 During
              the third and fourth quarters of 2005 the Company took actions to reduce
              costs
              and expenses. A substantial portion of these actions was a reduction
              in force.
              The Company expects to replace key positions as necessary and will
              add
              additional personnel to support additional contract order opportunities.
              In
              addition discretionary spending has been reduced. As a result of these
              cost and
              expense reduction actions taken in 2005, the Company expects that the
              total of
              its fixed costs and discretionary expenses will be reduced as much
              as $1.5
              million to $2 million per quarter in 2006.
 
 Historically
              the Company has had access to additional capital and has raised money
              through
              both equity and debt financings. The Company believes that it will
              continue to
              have access to capital to fund the operations but the Company has no
              plans as of
              the filing date of this report to raise additional funds. From time-to-time
              in
              2005 the Company's CEO has advanced funds to the Company to meet short-term
              working capital needs. The total amounts advanced during 2005 were
              approximately
              $881,000, all of which was repaid to the CEO by February 1, 2006. The
              Company's
              CEO has committed to advance the Company up to three million dollars
              in funding
              should it be necessary for short term working capital needs through
              March 2007.
              The terms and conditions of any advance to the Company from the CEO
              will be
              established by the Company's Board of Directors.
 
 The
              Company believes that the execution of its business plan including
              strategies to
              grow revenue and control costs and expenses, combined with liquidity
              available
              from our Factoring Agreement and the commitment from the Company's
              CEO, is
              sufficient to fund operations for the next twelve months. If needed,
              Citadel may
              also consider raising additional debt or equity capital under the right
              circumstances. However, there can be no assurance that the Company
              will be able
              to raise debt or equity capital at terms it considers reasonable and
              prudent or
              that the Company will be able to fully execute its business plan in
              2006.
  F-11
 *Table
                  of Contents*
 
 *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 disclosure
            of
            contingent assets and liabilities at the date of the financial statements
            and
            the reported amounts of revenue and expenses during the reporting period.
            Actual
            results could differ from those estimates.
 
 *Revenue
            Recognition*
 
 The
            Company's customers consist of large and small corporations, healthcare
            organizations, financial institutions and government and educational
            agencies.
            The Company's revenue recognition policies have been designed to follow
            the
            guidance provided by Statement of Position (“SOP”) 97-2, “Software Revenue
            Recognition,” as amended by SOP
            98-9
            and Staff Accounting Bulletin (“SAB”) 104, “Revenue Recognition.” Revenue from
            license fees is generally recognized when a fixed fee order has been
            received
            and delivery to the customer has occurred. If software media and documentation
            are shipped FOB “Origin”, license fee revenue is recognized when shipped. If
            software media and documentation are shipped FOB “Destination”, license fee
            revenue is recognized when delivered. In addition, revenue is recognized
            only
            when the collectibility of the invoiced amounts is probable and acceptance
            criteria, if any, have been met. Customer support contracts provide the
            customer
            the right to telephone support, software updates, point releases of new
            features
            and functionality, and content subscriptions provide the customer
            with vulnerability remediation content updates on a when and if available
            basis. Content and customer support contracts include access to the
            vulnerability remediation content database for the term of the agreement
            and are
            sold separately from the license. The related revenue is recognized ratably
            over
            the term of the support contract. Professional services revenue is recognized
            as
            the services are performed assuming all other revenue recognition criteria
            are
            met. In arrangements that include multiple elements, including perpetual
            software licenses and maintenance and/or services, revenue is allocated
            to the
            various elements based on vendor specific objective evidence (“VSOE”) and
            recognized based on management's estimate of the fair value of each component
            as
            described in SOP 97-2, SOP 98-9 and SAB 104.
 
 Customers
            may obtain a license from Citadel's direct sales organization, or license
            products through promotions or agreements with independent third party
            resellers
            and strategic partners. The Company's products are not licensed through
            retail
            distribution channels. A customer may return a product only under very
            limited
            circumstances during the first thirty to ninety days from the date of
            shipment
            for a replacement if the media is damaged or for a full refund if the
            software
            does not perform in accordance with written specifications. Accordingly,
            the
            Company records a provision for returns against license revenue in the
            same
            period the revenue is recorded. The provision is subject to estimation
            by
            management and has been based on historical product returns, average
            invoice
            size, revenue volume and other known data as well as market and economic
            conditions. An allowance for returns, allowances and bad debts of $209,000
            has
            been estimated and recorded at December 31, 2005. The estimate of the
            allowance
            for returns, allowances and bad debts may fluctuate from period to period
            due to
            factors including but not limited to the value of actual returns, the
            average
            dollar value of licenses granted during the period, the relative license
            revenue
            volume for the period and changes in financial condition of individual
            customers.
 
 Citadel
            utilizes a sell-through business model for distributors and resellers
            under
            which revenue is recognized on products sold through distributors and
            resellers at the time the distributors and resellers liscense the
            products to the end-user. When distributors and resellers
            agreements provide for a contractual right of return, future price
            concessions, or minimum purchase commitments. Citadel records an estimated
            allowance for returns and allowances based on historical returns and
            other facts
            and circumstances known at the time the estimate is made. When payment
            is contingent upon the distributor's future licensing of products. Citadel
            defers revenue until payment is received. Revenue generated from products
            licensed through various marketing channels where the right of return
            might
            expressly or implicitly exist is reduced by reserves for estimated product
            returns. Such reserves are estimates developed by management based on
            returns
            history and current economic and market trends. Management determined
            that no
            reserve for returns from distributors was required at December 31, 2005.
 
 F-12
 *Table
                  of Contents*
 
 Under
            the
            Company’s sell-through business model, and as a convenience to government
            customers, the Company’s products may be licensed through government
            contractors, including system integrators. These government contractors
            hold the
            preferred purchasing and contracting vehicles for the various government
            agencies to purchase information technology products and services including
            the
            Company’s products and services. The Company typically enters into a subcontract
            with these prime contractors to sell through to the government agency.
            The
            Company’s contracts with these government contractors generally do not contain
            an express right of return; however, these government contractors may
            order
            products in advance of receiving the order from the government agency.
            When the
            government contractor has not delivered the product to the end user customer,
            the Company defers revenue recognition until the government contractor
            has
            received confirmation of delivery to the end user agency or the Company
            has
            received payment for the product and any contingencies have lapsed.
 
 The
            Company also offers its products to customers under subscription licenses
            with
            one-year to three-year terms. The customer may renew the subscription
            at the end
            of the subscription term or may convert the subscription into a perpetual
            use
            license at any time for an additional fee. Under a subscription license
            the
            customer receives the right to use the product, to post sale customer
            support
            and to content (i.e., vulnerability remedy updates) for the term of the
            subscription and for as long as the customer meets its payment obligation.
            The
            subscription fee payment is generally due in equal payments at the beginning
            of
            the subscription term or on a monthly basis and then on each anniversary
            date
            thereafter. Revenue from subscriptions is recognized ratably over the
            term of
            the subscription. If a customer fails to adhere to the payment terms
            of the
            subscription, the revenue recognized is limited to the ratable recognition
            of
            the amount of payments actually received. For the year ended December
            31, 2005,
            the Company had approximately $109,000 of contracts under subscription
            of which
            the Company recognized approximately $44,000 of subscription revenue.
            No
            subscription revenue was recognized for the years ended December 31,
            2004 and
            2003.
 
 In
            June
            2005 Citadel announced the availability of the Company’s Hercules product under
            a usage based pricing model which provides the end-user customer a method
            to pay
            for the use of the product on a transaction-by-transaction basis. Assuming
            all
            other requirements for revenue recognition have been met, the revenue
            from the
            transaction fees are accounted for based upon the transaction fees earned
            during
            a reporting period. No transaction fee revenue was recorded during the
            year
            ended December 31, 2005.
 
 *Software
            Development Costs*
 
 The
            Company follows the guidance provided in Statement of Financial Accounting
            Standards (“SFAS”) No. 86 “Accounting for the Costs of Computer Software to Be
            Sold, Leased, or Otherwise Marketed” regarding the accounting for the costs of
            developing its products. Purchased software (i.e., software acquired
            from a
            third party) is recorded at the lower of acquisition cost or net realizable
            value. The Company develops software for licensing to its customers and
            capitalizes software development costs when technological feasibility
            has been
            established. Technological feasibility generally occurs at the time a
            detailed
            design and analysis plan is completed and programming of the software
            code
            begins. Software development costs that qualify for capitalization include
            the
            salaries and benefits of the software engineers assigned to the projects,
            internal and external quality assurance testing costs, overhead allocations
            primarily associated with facilities costs, the costs of outsourced development
            activities and costs of independent product testing and certification
            labs.
            Software development costs not qualifying for capitalization are expensed
            and
            classified as product development expense in the statements of operations
            as
            incurred. Product development expense and the capitalization rate will
            fluctuate
            from period to period depending upon the number and status of software
            development projects that are in process and the related number of people
            assigned to those projects.
 
 Purchased
            software and capitalized software development costs are amortized using
            the
            greater of the revenue method or the straight-line method with useful
            lives
            ranging from one to five years. Amortization of capitalized software
            development
            cost is classified in costs of revenue on the statements of operations.
            The
            Company’s products operate on or with other third party operating systems and
            software. When determining the useful life of a product, the Company
            considers
            factors such as the current state of the technology, operating systems
            upon
            which the Company’s products operate, competitive products and the potential use
            of its products by the end user. Technological advances in software operating
            systems and other software technologies upon which the Company’s products rely
            may shorten the expected life cycle of some versions of its products.
            The
            Company makes an assessment of the useful lives of its products at each
            balance
            sheet date. If that assessment determines that a shortened product life
            has
            occurred, the Company amortizes the remaining unamortized balances over
            the new
            estimated useful life of the product.
 
 The
            Company's product development strategy has been architected for the current
            and
            future releases of Microsoft Windows, UNIX, Linux, Mac and other well
            established operating systems. The Company believes that this cross platform
            strategy reduces the potential exposure to product obsolescence due to
            rapid
            changes in operating systems, customer preferences or technological obsolescence
            due to the introduction of new operating systems or competing products.
            However,
            it is possible that these factors may change in the future as the Company's
            business model is adapted to changes in technology, changes in customer
            buying
            patterns and changes in the software industry's revenue licensing models.
 
 F-13
 *Table
                  of Contents*
 
 The
            Company evaluates the estimated net realizable value of each software
            product at
            each balance sheet date. The Company’s estimate is based on historical and
            forecasted net revenue for each product. Net revenue is the product revenue
            reduced by the estimated costs of revenue and, if in development, the
            estimated
            cost to complete the development of the product. When the net book value
            exceeds
            the estimate of net realizable value, the Company records a write-down
            to net
            realizable value on each product affected. Management’s ability to achieve its
            revenue forecast is subject to judgment, competitive pressures, market
            and
            economic conditions and management’s ability to successfully license its
            products to its customers. A change in one or more of these factors may
            influence management’s estimates. Accordingly, currently estimated net
            realizable values are subject to reductions in corresponding charges
            for
            impairment in the future. The Company determined that no write-down of
            capitalized software development costs was required at December 31, 2005,
            2004
            or 2003, respectively.
 
 A
            summary
            of capitalized costs, expenses and amortization discussed above is presented
            in
            the following table:
 
 Years
                      Ended December 31,2005
                  
                  2004
                  
                  2003Product
                      development expense, net of capitalized software development
                      costs
                  
                  $
                  2,443,864
                  
                  $
                  1,995,612
                  
                  $
                  392,967Software
                      development costs capitalized
                  
                  $
                  2,574,984
                  
                  $
                  3,261,210
                  
                  $
                  1,897,47Software
                      amortization expense
                  
                  $
                  2,192,115
                  
                  $
                  1,287,927
                  
                  $
                  473,881
 
 *Net
            Loss per Common Share*
 
 Basic
            net
            loss per common share is computed by dividing net loss to common shareholders
            by
            the weighted average number of shares of common stock outstanding during
            the
            period. Diluted net income per share is computed using the weighted average
            number of common shares outstanding plus potentially dilutive common
            shares
            outstanding during the periods, including the assumed conversions of
            dilutive
            securities such as preferred stock, options, and warrants. For the years
            ended
            December 31, 2005, 2004 and 2003, basic and diluted net loss per common
            share
            are identical because the number of shares assumed in the conversion
            of the
            preferred stock, and the exercise of common stock options and warrants
            outstanding would be antidilutive and are therefore excluded from the
            computation of diluted loss per common share.
 
