**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


WASHINGTON,
      D.C. 20549





**FORM
      10-KSB**





**x ANNUAL
      REPORT
      UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE**


**ACT
      OF 1934**





**FOR
      THE FISCAL YEAR ENDED DECEMBER 31, 2006**





**o TRANSITION
      REPORT
      UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE**


**ACT
      OF 1934**





**FOR
      THE TRANSITION PERIOD FROM ______________ TO________________**





*COMMISSION
      FILE NO. 0-31136*





**CYBER
      DEFENSE SYSTEMS, INC.**





(NAME
      OF
      SMALL BUSINESS ISSUER IN ITS CHARTER)


A
                  FLORIDA CORPORATION
              45-0508387(STATE
                  OR OTHER JURISDICTION
              (IRS
                  EMPLOYEROF
                  INCORPORATION OR ORGANIZATION)
              IDENTIFICATION
                  NUMBER)





**10901
      ROOSEVELT BOULEVARD**


**ST.
      PETERSBURG, FLORIDA 33716**


(ADDRESS
      OF PRINCIPAL EXECUTIVE OFFICES)





(727)
      577-0878


(ISSUER'S
      TELEPHONE NUMBER)





Securities
      registered under Section 12(b) of the Securities Exchange Act


of
      1934,
      as amended ("Exchange Act"): NONE.





Title
      of
      each class name of each exchange on which registered Securities


registered
      under Section 12(g) of the Exchange Act:





CLASS
      A
      COMMON STOCK, PAR VALUE $0.001 PER SHARE.


CLASS
      B
      COMMON STOCK, PAR VALUE $0.001 PER SHARE.


CLASS
      C
      COMMON STOCK, PAR VALUE $0.001 PER SHARE.





Check
      whether the issuer (1) filed all reports required to