 The
            effect of Citadel stock options for 8,843,250 shares of Citadel common
            stock and
            4,336,641 Citadel warrants outstanding at December 31, 2005 have been
            excluded
            from the weighted average shares computation as they are antidilutive.
            In
            addition, the effect of the “as if” conversion of the preferred stock
            outstanding at December 31, 2005 into 9,516,129 shares of common stock
            has been
            excluded from the computation of net loss per share to common shareholders
            as
            the effect is antidilutive. The effect of Citadel stock options for 7,993,000
            shares of Citadel common stock and 1,434,881 Citadel warrants outstanding
            at
            December 31, 2004 have been excluded from the weighted average shares
            computation as they are antidilutive. In addition, the effect of the
“as if”
conversion of the preferred stock outstanding at December 31, 2004 into
            3,000,000 shares of common stock has been excluded from the computation
            of net
            loss per share to common shareholders as the effect is antidilutive.
            The effect
            of Citadel stock options for 6,846,000 shares of Citadel common stock
            and
            165,000 Citadel warrants outstanding at December 31, 2003 have been excluded
            from the weighted average shares computation as they are antidilutive.
 
 *Cash
            and Cash Equivalents*
 
 The
            Company considers all highly liquid investments purchased with an initial
            maturity of three months or less to be cash equivalents.
 
 F-14
 *Table
                  of Contents*
 
 *Accounts
            Receivable*
 
 Trade
            accounts receivable are stated at the amount the Company expects to collect.
            The
            Company maintains allowances for doubtful accounts for estimated losses
            resulting from the inability of its customers to make required payments.
            Management considers the following factors when determining the collectibility
            of specific customer accounts: customer credit worthiness, past transaction
            history with the customer, current economic industry trends, and changes
            in
            customer payment terms. If the financial condition of the Company’s customers
            were to deteriorate, adversely affecting their ability to make payments,
            additional allowances would be required. Based on management’s assessment, the
            Company provides for estimated uncollectible amounts through a charge
            to expense
            and a credit to a valuation allowance. Balances that remain outstanding
            after
            the Company has used reasonable collection efforts are written off through
            a
            charge to the valuation allowance and a credit to accounts receivable.
            In
            addition, the Company maintains an allowance for returns, payment discounts,
            and
            other allowances based on historical returns and payment discounts and
            allowances that may be offered to customers from time-to-time or as incentive
            to
            make payments to the Company sooner than the customer’s contractual payment
            terms. Returns, payment discounts and other adjustments are charged to
            the
            allowance when incurred. The Company provides for returns, discounts
            and other
            allowances as a reduction of revenue and a credit to the valuation
            allowance.
 
 During
            2005, pursuant to the terms of the Allied Agreements, Citadel transferred
            $3,514,248 of the Company’s accounts receivable to Allied, for which Citadel
            received $2,864,112 in cash proceeds. The Company has the right, and
            is
            obligated, to repurchase transferred receivables under the Allied Agreements
            and, therefore, the transaction does not qualify as a sale under the
            terms of
            SFAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and
            Extinguishments of Liabilities”. The December 31, 2005 balance sheet includes
            $1,177,916 of uncollected trade receivables transferred to Allied and
            a balance
            due to Allied of $924,777, presented on the balance sheet as “Factoring line of
            credit”.
 
 *Impairment
            of Long-Lived Assets*
 
 In
            accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of
            Long-Lived Assets”, the Company reviews its long-lived assets for impairment
            whenever events or changes in circumstances indicate that the carrying
            amount of
            an asset may not be recoverable and exceeds its fair value. If conditions
            indicate an asset might be impaired, the Company estimates the future
            cash flows
            expected to result from the use of the asset and its eventual disposition.
            The
            impairment, if any, is measured by the amount by which the asset exceeds
            its
            fair value typically represented by quoted marked values or, when and
            if
            available, the future discounted cash flow associated with the asset.
 
 *Income
            Taxes*
 
 Income
            taxes are accounted for using the asset and liability method. Deferred
            income
            tax expenses are provided based upon estimated future tax effects of
            differences
            between the carrying amounts of assets and liabilities for financial
            reporting
            purposes and the amounts used for income tax purposes calculated based
            upon
            provisions of enacted laws.
 
 *Advertising
            Expense*
 
 The
            Company expenses costs associated with advertising as they are incurred
            and
            includes these costs in selling, general and administrative expense.
            Advertising
            expense, including design and production of product collaterals, industry
            trade
            shows and printing, for the years ended December 31, 2005, 2004 and 2003
            was
            approximately $1,573,000, $1,183,000 and $220,000, respectively.
 
 *Stock-Based
            Compensation*
 
 The
            Company accounts for stock-based employee compensation arrangements in
            accordance with provisions of Accounting Principles Board (“APB”) Opinion No.
            25, “Accounting for Stock Issued to Employees,” and complies with the disclosure
            provisions of SFAS No. 123, “Accounting for Stock-Based Compensation” as amended
            by SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and
            Disclosure, an amendment of FASB Statement No. 123”. Under APB Opinion No. 25,
            compensation expense for employees is based on the excess, if any, on
            the date
            of grant, of the fair value of the Company's stock over the exercise
            price and
            is recognized on a straight-line basis over the vesting term of the
            option.
 
 F-15
 *Table
                  of Contents*
 
 The
            Company accounts for equity instruments issued to non-employees in accordance
            with the provisions of SFAS No. 123 and SFAS No. 148 and Emerging Issues
            Task
            Force Issue No. 96-18, “Accounting for Equity Instruments That Are Issued to
            Other Than Employees for Acquiring, or in Conjunction with Selling, Goods
            or
            Services.” All transactions in which goods or services are the consideration
            received for the issuance of equity instruments are accounted for based
            on the
            fair value of the consideration received or the fair value of the equity
            instrument issued, whichever is more reliably measurable. The measurement
            date
            of the fair value of the equity instrument issued is the earlier of the
            date on
            which the counterparty's performance is complete or the date on which
            it is
            probable that performance will occur.
 
 If
            the
            Company had recognized compensation expense on a straight-line basis
            over the
            vesting period of the options, based upon the fair value at the grant date
            for options granted to employees, officers and directors during the year
            ended
            December 31, 2005, 2004 and 2003 the pro forma effect on net loss and
            net loss
            per share would have been as follows:
  Years
                        Ended December 31,2005
                    
                    2004
                    
                    2003Net
                        loss to common shareholders as reported
                    
                    $
                    (19,156,907
                    )
                    $
                    (8,719,362
                    )
                    $
                    (5,248,581
                    )Add:
                        Stock-based employee compensation expense included in reported
                        net
                        loss
                    
                    
                    37,000
                    
                    
                    129,995
                    
                    
                    82,500Deduct:
                        Stock-based employee compensation expense determined under
                        fair value
                        based method
                    
                    
                    (1,838,922
                    )
                    
                    (1,916,398
                    )
                    
                    (1,073,445
                    )Pro
                        forma net loss to common shareholders
                    
                    $
                    (20,958,829
                    )
                    $
                    (10,505,765
                    )
                    $
                    (6,239,526
                    )Net
                        loss per share to common shareholders:As
                        reported - basic and diluted
                    
                    $
                    (0.64
                    )
                    $
                    (0.30
                    )
                    $
                    (0.24
                    )Pro
                        forma - basic and diluted
                    
                    $
                    (0.70
                    )
                    $
                    (0.36
                    )
                    $
                    (0.28
                    )
 On
            December 16, 2004, the Financial Accounting Standards Board issued SFAS
            No. 123
            (revised 2004), Share-Based Payment (“SFAS No. 123R”), which is a revision of
            SFAS No. 123, “Accounting for Stock-Based Compensation”. SFAS No. 123R
            supersedes APB Opinion No. 25, and amends SFAS No. 95, “Statement of Cash
            Flows”. Generally, the approach in SFAS No. 123R is similar to the approach
            described in SFAS No. 123. However, SFAS 123R requires all share-based
            payments
            to employees, including grants of employee stock options, to be recognized
            in
            the income statement based on their fair values. Pro forma disclosure
            is no
            longer an alternative. The Company will adopt the modified prospective
            method of
            SFAS No. 123R on January 1, 2006.
 
 The
            adoption of SFAS No. 123R will require the Company to record substantial
            non-cash stock compensation expenses. While the adoption of SFAS 123R
            is not
            expected to have a significant effect on the Company's financial condition
            or
            cash flows, it is expected to have a significant effect on the Company's
            results
            of operations. The future impact of the adoption of SFAS 123R cannot
            be
            predicted at this time because it will depend on the levels of share-based
            payments granted by the Company in the future. However, had the Company
            adopted
            SFAS 123R in prior periods, the impact of the standard would have approximated
            the impact of SFAS 123 as described in the pro forma net loss attributable
            to
            common shareholders.
 
 *Fair
            Value of Financial Instruments*
 
 The
            Company's financial instruments, including cash and cash equivalents,
            accounts
            receivable, accounts payable and notes payable are carried at cost, which
            approximates fair value.
 
 *Recent
            Accounting Pronouncements*
 
 In
            May
            2005, the Financial Accounting Standards Board issued SFAS No. 154, “Accounting
            Changes and Error Corrections” (“SFAS 154”). SFAS 154 is a replacement of APB
            Opinion No. 20 and FASB Statement No. 3. SFAS 154 provides guidance on
            the
            accounting for and reporting of accounting changes and error corrections.
            It
            establishes retrospective application as the required method for reporting
            a
            change in accounting principle. SFAS 154 provides guidance for determining
            whether retrospective application of a change in accounting principle
            is
            impracticable and for reporting a change when retrospective application
            is
            impracticable. The reporting of a correction of an error by restating
            previously
            issued financial statements is also addressed by SFAS 154. This Statement
            defines *retrospective
            application* as the
            application of a different accounting principle to prior accounting periods
            as
            if that principle had always been used or as the adjustment of previously
            issued
            financial statements to reflect a change in the reporting entity. This
            Statement
            also redefines *restatement* as the
            revising of previously issued financial statements to reflect the correction
            of
            an error. SFAS 154 is effective for accounting changes and corrections
            of errors
            made in fiscal years beginning after December 15, 2005. The Company will
            adopt
            this pronouncement beginning in fiscal year 2006 and does not expect
            SFAS 154 to
            have a material impact on its consolidated results of operations or financial
            statements.
 
 F-16
 *Table
                  of Contents*
 
 NOTE
            B -
            CONCENTRATION OF CREDIT RISK
 
 At
            December 31, 2005, the Company had approximately $1.2 million in cash
            and cash
            equivalents at financial institutions which were in excess of the FDIC
            insured
            limits.
 
 The
            Company performs credit evaluations of its customers’ financial condition and
            does not require collateral from their customers. At December 31, 2005,
            approximately 91% of the Company’s gross accounts receivable was due from BAE
            Systems, Inc., a U.S. government systems integrator. At December 31,
            2004,
            approximately 74% of the Company’s gross accounts receivable was due from the
            following three customers: approximately $193,000 due from BAE Systems,
            Inc.;
            approximately $126,000 due from Providence Health Systems; and approximately
            $140,000 due from WorldCom Purchasing. Allowances for credit losses are
            maintained at levels considered adequate by management.
 
 NOTE
            C -
            PREPAID EXPENSES AND OTHER CURRENT ASSETS
 
 The
            components of prepaid expenses and other current assets consist of the
            items
            listed in the table below:
 December
                        31,2005
                    
                    2004Prepaid
                        commissions
                    
                    $
                    380,147
                    
                    $
                    695,371Prepaid
                        marketing and advertising expenses
                    
                    
                    336,131
                    
                    
                    387,727Prepaid
                        insurance premiums
                    
                    
                    148,772
                    
                    
                    227,337Prepaid
                        software and hardware maintenance contracts
                    
                    
                    65,296
                    
                    
                    147,205Other
                    
                    
                    2,245
                    
                    
                    8,714$
                    932,591
                    
                    $
                    1,466,354
  NOTE
              D -
              PROPERTY AND EQUIPMENT
 
 Property
              and equipment is stated at cost and depreciation is computed using
              the
              straight-line method over the estimated useful lives ranging from one
              to eight
              years. Amortization of leasehold improvements is computed using the
              straight-line method over the lesser of the useful life of the asset
              or the
              remaining term of the lease. Major classes of property and equipment
              are as
              follows:
 
 December
                        31,Useful
                        life (in years)
                    
                    2005
                    
                    2004Furniture
                    
                    
                    1
                        - 8
                    
                    $
                    1,088,112
                    
                    $
                    980,714Office
                        equipment
                    
                    
                    1
                        - 5
                    
                    
                    393,281
                    
                    
                    384,377Computer
                        equipment and internal use software
                    
                    
                    1
                        - 5
                    
                    
                    3,678,648
                    
                    
                    3,429,681Leasehold
                        improvements
                    
                    
                    2
                        - 8
                    
                    
                    2,449,585
                    
                    
                    2,288,0347,609,626
                    
                    
                    7,082,806Less
                        accumulated depreciation and amortization
                    
                    
                    
                    
                    
                    (2,483,398
                    )
                    
                    (726,444
                    )Net
                        property and equipment
                    
                    
                    
                    
                    $
                    5,126,228
                    
                    $
                    6,356,362
 F-17
 *Table
                  of Contents*
  In
              May
              2004 the Company signed an 8 year lease for approximately 33,500 square
              feet of
              office space in Dallas, Texas. The Company moved into the new office
              space in
              November 2004 and at that time abandoned certain furniture, equipment
              and
              leasehold improvements in place at the prior office resulting in a
              write-off of
              property and equipment of $77,786. The write-off consisted of following
              assets:
 
 Furniture
                    
                    $
                    240,232Office
                        equipment
                    
                    
                    87,101Computer
                        equipment and internal use software
                    
                    
                    761,804Leasehold
                        improvements
                    
                    
                    143,4941,232,631Less
                        accumulated depreciation and amortization
                    
                    
                    (1,154,845
                    )Net
                        property and equipment
                    
                    $
                    77,786
 
 NOTE
              E -
              ACCOUNTS PAYABLE AND ACCRUED EXPENSES
 
 The
              components of accounts payable and accrued expenses consist of the
              items listed
              in the table below:
 
 December
                        31,2005
                    
                    2004Accounts
                        payable, trade
                    
                    $
                    2,475,077
                    
                    $
                    1,695,566Accrued
                        rent
                    
                    
                    717,730
                    
                    
                    251,823Accrued
                        sales and franchise taxes
                    
                    
                    171,739
                    
                    
                    350,974Accrued
                        interest payable
                    
                    
                    103,750
                    
                    
                    -Other
                        accrued expenses
                    
                    
                    253,255
                    
                    
                    742,302$
                    3,721,551
                    
                    $
                    3,040,665
 
 NOTE
              F -
              ACCRUED COMPENSATION AND PAYROLL TAX OBLIGATIONS
 
 The
              components of accrued compensation consist of the items listed in the
              table
              below:
 
 December
                        31,2005
                    
                    2004Accrued
                        commissions and incentive compensation
                    
                    $
                    724,579
                    
                    $
                    712,603Accrued
                        vacation pay
                    
                    
                    301,777
                    
                    
                    350,974Payroll
                        tax obligations
                    
                    
                    219,045
                    
                    
                    350,093$
                    1,245,401
                    
                    $
                    1,413,670
 
 NOTE
              G -
              INCOME TAXES
 
 The
              significant components of the Company's deferred tax liabilities and
              assets are
              as follows:
 
 December
                        31,Deferred
                        tax assets (liabilities)
                    
                    2005
                    
                    2004Net
                        operating loss carryforwards
                    
                    $
                    11,306,000
                    
                    $
                    4,582,000Accounts
                        receivable allowance
                    
                    
                    71,000
                    
                    
                    71,000Accrued
                        expenses
                    
                    
                    601,000
                    
                    
                    333,000Long-term
                        deferred revenue
                    
                    
                    135,000
                    
                    
                    -Stock
                        compensation expense
                    
                    
                    (38,000
                    )
                    
                    -Prepaid
                        expenses
                    
                    
                    (129,000
                    )
                    
                    -Capitalized
                        software development costs
                    
                    
                    (1,507,000
                    )
                    
                    (1,376,000
                    )Property
                        and equipment
                    
                    
                    (581,000
                    )
                    
                    (121,000
                    )Total
                        deferred tax assets
                    
                    
                    9,858,000
                    
                    
                    3,489,000Valuation
                        allowance
                    
                    
                    (9,858,000
                    )
                    
                    (3,489,000
                    )Total
                        deferred tax assets, net
                    
                    $
                    -
                    
                    $
                    -
  F-18
 *Table
                    of Contents*
 The
            difference between the provision for income taxes and the amount computed
            by
            applying the federal statutory rate to loss before provision for income
            taxes is
            explained below:
 
 Years
                      Ended December 31,2005
                  
                  2004
                  
                  2003Benefit
                      computed at federal statutory rate
                  
                  $
                  (6,311,000
                  )
                  $
                  (2,665,000
                  )
                  $
                  (1,785,000
                  )Increase
                      in valuation allowance
                  
                  
                  6,369,000
                  
                  
                  2,457,000
                  
                  
                  678,000Other
                  
                  
                  (273,000)
                  
                  
                  -
                  
                  
                  -Permanent
                      differences
                  
                  
                  215,000
                  
                  
                  208,000
                  
                  
                  1,107,000$
                  -
                  
                  $
                  -
                  
                  $
                  -
 
 For
            federal income tax purposes, at December 31, 2005 the Company had a net
            operating loss carryforward of approximately $33,200,000. The net operating
            loss
            carryover, which is subject to annual limitations as prescribed by the
            Internal
            Revenue Code, is available to offset future taxable income and begins
            to expire
            in 2023. A valuation allowance has been recorded for the entire amount
            of the
            net deferred tax asset due to uncertainty of realization.
 
 NOTE
            H -
            LONG-TERM DEBT
 
 On
            April
            15, 2004 the Company completed a Loan and Security Agreement (the “Original
            Agreement”) with Comerica Bank (“Comerica”), securing credit lines aggregating
            $3,500,000. Of this amount, $750,000 was a revolving line of credit which
            if
            used would be secured by accounts receivable defined in the Original
            Agreement
            and bear interest at 1.5% above Comerica’s prime lending rate. The remaining
            $2,750,000 credit line was available in two tranches to fund capital
            equipment
            expenditures through December 31, 2004. These loans would be secured
            by the
            capital equipment acquired with the proceeds of the borrowings and bear
            interest
            at 1.75% above Comerica’s prime lending rate. Through December 30, 2004 the
            Company used the full amount of the $2,750,000 credit line to fund capital
            expenditures during 2004. The revolving line of credit remained unused
            as of
            December 30, 2004 and on that date Citadel and Comerica entered into
            a First
            Amendment to Loan and Security Agreement (the “First Amendment”), pursuant to
            which Comerica and Citadel agreed to amend the Original Agreement to
            convert
            $750,000 of available indebtedness under the Original Agreement from
            revolving
            indebtedness to equipment financing. Comerica advanced this $750,000
            to Citadel
            on December 31, 2004. During 2004, the Company made payments against
            the
            borrowings of $183,334, resulting in a total note payable as of December
            31,
            2004 of $3,316,666, of which $1,327,273 was classified as current and
            $1,989,393
            was classified as long-term.
 
 The
            Original Agreement required the Company to maintain cash balances at
            Comerica
            and to meet certain financial, non-financial and other affirmative and
            restrictive covenants, including adjusted quick ratio, EBITDA as defined
            in the
            Original Agreement and fixed charged coverage ratio. Prior to December
            31, 2004
            the Company recognized that it would not be in compliance with certain
            of the
            fixed charge and adjusted quick ratios and received a waiver from Comerica
            for
            the defaults, conditional upon the restructuring of the covenants, which
            was
            completed in the first quarter of 2005.
 
 During
            2005, Citadel entered into four amendments (the “Amendments”) to the Original
            Agreement. Citadel and Comerica agreed to modify the existing financial
            covenants to require the Company to maintain its minimum cash balance
            at
            $1,000,000 and eliminate the liquidity ratio test and EBITDA requirements.
            Per
            the Amendments, Citadel's minimum cash balance requirement of $1,000,000
            would
            be waived from August 15, 2005 until the earlier of (i) the date on which
            Citadel raises additional equity capital or (ii) September 30, 2005. 
Following October 1, 2005, Citadel would be required to maintain a minimum
            cash
            balance of $1,500,000.  In addition, as of October 1, 2005, Citadel's
            monthly payments on one tranche of its loans from Comerica would increase
            from
            $22,727 plus interest, to $72,727 per month. The Amendments also provided
            for an
            additional revolving credit line of up to $750,000 based on a borrowing
            base of
            up to 80% of Citadel’s eligible accounts receivable. The loan would bear
            interest at Comerica’s prime rate plus 1.75% and had a maturity date of
            September 30, 2005. On September 15, 2005, Citadel borrowed $750,000
            pursuant to
            an additional revolving credit line provided by a Fifth Amendment bringing
            the
            total principal amounts due to Comerica Bank to approximately $3.1 million.
            The
            other material terms of the credit facilities, including interest rate,
            security, and final maturity, remained the same as under the Original
            Agreement,
            as amended.
 
 In
            2004,
            Comerica received warrants to purchase 9,881 shares of common stock at
            an
            exercise price of $5.06 per share at a Black-Scholes fair value of approximately
            $45,838. In 2005, Comerica received warrants for 18,050 of common stock
            at an
            exercise price of $1.79 per share at a Black-Scholes fair value of approximately
            $31,317 and 45,000 shares of common stock at an exercise price of $1.56
            per
            share at a Black-Scholes fair value of approximately $33,005. The fair
            value of
            the warrants was recorded as debt issue costs and an increase to additional
            paid
            in capital. Debt issue costs are amortized to interest expense at the
            greater of
            the interest method or straight-line over the remaining term of the debt.
            For
            the years ended December 31, 2005, 2004, and 2003, debt issue cost amortization
            included in interest expense was $130,192, $16,052 and $333,725,
            respectively.
 
 F-19
 *Table
                  of Contents*
 
 On
            October 10, 2005 Citadel and Lacerte entered into a Loan and Security
            Agreement
            and Intellectual Property Security Agreement (the “Agreements”). Under the
            Agreements, Lacerte agreed to advance $3.75 million to Citadel with a
            maturity
            date of October 10, 2007 and an interest rate of 12%. The proceeds of
            the loan
            were used to retire principal amounts due to Comerica on October 10,
            2005 of
            approximately $2.9 million and for general working capital purposes.
            As a result
            of the retirement of the Comerica notes payable, the loan and security
            agreement, as amended, between Citadel and Comerica, including debt covenants,
            was terminated. The terms of the Agreements require quarterly interest
            payments
            and payment of the principal balance at maturity. The loan is secured
            by a
            security interest in the Company’s assets except trade accounts receivable.
            Citadel has agreed to pay a five percent (5%) premium to Lacerte upon
            early
            repayment of the loans or upon a change in control, and paid a one percent
            (1%)
            loan origination fee. The obligations under the Agreements may be accelerated
            in
            the event of a default under the Agreements, including a failure to pay
            amounts
            when due or a breach of the Agreements by Citadel. Satellite, holder
            of the
            Series A and Series B convertible preferred stock, agreed to permit Citadel
            to
            issue the senior security to Lacerte in consideration for a reduction
            in the
            exercise price of their warrants to purchase approximately 4.0 million
            shares of
            the Company’s common stock issued in conjunction with the Series A and Series B
            convertible preferred stock from $1.75 per share to $1.56 per share,
            as
            discussed in Note M. The December 31, 2005 balance of the note payable
            to
            Lacerte was $3,750,000 and was classified as long-term debt on the balance
            sheet.
 
 NOTE
            I -
            OTHER NON-CURRENT LIABILITIES
 
 In
            accordance with FASB Technical Bulletin No. 88-1 “Issues Relating to Accounting
            for Leases”, tenant improvement allowances are recognized as deferred rent
            credits and amortized over the lease term as a reduction of rent expense
            on the
            consolidated statements of income and as a component of operating activities
            on
            the consolidated statement of cash flows. During the year ended December
            31,
            2004, the Company entered into a lease agreement with an eight year term
            for new
            office space in Dallas, Texas. The lease agreement included a lease incentive
            for tenant improvements of $836,448 which was recorded as leasehold improvements
            and deferred rent liability. At December 31, 2005, $104,556 was recorded
            as
            current deferred rent and $609,912 was recorded as a non-current liability.
            At
            December 31, 2004, $104,556 was recorded as current deferred rent and
            $714,466
            has been recorded as a non-current liability. The current and non-current
            deferred rent liabilities are being amortized as an offset to rent expense
            over
            the remaining lease term.
 
 NOTE
            J -
            COMMON STOCK AND WARRANTS ISSUED DURING 2003
 
 *Subscription
            Agreements with Accredited Investors*
 
 In
            January 2003, the Company entered into subscription agreements with 15
            accredited investors (the “Accredited Investors”) for the sale of (i) 3,275,000
            shares of common stock for gross proceeds of $2,625,000 (before approximately
            $228,000 of placement agent as well as legal and accounting and fees)
            and (ii)
            warrants to buy 1,637,500 shares of common stock. The warrants have an
            exercise
            price of $1.50 per share, expire in three years and may be terminated
            by the
            Company, at its option, when the closing market price of the Company's
            common
            stock has closed at or above $2.40 per share for ten consecutive trading
            days.
            In addition, the placement agent received warrants to purchase 245,625
            shares of
            common stock at $1.18 per share, the closing per share price of common
            stock on
            January 29, 2003, and have a five year term.
 
 On
            April
            21, 2003, the Company issued 1,637,500 of new warrants to the Accredited
            Investors plus 245,625 new warrants to the placement agent and its assignees
            (collectively the "New Warrants"). The exercise price of the warrants
            issued to
            the investors and the placement agent in the January 2003 private placement
            (the
            "Prior Warrants") was reduced from $1.50 to $0.80 per share for a period
            that
            ended on May 6, 2003.
 
 F-20
 *Table
                  of Contents*
 
 In
            May
            2003, Accredited Investors, the placement agent and the placement agent's
            assignees holding Prior Warrants to purchase 1,560,559 shares of Citadel
            common
            stock exercised their Prior Warrants, for aggregate gross proceeds of
            approximately $1,248,000 to Citadel (before approximately $126,000 of
            placement
            agent, legal and accounting fees). As a result of their exercise of the
            Prior
            Warrants, the expiration date of the New Warrants was extended from May
            6, 2003
            to the earlier of April 1, 2006 or the date 10 days after the Company
            provides
            the holders notice that the closing market price of the Company's common
            stock
            has closed at or above $2.40 per share for ten consecutive trading days.
            The New
            Warrants have an exercise price of $1.27 per share (the closing market
            price on
            April 17, 2003, the last trading date prior to issuance of the New Warrants).
            The remaining 322,566 New Warrants that were originally issued on April
            21, 2003
            expired unexercised on May 6, 2003. On May 6, 2003, the period to exercise
            the
            Prior Warrants at a reduced price expired, and 112,500 unexercised Prior
            Warrants issued to the Accredited Investors returned to an exercise price
            of
            $1.50 per share and 210,066 unexercised Prior Warrants issued to the
            placement
            agent returned to an exercise price of $1.18 per share. In addition,
            the
            placement agent received warrants to purchase 39,014 shares of Citadel
            common
            stock, based on a rate of 2.5% of 1,560,559 of New Warrants that were
            outstanding on May 6, 2003. The placement agent's warrants have a per
            share
            exercise price of $1.80, the closing price of Citadel common stock on
            May 6,
            2003 and have a five year term. The proceeds of the transaction were
            used for
            general working capital purposes. The Company filed a registration statement
            on
            Form SB-2 to register the shares issued in the private placement, the
            shares
            issued upon the exercise of Prior Warrants and the shares underlying
            the New
            Warrants and Prior Warrants outstanding at May 6, 2003.
 
 On
            October 31, 2003 the closing market price of the Company's common stock
            had
            exceeded $2.40 per share for the previous ten days and as a result, the
            Company
            notified the warrant holders of its intent to terminate the warrants
            on November
            10, 2003. On November 10, 2003 proceeds of approximately $2,373,000 were
            received from the exercise of 314,763 Prior Warrants and 1,560,559 New
            Warrants
            for 1,875,322 shares of stock. In addition, warrants for 99,014 shares
            of common
            stock were exercised by the placement agent for approximately $133,000
            of cash
            proceeds. At December 31, 2005, 2004 and 2003, no Prior Warrants remain
            outstanding.
 
 *Issuance
            and Conversion of 12% Senior Convertible Notes*
 
 In
            September 2003 the Company closed a debt financing transaction and received
            gross proceeds of $2,120,000 and issued 12% Senior Convertible Promissory
            Notes
            (the "Notes") to a limited number of accredited investors (the "Noteholders").
            The Notes and accrued interest were due the sooner of 90 days after issuance
            or
            10 days after the Company received at least $2,000,000 in proceeds from
            the sale
            of equity securities. The net proceeds of the Notes were used for general
            working capital purposes. In addition, the Noteholders received 848,000
            restricted shares of common stock of the Company with an estimated fair
            value of
            approximately $783,079. The debt discount was fully amortized into interest
            expense during the year ended December 31, 2003. In the event of default,
            for
            each month in default, the Noteholders would have received warrants to
            purchase
            one half of one share for every dollar of principal amount loaned, with
            an
            exercise price of $0.50 per share.
 
 Pursuant
            to the terms of the Notes, principal and accrued interest may be converted
            into
            shares of common stock of the Company (the "Converted Shares") at a conversion
            price of $1.25 per share at the option of the Noteholder at any time
            prior to
            maturity. The difference between the effective conversion price and the
            estimated fair market value of the underlying shares of approximately
            $1,147,479
            was recorded as debt discount. This debt discount was amortized over
            the term of
            the notes and has been fully amortized into interest expense during the
            year
            ended December 31, 2003.
 
 In
            addition, the placement agent for this transaction received a fee of
            $212,000
            plus warrants to purchase 125,000 shares of common stock at $1.25 per
            share that
            had the same rights as the warrants the Noteholders may receive in the
            event of
            default. The fee of $212,000 plus the estimated fair value of the warrants
            of
            approximately $121,725 was recorded as debt issuance costs and has been
            fully
            amortized to interest expense during the year ended December 31, 2003.
            On
            September 4, 2003, the $212,000 fee plus $50,000 of unpaid fees, unrelated
            to
            the Notes, were rolled into a 12% convertible note payable due 90 days
            after
            issuance with the same terms and conditions as the Notes including registration
            rights and default provisions. In conjunction with this note, the Company
            issued
            104,800 shares of common stock to the placement agent having a relative
            fair
            value of approximately $98,250. The note plus accrued interest was convertible
            into shares of common stock of the Company at a conversion price of $1.25
            per
            share. The difference between the effective conversion price and the
            estimated
            fair value of the underlying shares of approximately $150,650 was recorded
            as
            debt discount has been fully amortized into interest expense during the
            year
            ended December 31, 2003. The Company paid the note in full on
 December
            31, 2003.
 
 As
            of
            December 31, 2003 holders of all $2,120,000 principal amount of the Notes
            had
            elected to convert the Notes plus approximately $49,000 of accrued interest
            into
            approximately 1,735,000 shares of the Company’s common stock.
 
 F-21
 *Table
                  of Contents*
 
 *Convertible
            Shareholder Notes*
 
 On
            July
            16, 2003 the Company entered into a $200,000, 8% note payable with a
            shareholder. The note was originally due September 1, 2003 and was personally
            guaranteed by the Company's Chief Executive Officer. The note was convertible
            into 200,000 shares of common stock at a conversion price of $1.00 per
            share.
            The fair value of the conversion feature of approximately $118,187 was
            recorded
            as debt discount and was fully amortized as interest expense in the year
            ended
            December 31, 2003. In the event of payment default the note would accrue
            interest at 18% per annum. In conjunction with this note, the Company
            issued
            50,000 shares of common stock in exchange for $500 in cash. The relative
            fair
            value of the shares of approximately $50,687 was recorded as interest
            expense
            during the year ended December 31, 2003. The due date of the note was
            later
            extended by the noteholder to October 31, 2003 and 30,000 additional
            shares of
            common stock were issued to the noteholder in exchange for $300. The
            Company
            recorded debt discount of $39,450 representing the difference between
            the
            proceeds of $300 and the relative fair value of the 30,000 shares of
            common
            stock. The debt discount was fully amortized to interest expense during
            the year
            ended December 31, 2003. In October 2003, the shareholder converted the
            principal amount of the note plus $4,252 of accrued interest into 204,252
            shares
            of the Company’s common stock.
 
 On
            July
            17, 2003 the Company entered into a $250,000 8% note payable with another
            shareholder. The note was originally due September 17, 2003 and was personally
            guaranteed by the Company's Chief Executive Officer. A principal payment
            of
            $50,000 was due and paid in August 2003. In conjunction with this note,
            the
            Company issued 50,000 shares of its common stock for $500, to be offset
            against
            accrued interest. The Company recorded a note discount of approximately
            $49,679
            representing the difference between the proceeds of $500 and the relative
            fair
            value of the stock. This discount was fully amortized to interest expense
            in the
            year ended December 31, 2003. The maturity date was later extended to
            October
            31, 2003 and the Company agreed to give the noteholder a right to convert
            the
            note plus accrued interest into shares of common stock at a conversion
            price of
            $1.25 per share. The difference between the effective conversion price
            and the
            relative fair value of the shares of approximately $73,344 was recorded
            as a
            debt discount and has been fully amortized into interest expense in the
            year
            ended December 31, 2003. In October 2003, the shareholder converted the
            principal amount of the note plus $5,962 of accrued interest into 164,769
            shares
            of the Company’s common stock.
 
 On
            April
            1, 2002, prior to the Distribution, CT Holdings entered into a $600,000
            non-interest bearing convertible note payable due April 1, 2003 to a
            shareholder. The note payable was convertible at the option of the shareholder,
            into a maximum of 2,700,000 shares of CT Holdings common stock and 675,000
            shares of Citadel common stock. During the year ended December 31, 2003
            this
            note was converted and 675,000 shares of the Company's common stock were
            issued
            to the noteholder.
 
 *Other
            Common Stock Issuances*
 
 During
            the year ended December 31, 2003, 78,000 shares of common stock (plus
            stock
            options for 75,000 shares of common stock) were issued for services rendered
            by
            consultants to the Company. The fair value of the shares of common stock
            and
            options was approximately $165,570 and was recorded as general and
            administrative expense. In addition, the Company issued 25,000 shares
            of stock,
            with a fair value of approximately $35,500, to a former employee in settlement
            of a claim for compensation.
 
 NOTE
            K - EXCHANGE
            RIGHT
 
 In
            February 2004, the Company’s CEO exercised an exchange right and the Company
            issued 1,500,000 shares of common stock to the CEO. The exchange right
            was
            issued to the CEO in June 2001 in connection with the CEO funding and
            granting a
            guarantee of participation by CT Holdings, the Company's former parent,
            in a
            bank bridge loan of an affiliate of CT Holdings. The exchange right permitted
            the CEO to exchange up to 5,000,000 (pre 1:1000 reverse split) shares
            of the
            affiliate into up to 6,000,000 shares of CT Holdings common stock including
            the
            right to any dividends. This right resulted in a commitment by Citadel
            upon
            exercise of the exchange right to issue up to 1,500,000 shares of Citadel
            common
            stock. The exercise of this exchange right was conditional upon compliance
            with
            first refusal and co-sale rights by the affiliated company and its majority
            shareholder. The Company has accounted for this issuance as an increase
            of
            $15,000 to the par value of common stock and recording an offsetting
            reduction
            to additional paid capital.
 
 F-22
 *Table
                  of Contents*
 
 NOTE
            L -
            COMMON STOCK ISSUED IN 2005
 
 In
            2005,
            the Company issued 110,000 shares of common stock to an investor relations
            firm
            for payment of services in lieu of cash.  The fair value of the common
            stock of $88,000 was recorded as a charge to selling, general and administrative
            expense with a credit to common stock for the par value and to additional
            paid-in capital for the excess over par value.  In addition, the Company
            issued 112,500 shares of its common stock upon the exercise of employee
            stock
            options in return for cash of $36,000 received for the aggregate exercise
            price
            of the options.
 
 Also
            in
            2005, the Company  issued 50,000 shares of common stock in lieu of cash to
            a board member for director’s fees. The fair value of the common stock of
            $46,500 was recorded as a charge to selling, general and administrative
            expense
            with a credit to common stock for par value and to additional paid in
            capital
            for the excess over par value.
 
 On
            December 21, 2005, the Company granted 50,000 shares of restricted stock
            to each
            of six executives and 25,000 shares of restricted stock to each of the
            Company’s
            four outside directors. The shares of restricted stock issued to the
            executives
            vest in one year or upon a change in control if the executive remains
            employed
            with the Company (unless terminated without cause), and the shares of
            restricted
            stock issued to the directors are immediately vested. The fair value
            of the
            restricted stock was based on the closing market value of Citadel’s stock on the
            grant date. The $37,000 fair value of the directors’ 100,000 shares of
            restricted stock was recorded as general and administrative expense in
            2005. The
            $111,000 fair value of the executives’ 300,000 shares of restricted stock was
            recorded as a decrease to additional paid in capital and will be amortized
            to compensation expense over the one year vesting period.
 
 NOTE
            M -
            REDEEMABLE PREFERRED
            STOCK
 
 *Series
            A Convertible Preferred Stock (“Series A Shares”)*
 
 On
            February 10, 2004 the Company completed a private placement of $15,000,000
            in
            gross proceeds for the issuance of 15,000 shares of its Series A Shares
            and
            five-year warrants (“Series A Warrants”) for 1.2 million shares of common stock.
            Net proceeds received were approximately $13,797,000 after payment of
            placement
            fees of $1,125,000 as well as legal, accounting and filing fees of approximately
            $78,000. The placement agents for the transaction also received warrants
            (with
            the same terms and conditions as the Series A Warrants) to purchase 225,000
            shares of common stock at an exercise price of $5.15 per share, a premium
            to the
            market price at the commitment date. Using the Black-Scholes pricing
            model, the
            fair value of the Series A Shares, the Series A Warrants and the placement
            agents warrants were estimated at approximately $11,471,000, $1,915,000
            and
            $411,000, respectively, with the fair value of all of the warrants recorded
            as a
            credit to additional paid in capital. Using the relative fair values
            of the
            Series A Shares and the warrants, the Company estimated the non-cash
            relative
            fair value of the Series A Share beneficial conversion feature to be
            approximately $985,000, which was recorded as an increase to additional
            paid in
            capital. For the year ended December 31, 2004, $215,397 of the beneficial
            conversion feature was accreted and during the first nine months of 2005,
            $141,145 of the beneficial conversion feature was accreted. In the third
            quarter
            of 2005, in conjunction with the revised terms and conditions of the
            Series A
            Shares approved at the Company’s annual stockholder’s meeting, as well as a
            decline in the market price of the Company’s common stock, the Company
            determined that the beneficial conversion feature no longer existed and
            accordingly, fully accreted the remaining unaccreted fair value of the
            beneficial conversion feature related to the Series A Shares of $628,107,
            representing a decrease to additional paid-in capital and an increase
            to the net
            loss to common shareholders.
 
 On
            May 9,
            2005, in connection with the issuance of the Series B preferred stock
            (discussed
            below), Citadel and Satellite entered into an Exchange Agreement where
            Citadel
            agreed to exchange the Series A Warrants for Exchange Warrants to purchase
            up to
            1.2 million shares of Common Stock at an initial exercise price of $1.75,
            subject to adjustment upon certain events, including as a result of the
            sale of
            equity securities by the Company at a price below the exercise price
            of the
            Warrants. On May 9, 2005, 1 million shares of the Exchange Warrants became
            immediately exercisable. The remaining 200,000 became exercisable upon
            shareholder approval in July 2005. The Warrants issued are exercisable
            (in whole
            or in part) at any time on or before the expiration of their 10-year
            terms. The
            fair value of the Series A Warrants on May 9, 2005 was estimated and
            compared to
            the estimated fair value of the Exchange Warrants and the excess in the
            fair
            value of the Exchange Warrants over the Series A Warrants resulted in
            a net
            increase to additional paid in capital and a net increase to the net
            loss to
            common shareholders of $274,800.
 
 F-23
 *Table
                  of Contents*
 
 In
            October 2005, Satellite agreed to permit Citadel to issue a senior security
            in
            consideration for a reduction in the exercise price of their 1,200,000
            Exchange
            Warrants from $1.75 per share to $1.56 per share. The fair value of the
            Exchange
            Warrants immediately prior to the conversion price change was estimated
            and
            compared to the fair value of the Exchange Warrants immediately following
            the
            conversion price change, resulting in an increase to additional paid
            in capital
            and an decrease to the net loss to common shareholders of $12,000.
 
 The
            Series A Shares have a maturity of four years and are convertible into
            common
            stock of Citadel at a conversion price of $5.00 per share, a premium
            over the
            closing price on the commitment date of the transaction. The conversion
            and
            exercise prices are subject to adjustment in certain events, and the
            investor
            has the right to require Citadel to redeem the securities in
            cash
            at 101% of the liquidation preference of the Series A Shares in the event
            that
            (i) Citadel fails to issue shares of common stock and deliver certificates
            representing such shares to the holder as and when required upon conversion
            of
            the Series A Shares or upon conversion of the Series A/Exchange Warrants
            (and
            such failure continues for ten business days), (ii) Citadel fails to
            file the
            registration statement as required by the terms of the transaction documents,
            or
            (iii) a change in control occurs. The occurrence of an event requiring
            mandatory
            redemption is not considered probable.
  The
            Series A Shares have a liquidation preference in an amount equal to their
            stated
            value of $1,000 per share plus accrued and unpaid dividends. Holders
            of the
            Series A Shares have liquidation preference rights over common stockholders.
            Citadel also has the right to automatically convert the Series A Shares
            into
            common stock upon achieving certain milestones. Upon maturity, the Company
            will
            pay the holders of Series A Shares cash equal to the aggregate liquidation
            preference of the Series A Shares, or, if certain conditions are met,
            including
            the listing of the Company’s common stock on the New York Stock Exchange, NASDAQ
            National Market, or NASDAQ Capital Market, the Company may pay the holders
            in
            shares of common stock. Holders of the Series A Shares have no voting
            rights
            with respect to the business, management or affairs of the Company; provided
            that the Company shall provide each holder with prior notification of
            each
            meeting of stockholders.
 
 Prior
            to
            the July 2005 shareholders meeting, dividends on the Series A Shares
            were
            payable quarterly in cash at a 5% annual rate or 6% if paid in shares
            of common
            stock at Citadel’s option and if certain milestones were met. The Company paid
            $477,439 of preferred stock dividends during 2004 and had accrued dividends
            payable $187,500 at December 31, 2004. The Company paid $456,250 of preferred
            stock dividends in 2005. In July 2005, the holder of the Series A Shares
            agreed
            to waive the dividend requirements of the Series A Shares upon shareholder
            approval obtained at the shareholders meeting. The estimated fair value
            of the
            benefit related to the waiver of dividends of $1,826,000 resulted in
            an increase
            to additional paid in capital and a decrease to the net loss to common
            shareholders.
 
 Also
            in
            July 2005, Citadel obtained shareholder approval for the possible issuance
            of
            common stock in excess of 19.99% of the number of shares of common stock
            outstanding on the closing date (as a result of possible adjustment to
            the
            conversion price), as required under the applicable listing requirements
            of the
            NASDAQ Capital Market, to increase its authorized number of shares common
            stock
            to 100,000,000, and to amend the Certificate of Designations of its Series
            A
            Shares to reduce the conversion price from $5 to $3. The fair value of
            the
            Series A Shares immediately prior to the conversion price change was
            estimated
            and compared to the fair value of the Series A Shares immediately following
            the
            approval of the conversion price change, resulting in a decrease to additional
            paid in capital and an increase to the net loss to common shareholders
            of
            $1,064,000.
 
 *Series
            B Convertible Preferred Stock (“Series B Shares”)*
 
 On
            May 9,
            2005, Citadel entered into agreements with Satellite related to a private
            placement for up to $11 million, consisting of up to 11,000 shares of
            Series B
            Shares, convertible into approximately 7.1 million shares of common stock
            at the
            initial conversion price of $1.55, and Series B Warrants to purchase
            approximately 2.8 million shares of common stock of Citadel at an initial
            exercise price of $1.75 per share, subject to adjustment upon certain
            events,
            including as a result of the sale of equity securities by the Company
            at a price
            below the exercise price of the Series B Warrants, in a private placement
            to
            accredited investors under Regulation D of the Securities Act of 1933,
            as
            amended.
 
 On
            May 9,
            2005, Citadel completed the sale to Satellite of $7 million of the $11.0
            million
            private placement of the Series B Shares (convertible into approximately
            4.5
            million shares of common stock at the initial conversion price) and Series
            B
            Warrants to purchase approximately 1.8 million shares of common stock.
            Net
            proceeds received were approximately $6,902,000 after payment of approximately
            $98,000 of legal fees. The relative fair value of the Series B Shares
            and the
            Series B Warrants were estimated at approximately $5,796,000 and $1,204,000,
            respectively. The fair value of the Series B Warrants is recorded as
            a credit to
            additional paid in capital. The proceeds from the preferred stock financing
            are
            being used for working capital and general corporate purposes.
 
 F-24
 *Table
                  of Contents*
 
 The
            Company had a put option to sell up to an additional $4 million of Series
            B
            Shares (convertible into approximately 2.6 million common shares) and
            Series B
            Warrants to purchase approximately 1 million shares of common stock at
            an
            exercise price of $1.75 per share, upon satisfaction of certain milestones,
            including shareholder approval, which was obtained at the annual meeting
            in July
            2005, effectiveness of the registration statement covering the resale
            of the
            securities issued in the first tranche and a minimum bid price. The registration
            statement became effective in September 2005, however, the minimum bid
            requirement was not met and the put option expired. Pursuant to the requirements
            of the put option, Citadel issued approximately 1 million additional
            Series B
            Warrants to the investor in August 2005. The fair value of these additional
            Series B Warrants was estimated at approximately $419,000 and is recorded
            as a
            credit to additional paid in capital. The Series B Warrants are exercisable
            (in
            whole or in part) at any time on or before the expiration of their 10-year
            terms.
 
 In
            October 2005, Satellite agreed to permit Citadel to issue a senior security
            in
            consideration for a reduction in the exercise price of their 2,838,710
            Series B
            Warrants from $1.75 per share to $1.56 per share. The fair value of the
            Series B
            Warrants immediately prior to the conversion price change was estimated
            and
            compared to the fair value of the Series B Warrants immediately following
            the
            conversion price change, resulting in an increase to additional paid
            in capital
            and a decrease to the net loss to common shareholders of $31,226.
 
 The
            Series B Shares have a maturity of four years and are convertible into
            common
            stock of Citadel, initially at a conversion price of $1.55 per share.
            The
            conversion and exercise prices are subject to adjustment in certain events,
            and
            the investor has the right to require Citadel to redeem the securities
in
            cash
            at 101% of the liquidation preference of the Series B Shares in the event
            that
            (i) any representation or warranty of the company made in the transaction
            documents fails to be true and correct in all material respects, (ii)
            the
            Company fails to perform in all material respects its covenants and agreements
            in the transaction documents, or (iii) a liquidation event occurs. If
            a change
            in control occurs, a holder may require Citadel to repurchase such holder’s
            Series B Shares in cash at 120% of the liquidation preference. The occurrence
            of
            an event requiring mandatory redemption is not considered
            probable.
  The
            Series B Shares have a liquidation preference in an amount equal to their
            stated
            value of $1,000 per share and are pari passu securities with the Series
            A
            Shares. The Series B Shares do not accrue dividends (unless Citadel declares
            dividends on its common stock). Citadel has the right to automatically
            convert
            the Series B Shares into common stock upon achieving certain milestones.
            Upon
            maturity, the Company will pay the holders of Series B Shares cash equal
            to the
            aggregate liquidation preference of the Series B Shares, or, if certain
            conditions are met, including the listing of the Company’s common stock on the
            New York Stock Exchange, NASDAQ National Market, or NASDAQ Capital Market,
            the
            Company may pay the holders in shares of common stock. The Series B Shares
            are
            generally non-voting securities, except for certain protective provisions
            where
            the holders of Series B Shares are entitled to vote as a separate
            class.
 
 NOTE
            N -
            STOCK OPTIONS AND WARRANTS
 
 The
            Company's 2002 Stock Incentive Plan (the “Plan”) became effective on May 17,
            2002. Under the Plan the Company may grant options to purchase shares
            of common
            stock to eligible participants. On September 21, 2004 the Company's stockholders
            approved amendments to the Plan, including an increase in the shares
            of common
            stock reserved for issuance by 1,500,000 shares of common stock to an
            aggregate
            of 3,000,000 shares. Eligible participants include all employees, officers,
            directors and certain consultants to the Company. The Plan allows for
            the grant
            of non-qualified or incentive stock options. The options granted have
            a term of
            10 years and generally vest over a period of three years. Activity under
            the
            Plan for the years ended December 31, 2005, 2004 and 2003 was as follows:
  Outstanding
                        OptionsOptions
                        available for issuance
                    
                    Number
                        of options
                    
                    Weighted
                        average exercise priceBalance
                        at December 31, 2002
                    
                    
                    1,066,500
                    
                    
                    433,500
                    
                    $
                    0.54Grants
                    
                    
                    (998,000
                    )
                    
                    998,000
                    
                    $
                    1.60Exercised
                    
                    
                    -
                    
                    
                    (160,335
                    )
                    $
                    0.36Cancelled
                    
                    
                    252,665
                    
                    
                    (252,665
                    )
                    $
                    1.00Balances
                        at December 31, 2003
                    
                    
                    321,165
                    
                    
                    1,018,500
                    
                    $
                    1.47Authorized
                    
                    
                    1,500,000
                    
                    
                    
                    
                    
                    -Grants
                    
                    
                    (854,000
                    )
                    
                    854,000
                    
                    $
                    3.86Exercised
                    
                    
                    -
                    
                    
                    (176,889
                    )
                    $
                    1.07Cancelled
                    
                    
                    377,611
                    
                    
                    (377,611
                    )
                    $
                    2.59Balances
                        at December 31, 2004
                    
                    
                    1,344,776
                    
                    
                    1,318,000
                    
                    $
                    2.73Grants
                    
                    
                    (1,899,000
                    )
                    
                    1,899,000
                    
                    $
                    1.13Exercised
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -Cancelled
                    
                    
                    890,000
                    
                    
                    (890,000
                    )
                    $
                    2.41Balances
                        at December 31, 2005
                    
                    
                    335,776
                    
                    
                    2,327,000
                    
                    $
                    1.59
  F-25
 *Table
                    of Contents*
  The
                table
                below summarizes the range of exercise prices of options outstanding
                and
                exercisable under the Plan at December 31, 2005:
 
 Options
                          Outstanding
                      
                      Options
                          ExercisableRange
                          of exercise prices:
                      
                      Number
                          of options
                      
                      Weighted
                          average remaining contractual life in years
                      
                      Weighted
                          average exercise price
                      
                      Number
                          of options
                      
                      Weighted
                          average exercise price$0.32
                          to $1.09
                      
                      
                      1,068,000
                      
                      
                      9.39
                      
                      $
                      0.61
                      
                      
                      99,500
                      
                      $
                      0.63$1.18
                          to $1.32
                      
                      
                      190,000
                      
                      
                      7.36
                      
                      $
                      1.28
                      
                      
                      152,085
                      
                      $
                      1.28$1.35
                          to $2.35
                      
                      
                      637,500
                      
                      
                      8.77
                      
                      $
                      1.79
                      
                      
                      99,792
                      
                      $
                      1.83$2.49
                          to $3.05
                      
                      
                      121,500
                      
                      
                      8.47
                      
                      $
                      2.65
                      
                      
                      53,584
                      
                      $
                      2.65$3.13
                          to $4.35
                      
                      
                      205,000
                      
                      
                      8.43
                      
                      $
                      4.07
                      
                      
                      97,543
                      
                      $
                      4.13$4.40
                          to $6.25
                      
                      
                      105,000
                      
                      
                      8.44
                      
                      $
                      4.99
                      
                      
                      50,001
                      
                      $
                      5.07
 
 In
                addition, the Company granted options outside of the Plan. The table
                below
                summarizes option grants and exercises outside of the Plan. The options
                granted
                have a term of 10 years and generally vest over periods of from one
                to three
                years.
 
 Outstanding
                          OptionsNumber
                          of options
                      
                      Weighted
                          average exercise priceBalances
                          at December 31, 2002
                      
                      
                      5,466,667
                      
                      $
                      0.33Grants
                      
                      
                      2,075,000
                      
                      $
                      1.62Exercised
                      
                      
                      (1,095,825
                      )
                      $
                      0.38Cancelled
                      
                      
                      (618,342
                      )
                      $
                      0.90Balances
                          at December 31, 2003
                      
                      
                      5,827,500
                      
                      $
                      0.72Grants
                      
                      
                      1,447,500
                      
                      $
                      3.69Exercised
                      
                      
                      (173,330
                      )
                      $
                      0.85Cancelled
                      
                      
                      (426,670
                      )
                      $
                      3.25Balances
                          at December 31, 2004
                      
                      
                      6,675,000
                      
                      $
                      1.17Grants
                      
                      
                      825,000
                      
                      $
                      1.32Exercised
                      
                      
                      (112,500
                      )
                      $
                      0.32Cancelled
                      
                      
                      (871,250
                      )
                      $
                      2.74Balances
                          at December 31, 2005
                      
                      
                      6,516,250
                      
                      $
                      0.99
 
 The
                table
                below summarizes the range of exercise prices of options outstanding
                and
                exercisable outside the Plan at December 31, 2005:
 
 Options
                          Outstanding
                      
                      Options
                          ExercisableRange
                          of exercise prices:
                      
                      Number
                          of options
                      
                      Weighted
                          average remaining contractual life in years
                      
                      Weighted
                          average exercise price
                      
                      Number
                          of options
                      
                      Weighted
                          average exercise price$0.32
                          to $0.34
                      
                      
                      4,043,750
                      
                      
                      6.22
                      
                      $
                      0.33
                      
                      
                      4,043,750
                      
                      $
                      0.33$0.87
                          to $0.93
                      
                      
                      450,000
                      
                      
                      9.57
                      
                      $
                      0.88
                      
                      
                      12,500
                      
                      $
                      0.93$1.11
                          to $1.28
                      
                      
                      675,000
                      
                      
                      7.52
                      
                      $
                      1.24
                      
                      
                      675,000
                      
                      $
                      1.24$1.65
                          to $2.35
                      
                      
                      690,000
                      
                      
                      8.77
                      
                      $
                      1.85
                      
                      
                      356,250
                      
                      $
                      1.84$2.55
                          to $3.56
                      
                      
                      285,000
                      
                      
                      8.56
                      
                      $
                      3.01
                      
                      
                      159,167
                      
                      $
                      3.04$4.20
                          to $5.15
                      
                      
                      372,500
                      
                      
                      8.24
                      
                      $
                      4.72
                      
                      
                      279,167
                      
                      $
                      4.73
 F-26
 *Table
                  of Contents*
 The
              weighted-average grant date fair value for the options granted was
              approximately
              $0.44, $3.75 and $1.06 per share for the years ended December 31, 2005,
              2004 and
              2003 respectively. This estimate was made using the Black-Scholes option
              pricing
              model with the weighted-average assumptions shown in the table below.
              The
              weighted-average expected volatility was based on the volatility of
              the trading
              prices for Citadel common stock. The risk free rate presented is a
              weighted
              average based on the daily published interest rates for treasury bills
              with
              similar maturities as the estimated option lives.
 
 2005
                    
                    2004
                    
                    2003Expected
                        dividend yield
                    
                    
                    0.0
                    %
                    
                    0.0
                    %
                    
                    0.0
                    %Risk-free
                        interest rate
                    
                    
                    3.85
                    %
                    
                    2.55
                    %
                    
                    1.76
                    %Expected
                        volatility
                    
                    
                    109
                    %
                    
                    124
                    %
                    
                    115
                    %Expected
                        life (in years)
                    
                    
                    5.0
                    
                    
                    5.0
                    
                    
                    5.0
 
 During
              the year ended December 31, 2004 the Company agreed to modify the option
              agreement to extend the exercise termination date for one terminated
              employee
              and accordingly recognized the estimated fair value of the stock options
              of
              approximately $130,000 which is included in general and administrative
              expense.
 
 The
              warrants issued during 2005, 2004 and 2003 were issued in conjunction
              with the
              debt and equity financing transactions (see Notes H, K and M). The
              proceeds from
              the exercise of warrants during the years ended December 31, 2004 and
              2003 were
              $216,550 and $3,629,244, respectively. There were no warrant exercises
              in the
              year ended December 31, 2005.
 
 Outstanding
                        WarrantsNumber
                        of warrants
                    
                    Weighted
                        average exercise priceBalance
                        at December 31, 2002
                    
                    
                    20,000
                    
                    $
                    0.80Issued
                    
                    
                    3,687,698
                    
                    $
                    1.08Exercised
                    
                    
                    (3,534,895
                    )
                    $
                    1.07Cancelled
                    
                    
                    (7,803
                    )
                    $
                    1.18Balance
                        at December 31, 2003
                    
                    
                    165,000
                    
                    $
                    1.31Issued
                    
                    
                    1,434,881
                    
                    $
                    5.15Exercised
                    
                    
                    (165,000
                    )
                    $
                    1.31Cancelled
                    
                    
                    -
                    
                    
                    -Balance
                        at December 31, 2004
                    
                    
                    1,434,881
                    
                    $
                    5.15Issued
                    
                    
                    4,101,760
                    
                    $
                    1.56Exercised
                    
                    
                    -
                    
                    
                    -Cancelled
                    
                    
                    (1,200,000
                    )
                    $
                    5.15Balance
                        at December 31, 2005
                    
                    
                    4,336,641
                    
                    $
                    1.76
 
 NOTE
              O -
              EMPLOYEE BENEFIT PLANS
 
 Citadel
              sponsors the Citadel Security Software Inc. 401(k) Retirement Savings
              Plan (the
“Plan”) for all eligible employees of the Company. Under the terms of the
              Plan,
              employees may make contributions to the Plan. The Company did not make
              contributions to the Plan during the years ended December 31, 2005,
              2004 and
              2003.
  F-27
 *Table
                  of Contents*
  NOTE
              P -
              COMMITMENTS AND CONTINGENCIES
 
 *Leases*
 
 As
              of
              December 31, 2005 future minimum lease payments under non-cancelable
              operating
              leases were as follows:
 
 2006
                    
                    $
                    759,9072007
                    
                    
                    673,8122008
                    
                    
                    645,4612009
                    
                    
                    752,8082010
                    
                    
                    752,808Thereafter
                    
                    
                    1,380,148Total
                    
                    $
                    4,964,944
 
 The
              Company leases office space for its corporate headquarters in Dallas,
              Texas
              under an operating lease, the base term of which expires in October
              2012. The
              Company also has an office lease for space in Reston, Virginia that
              expires in
              April 2007. Citadel does not have any obligations that extend beyond
              the base
              terms of these leases. Both leases contain escalation provisions. In
              accordance
              with SFAS No. 13 “Accounting for Leases”, FASB Technical Bulletin 88-1 “Issues
              Relating to Accounting for Leases”, and FASB Technical Bulletin 85-3 “Accounting
              for Operational Leases with Scheduled Rent Increases”, the Company records rent
              expense on facility leases on a straight-line basis. Citadel does not
              have any
              obligations that extend beyond the base terms of these leases. Rent
              expense for
              the years ended December 31, 2005, 2004 and 2003 was $808,180, $522,803
              and
              $197,282, respectively.
 
 *Commitment
              to Issue Stock*
 
 On
              May
              17, 2002 Citadel was spun off from its former parent company, CT Holdings,
              Inc.
              On May 1, 2002, CT Holdings, reserved shares of its common stock (together
              with
              dividends and distributions on these shares) for issuance in connection
              with the
              settlement of certain of its liabilities to certain parties. CT Holdings
              has
              reached settlements on all but one of the parties. Because the negotiation
              for
              the settlement of this liability has not been concluded, and if an
              when
              concluded, Citadel would be required to issue shares of its common
              stock, 12,500
              shares of common stock have been held in reserve at December 31, 2005
              to issue
              if and when, CT Holdings enters into a final settlement agreement with
              the
              remaining party.
 
 *Warranty
              Provision and Guarantees*
 
 FASB
              Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for
              Guarantees, Including Indirect Guarantees of Indebtedness of Others” (FIN 45)
              requires certain guarantees to be recorded at fair value and requires
              a
              guarantor to make disclosures, even when the likelihood of making any
              payments
              under the guarantee is remote. For those guarantees and indemnifications
              that do
              not fall within initial recognition and measurement requirements of
              FIN 45, the
              Company must continue to monitor the conditions that are subject to
              the
              guarantees and indemnifications, as required under existing generally
              accepted
              accounting principles, to identify if a loss has been incurred. If
              the Company
              determines that it is probable that a loss has been incurred, any such
              estimable
              loss would be recognized.
 
 Under
              the
              terms of Citadel’s software license agreements, the Company agrees that in the
              event the software sold infringes upon any patent, copyright, trademark,
              or
              trade secret of a third-party, Citadel will indemnify our customer
              licensees
              against any loss, expense, or liability from any damages that may be
              awarded
              against our customer. This infringement indemnification is included
              in all of
              our software license agreements. In the event the customer cannot use
              the
              software due to infringement and Citadel can not obtain the right to
              use,
              replace or modify the license in a commercially reasonable manner so
              that it no
              longer infringes then Citadel may terminate the license and provide
              the customer
              a pro-rata refund of the fees paid by the customer for the infringing
              license.
 
 Under
              the
              terms of Citadel’s customer support services agreements, if the Company is
              unable to resolve a problem within a reasonable time using reasonable
              commercial
              efforts and after a reasonable number of attempts, Citadel will terminate
              the
              service as of the date of the problem report and the customer will
              receive a
              pro-rated refund for the unused portion of the customer support services.
              Additionally, under the terms of Citadel’s Hercules vulnerability remediation
              updates warranty, Citadel warrants that, if qualified customers do
              not receive
              Hercules vulnerability remediation updates in accordance with the Company’s
              service level objectives for remediation and security content delivery
              as stated
              in Citadel’s customer support service agreement, Citadel will reimburse the
              customer for actual information asset losses in excess of $20,000 (per
              incident), up to a maximum of $1,000,000 per incident. The Hercules
              vulnerability remediation updates warranty extends for one year, from
              the date
              of the purchase of the customer support agreement covering fully paid
              Citadel
              software products that have been licensed with the vulnerability remediation
              updates service.
  F-28
 *Table
                  of Contents*
  The
              initial recognition and measurement requirements do not apply to the
              Company’s
              product warranties nor to the provisions contained in the majority
              of the
              Company’s software license agreements that indemnify licensees of the Company’s
              software from damages and costs resulting from claims alleging that
              the
              Company’s software infringes the intellectual property rights of a third party.
              The Company has not received any requests for payment under these provisions
              and
              has not been required to make payments pursuant to these provisions.
              The Company
              has not identified any losses that are probable under these provisions
              and,
              accordingly, the Company has not recorded a liability related to these
              indemnification provisions.
 
 *Change
              of Control Agreements*
 
 On
              December 23, 2005, Citadel approved change of control agreements for
              six of the
              Company’s executives. The agreements provide for payments of six months of
              the
              executive’s annual base salary in the event of certain terminations of
              employment following a change of control, and a payment of one year’s annual
              base salary in the event the executive remains employed with the Company
              or the
              successor on the first anniversary of the date of the agreement, following
              a
              change of control. The agreement for the Company’s Chief Executive Officer
              provides for payment of three times his annual base salary and gross
              up payments
              for taxes related to severance benefits and option exercises following
              a change
              of control. At December 31, 2005, the estimated maximum liability related
              to
              employee change of control agreements was approximately $4,900,000.
 
 *Legal
              Proceedings*
 In
                January, February and March 2005, seven virtually identical lawsuits
                were filed
                against Citadel, Steven B. Solomon, the Company’s Chief Executive Officer and a
                Director, and Richard Connelly, the Company’s Chief Financial Officer. These
                suits have been consolidated in one action styled Ruth R. Lentz v.
                Citadel
                Security Software, Inc., et al., Civil Action No. 3:05-CV-0100-D,
                in the United
                States District Court for the Northern District of Texas. Each case
                was filed on
                behalf of a putative class of persons and/or entities who purchased
                our
                securities between February 12, 2004 and December 16, 2004, inclusive.
                The suits
                seek recovery of unspecified damages under Sections 10(b) and 20(a)
                of the
                Securities Exchange Act of 1934, as amended, and Rule 10b-5 promulgated
                thereunder. The suits were filed after our announcement on December
                17, 2004
                that our projection of revenue and earnings for the full year 2004
                would be less
                than previously projected. On May 25, 2005, the court appointed a
                lead plaintiff
                and approved plaintiff's selection of lead counsel. On August 19,
                2005, the lead
                plaintiff filed a consolidated complaint. On October 18, 2005, the
                defendants
                filed a motion to dismiss this consolidated action, which motion
                is pending
                before the Court.  We believe these suits are without merit and intend to
                vigorously defend them. Discovery has not yet commenced, and no trial
                date has
                been set. These lawsuits could be time-consuming and costly and could
                divert the
                attention of our management personnel. We believe these suits are
                without merit
                and intend to vigorously defend them. Currently, the Company is unable
                to
                estimate the ultimate liability, if any, related to these suits,
                and therefore
                has not recorded a liability related to these suits at December 31,
                2005.
 On
              April
              1, 2005, a shareholder derivative suit styled Harry Brantley, derivatively
              on
              behalf of Citadel Security Software Inc. v. Steven B. Solomon, Richard
              Connelly,
              Chris A. Economou, John Leide and Joe M. Allbaugh, Cause No. 05-03117-L,
              was
              filed in the 193rd State District Court in Dallas County, Texas on
              behalf of
              Citadel against certain of the Company’s officers and directors: Steven B.
              Solomon, the Chief Executive Officer and a Director of the Company;
              Richard
              Connelly, the Company’s Chief Financial Officer; and Chris A. Economou, John
              Leide and Joe M. Allbaugh, Directors of the Company. The suit also
              names the
              Company as a nominal defendant. Based on allegations substantially
              similar to
              the federal securities action, the suit asserts claims for the defendants’
alleged violations of state law, including breaches of fiduciary duties,
              abuse
              of control, gross mismanagement, waste of corporate assets, and unjust
              enrichment that allegedly occurred during the same period of time at
              issue in
              the federal securities action. The suit seeks the recovery of damages,
              fees,
              costs, equitable and/or injunctive remedies, and disgorgement of all
              profits,
              benefits and other compensation. On July 5, 2005, the Court entered
              an order
              staying and administratively closing this case subject to being reopened
              upon
              the motion of any party. The ultimate outcome is not currently predictable.
              We
              believe this suit is without merit and intend to vigorously defend
              the suit.
              Currently, the Company is unable to estimate the ultimate liability,
              if any,
              related to this suit, and therefore has not recorded a liability related
              to this
              suit at December 31, 2005.
  F-29
 *Table
                  of Contents*
  On
              April
              28, 2005, a shareholder derivative suit styled Hans J. Baier, derivatively
              on
              behalf of Nominal Defendant, Citadel Security Software Inc., v. Steven
              B.
              Solomon, Richard Connelly and Chris Economou, Civil Action No. 3-05CV-0846-D,
              was filed in United States District Court for the Northern District
              of Texas,
              Dallas Division, against certain of the Company’s officers and directors: Steven
              B. Solomon, the Chief Executive Officer and a Director of the Company,
              Richard
              Connelly, the Company’s Chief Financial Officer and Chris Economou, a Director
              of the Company. The suit also names the Company as a nominal defendant.
              Based on
              allegations substantially similar to the federal securities action,
              the suit
              asserts claims for the defendants’ alleged violations of state law, including
              breaches of fiduciary duties, abuse of control, gross mismanagement,
              waste of
              corporate assets and unjust enrichment for the same period of time
              at issue in
              the federal securities action. The suit also purports to assert a claim
              against
              Steven B. Solomon and Richard Connelly pursuant to a federal statute
              for
              reimbursement of bonuses, profits and compensation. On September 12,
              2005, the
              Court entered an order staying this case until thirty (30) days after
              the Court
              rules on the pending motion to dismiss filed by the defendants in the
              consolidated federal securities action described below. The ultimate
              outcome is
              not currently predictable. The Company believesthis
              suit is without merit and intends to vigorously defend the suit. Currently,
              the
              Company is unable to estimate the ultimate liability, if any, related
              to this
              suit, and therefore has not recorded a liability related to this suit
              at
              December 31, 2005.
 
 On
              April
              8, 2005, Meyers Associates, L.P. f/k/a Roan/Meyers Associates, L.P.
              and f/k/a
              Janssen-Meyers Associates, L.P. (“Meyers”) filed a lawsuit in the Court of
              Chancery of the State of Delaware, in New Castle County, against the
              Company, CT
              Holdings, Inc. f/k/a Citadel Technology, Inc. and f/k/a Citadel Computer
              Systems, Inc. (“CT Holdings”) and certain current and former officers and
              directors of the Company and/or CT Holdings, including Steven B. Solomon,
              the
              Chief Executive Officer and a Director of the Company, Chris A. Economou,
              a
              Director of the Company, Lawrence Lacerte, a former Director of the
              Company, and
              Phillip J. Romano, a former Director of the Company (the “Individual
              Defendants”). The suit alleges that in connection with an action filed in the
              Supreme Court of New York, New York County, to enforce a Settlement
              Term Sheet
              executed on July 7, 2000 by Meyers and CT Holdings, Meyers was awarded
              a
              judgment against CT Holdings in the amount of $3 million plus interest
              on the
              judgment at the rate of 9% from October 31, 2000 until the date of
              entry of that
              judgment and thereafter at the statutory rate (the “Judgment”). CT Holdings has
              appealed the Judgment and that appeal is pending. The suit alleges
              that CT
              Holdings’ May 2002 spin-off of its interests in Citadel to CT Holdings’
shareholders rendered CT Holdings insolvent and constituted a fraudulent
              conveyance to defraud CT Holdings’ creditors, including Meyers. The suit asserts
              fraudulent conveyance claims against Citadel and CT Holdings pursuant
              to
              Delaware statutory and common law. The suit also asserts a claim against
              Citadel
              for successor liability as the alleged successor in interest or alter
              ego of CT
              Holdings. The suit alleges that the Individual Defendants who were
              officers
              and/or directors of CT Holdings at the time of the spin-off breached
              fiduciary
              duties allegedly owed to creditors of CT Holdings, including Meyers,
              by
              approving and allowing the spin-off transaction. The suit seeks to
              void the
              spin-off transaction or alternatively, to hold Citadel liable for the
              Judgment
              including interest, to recover damages against the Individual Defendants
              in an
              amount not less than the Judgment including interest, plus an unspecified
              amount
              of punitive, consequential and incidental damages, as well as attorneys’ fees
              and costs. The Company believes that this suit is without merit and
              intends to
              vigorously defend this action. The ultimate outcome is not currently
              predictable. Currently,
              the Company is unable to estimate the ultimate liability, if any, related
              to
              this suit, and therefore has not recorded a liability related to this
              suit at
              December 31, 2005.
 
 On
              February 14, 2006 the United States Patent and Trademark Office issued
              U.S.
              Patent No. 7,000,247 (the "'247 Patent") to Citadel for the
              Company's proprietary Hercules technology. Also on February 14,
              2006, Secure Elements filed a declaratory judgment action in the United
              States District Court for the District of Delaware seeking a declaration
              from
              the Court that the '247 Patent was both invalid and not infringed by
              Secure Elements. On March 6, 2006 Citadel answered Secure Element’s complaint,
              asserted counterclaims against Secure Elements for willful infringement
              of
              the '247 Patent, and sought an undisclosed amount of damages, costs and
              attorney’s fees, and an injunction barring Secure Elements from infringing
              the '247 Patent in the future. This case is in its infancy. The court has
              not yet entered a scheduling order and no discovery has been sought
              or obtained
              by either party. The Company believes this
              suit
              is without merit and intends to vigorously defend the suit.
  From
              time
              to time, we may be subject to additional legal claims incidental to
              our
              business. We may suffer an unfavorable outcome as a result of one or
              more claims
              including the specific items discussed previously. We do not expect
              the final
              resolution of these claims to have a material adverse effect on our
              financial
              position, individually or in the aggregate. However, depending on the
              amount and
              timing of unfavorable resolutions of claims against us, or the costs
              of
              settlement or litigation, our future results of operations or cash
              flows could
              be materially adversely affected.
  F-30
 *Table
                  of Contents*
  NOTE
              Q -
              SIGNIFICANT CUSTOMERS
 
 The
              following customers represented more than 10% of total revenue in at
              least one
              of the years presented below:
 
 Years
                        Ended December 31,2005
                    
                    2004
                    
                    2003End
                        User Customer:Defense
                        Information Systems Agency
                    
                    
                    32
                    %
                    
                    39
                    %
                    
                    -Department
                        of Veteran Affairs
                    
                    
                    21
                    %
                    
                    41
                    %
                    
                    67
                    %Industry
                        Segment:Government
                    
                    
                    58
                    %
                    
                    82
                    %
                    
                    80
                    %Corporate
                    
                    
                    25
                    %
                    
                    12
                    %
                    
                    3
                    %Financial
                        institutions
                    
                    
                    13
                    %
                    
                    4
                    %
                    
                    8
                    %Education
                    
                    
                    1
                    %
                    
                    1
                    %
                    
                    2
                    %All
                        other, primarily health
                    
                    
                    3
                    %
                    
                    1
                    %
                    
                    7
                    %Geographic
                        Segments:United
                        States
                    
                    
                    99
                    %
                    
                    100
                    %
                    
                    100
                    %Outside
                        of the United States
                    
                    
                    1
                    %
                    
                    -
                    
                    
                    -
 
 The
              Company operates in one business segment, the security software segment,
              but
              licenses it software and offers its services to a diverse group of
              customers in
              the Fortune 2000 in many industries, as well as, governmental agencies
              at the
              federal, state and local levels. Although the significant customers
              listed above
              represent 53% of the 2005 revenue the Company does not expect to rely
              on any one
              customer, group of customers or industry segment for a significant
              source of
              recurring revenue. Revenue from government agencies is anticipated
              to continue
              to be the larger portion of revenue composition by industry segment
              during 2006.
              Therefore, any one customer or groups of customers in the same industry
              segment
              could be a material component of revenue in any future quarter or year.
              However,
              there is no assurance that the distribution of revenue by industry
              segment or
              customer is representative of future revenue projections and the Company
              expects
              that the revenue distribution by industry segment and customer will
              vary
              markedly from period to period.
 
 NOTE
              R -
              RELATED PARTY TRANSACTIONS
 From
                time-to time in 2005 the Company's CEO has advanced funds to the
                Company to meet
                short-term working capital needs. The total amount advanced during
                2005 was
                approximately $881,000, all of which was repaid to the CEO prior
                to December 31,
                2005, except for approximately $81,000 reimbursed to the CEO in January
                2006.
                The Company's CEO has committed to advance the Company up to three
                million
                dollars in funding should it be necessary for short term working
                capital needs
                through March 2007. The terms and conditions of any advance to the
                Company from
                the CEO will be established by the Company's Board of
                Directors.
  During
              the year ended December 31, 2004 the Company recorded revenue of approximately
              $22,000 primarily for fees from a Hercules license granted to the investment
              fund that holds all 15,000 shares of Series A preferred stock issued
              in February
              2004 convertible into 3,000,000 shares of common stock and warrants
              to purchase
              1,200,000 shares of common stock. In addition, the Company recorded
              revenue of
              approximately $7,300 for fees from a Hercules license sold to one of
              the
              placement agents for preferred stock transaction that occurred in 2003.
              The
              license fees for both transactions were invoiced at list price with
              normal
              payment terms and the total amounts outstanding had been collected
              by December
              31, 2004. The Company believes that these transactions were arms length
              transactions and were properly recorded in its financial statements.
  F-31
 *Table
                  of Contents*
  As
              part
              of the spin off transaction in May 2002, Citadel entered into a transition
              services agreement with CT Holdings, its former parent. The agreement
              provides
              that CT Holdings and Citadel provide each other services in such areas
              as
              information management and technology, sharing of office space, personnel
              and
              indirect overhead expenses, employee benefits administration, payroll,
              financial
              accounting and reporting, claims administration and reporting, and
              other areas
              where CT Holdings and Citadel may need transitional assistance and
              support. The
              transition services agreement provides generally that each of Citadel
              and CT
              Holdings will undertake to provide substantially the same level of
              service and
              use substantially the same degree of care as their respective personnel
              provided
              and used in providing such services prior to the execution of the agreement.
              The
              agreement generally extends for a one year term, but may be terminated
              earlier
              under certain circumstances, including a default, and may be renewed
              for
              additional one-year terms. In August 2005, the Board of Directors approved
              the
              extension of the transition services agreement until May 2006. Initially,
              CT
              Holdings agreed to pay Citadel a monthly fee of $20,000, subject to
              adjustment
              on a quarterly basis. The fee was adjusted to $7,500 per month beginning
              in May
              2004. The Company believes that the terms and conditions of the transition
              services agreement are as favorable to Citadel as those available from
              unrelated
              parties for a comparable arrangement. At December 31, 2005 and 2004
              the Company
              has recorded amounts due from CT Holdings pursuant to the transition
              services
              agreement of $595,000 and $530,000, respectively. Due to the uncertainty
              of
              collection the Company has expensed the fees to general and administrative
              expense on a monthly basis as incurred.
 
 In
              April
              2003, a CT Holdings legal claim associated with a lawsuit was settled
              for
              $225,000 in cash. Citadel advanced $225,000 to CT Holdings in return
              for a
              demand note payable bearing interest at 12% per year and a release
              for any
              potential claims pertaining to the CT Holdings litigation. Since CT
              Holdings has
              a significant cash deficiency and stockholder's deficit this demand
              note
              receivable was fully reserved in the second quarter of 2003 as there
              can be no
              assurance that this note will be collected. At December 31, 2005, interest
              receivable of $76,857 was also fully reserved.
 
 During
              the years ended December 31, 2005, 2004 and 2003 the Company incurred
              legal fees
              in the amount of approximately $263,000, $237,000 and $165,000, respectively,
              to
              a law firm in which an attorney who is a partner and who was a former
              CT
              Holdings' employee and is a relative Citadel's CEO.
  F-32
 *Table
                  of Contents*
  NOTE
              S -
              QUARTERLY INFORMATION (unaudited)
 
 2005
                        For the Quarter EndedMarch
                        31
                    
                    June
                        30
                    
                    September
                        30
                    
                    December
                        31
                    
                    YearRevenueLicense
                        fees
                    
                    $
                    193,858
                    
                    $
                    613,418
                    
                    $
                    765,128
                    
                    $
                    996,049
                    
                    $
                    2,568,453Content,
                        subscription, and customer support services
                    
                    
                    1,160,511
                    
                    
                    1,201,350
                    
                    
                    1,079,483
                    
                    
                    1,426,198
                    
                    
                    4,867,542Professional
                        services
                    
                    
                    385,557
                    
                    
                    878,533
                    
                    
                    349,229
                    
                    
                    1,237,781
                    
                    
                    2,851,1001,739,926
                    
                    
                    2,693,301
                    
                    
                    2,193,840
                    
                    
                    3,660,028
                    
                    
                    10,287,095Costs
                        of revenue
                    
                    
                    1,077,349
                    
                    
                    1,157,640
                    
                    
                    1,171,128
                    
                    
                    1,260,586
                    
                    
                    4,666,703Operating
                        expenses
                    
                    
                    5,631,755
                    
                    
                    6,541,591
                    
                    
                    5,807,592
                    
                    
                    5,797,661
                    
                    
                    23,778,599Operating
                        loss
                    
                    
                    (4,969,178
                    )
                    
                    (5,005,930
                    )
                    
                    (4,784,880
                    )
                    
                    (3,398,219
                    )
                    
                    (18,158,207
                    )Interest
                        expense, net
                    
                    
                    (35,000
                    )
                    
                    (41,870
                    )
                    
                    (49,496
                    )
                    
                    (278,306
                    )
                    
                    (404,672
                    )Loss
                        before income taxes
                    
                    
                    (5,004,178
                    )
                    
                    (5,047,800
                    )
                    
                    (4,834,376
                    )
                    
                    (3,676,525
                    )
                    
                    (18,562,789
                    )Provision
                        for income taxes
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -Net
                        loss
                    
                    
                    (5,004,178
                    )
                    
                    (5,047,800
                    )
                    
                    (4,834,376
                    )
                    
                    (3,676,525
                    )
                    
                    (18,562,789
                    )Preferred
                        dividends
                    
                    
                    (187,500
                    )
                    
                    (81,250
                    )
                    
                    -
                    
                    
                    -
                    
                    
                    (268,750
                    )Non-cash
                        fair value adjustment for exchanged warrants
                    
                    
                    -
                    
                    
                    (274,800
                    )
                    
                    -
                    
                    
                    -
                    
                    
                    (274,800
                    )Non-cash
                        fair value adjustment for Series A Shares dividend waiver
                    
                    
                    -
                    
                    
                    -
                    
                    
                    1,826,000
                    
                    
                    -
                    
                    
                    1,826,000Non-cash
                        fair value adjustment for change in Series A Shares conversion
                        price
                    
                    
                    -
                    
                    
                    -
                    
                    
                    (1,064,000
                    )
                    
                    -
                    
                    
                    (1,064,000
                    )Non-cash
                        fair value adjustment for change in exercise price of Exchange
                        and Series
                        B Warrants
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    (43,226
                    )
                    
                    (43,226
                    )Non-cash
                        accretion of beneficial conversion feature
                    
                    
                    (61,542
                    )
                    
                    (61,542
                    )
                    
                    (646,168
                    )
                    
                    -
                    
                    
                    (769,252
                    )Net
                        loss attributable to common shareholders
                    
                    $
                    (5,253,220
                    )
                    $
                    (5,465,392
                    )
                    $
                    (4,718,544
                    )
                    $
                    (3,719,751
                    )
                    $
                    (19,156,907
                    )Net
                        loss per share to common shareholders-
                        basic and diluted
                    
                    $
                    (0.18
                    )
                    $
                    (0.18
                    )
                    $
                    (0.16
                    )
                    $
                    (0.12
                    )
                    $
                    (0.64
                    )Weighted
                        average shares outstanding-
                        basic and diluted
                    
                    
                    29,845,730
                    
                    
                    29,877,708
                    
                    
                    30,044,860
                    
                    
                    30,132,513
                    
                    
                    29,976,179
  F-33
 *Table
                  of Contents*
  2004
                        For the Quarter EndedMarch
                        31
                    
                    June
                        30
                    
                    September
                        30
                    
                    December
                        31
                    
                    YearRevenueLicense
                        fees
                    
                    $
                    1,819,835
                    
                    $
                    2,922,243
                    
                    $
                    7,071,477
                    
                    $
                    548,030
                    
                    $
                    12,361,585Content,
                        subscription, and customer support services
                    
                    
                    466,224
                    
                    
                    521,556
                    
                    
                    673,317
                    
                    
                    1,125,840
                    
                    
                    2,786,937Professional
                        services
                    
                    
                    36,056
                    
                    
                    -
                    
                    
                    28,670
                    
                    
                    39,907
                    
                    
                    104,6332,322,115
                    
                    
                    3,443,799
                    
                    
                    7,773,464
                    
                    
                    1,713,777
                    
                    
                    15,253,155Costs
                        of revenue
                    
                    
                    497,497
                    
                    
                    582,861
                    
                    
                    746,180
                    
                    
                    1,005,546
                    
                    
                    2,832,084Operating
                        expenses
                    
                    
                    3,434,885
                    
                    
                    4,710,023
                    
                    
                    6,043,339
                    
                    
                    6,106,418
                    
                    
                    20,294,665Operating
                        profit (loss)
                    
                    
                    (1,610,267
                    )
                    
                    (1,849,085
                    )
                    
                    983,945
                    
                    
                    (5,398,187
                    )
                    
                    (7,873,594
                    )Interest
                        income (expense) and other income (expense), net
                    
                    
                    22,885
                    
                    
                    33,770
                    
                    
                    12,047
                    
                    
                    (34,133
                    )
                    
                    34,569Income
                        (loss) before income taxes
                    
                    
                    (1,587,382
                    )
                    
                    (1,815,315
                    )
                    
                    995,992
                    
                    
                    (5,432,320
                    )
                    
                    (7,839,025
                    )Provision
                        for income taxes
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -
                    
                    
                    -Net
                        income (loss)
                    
                    
                    (1,587,382
                    )
                    
                    (1,815,315
                    )
                    
                    995,992
                    
                    
                    (5,432,320
                    )
                    
                    (7,839,025
                    )Preferred
                        dividends
                    
                    
                    (102,440
                    )
                    
                    (187,500
                    )
                    
                    (187,500
                    )
                    
                    (187,500
                    )
                    
                    (664,940
                    )Non-cash
                        accretion of beneficial conversion feature
                    
                    
                    (30,771
                    )
                    
                    (61,542
                    )
                    
                    (61,542
                    )
                    
                    (61,542
                    )
                    
                    (215,397
                    )Net
                        income (loss) attributable to common shareholders
                    
                    $
                    (1,720,593
                    )
                    $
                    (2,064,357
                    )
                    $
                    746,950
                    
                    $
                    (5,681,362
                    )
                    $
                    (8,719,362
                    )Net
                        income (loss) per share to common shareholders-
                        basic
                    
                    $
                    (0.06
                    )
                    $
                    (0.07
                    )
                    $
                    0.03
                    
                    $
                    (0.19
                    )
                    $
                    (0.30
                    )-
                        diluted
                    
                    $
                    (0.06
                    )
                    $
                    (0.07
                    )
                    $
                    0.02
                    
                    $
                    (0.19
                    )
                    $
                    (0.30
                    )Weighted
                        average shares outstanding-
                        basic
                    
                    
                    28,421,686
                    
                    
                    29,467,112
                    
                    
                    29,664,109
                    
                    
                    29,786,137
                    
                    
                    29,336,894-
                        diluted
                    
                    
                    28,421,686
                    
                    
                    29,467,112
                    
                    
                    33,932,949
                    
                    
                    29,786,137
                    
                    
                    29,336,894
 
  F-34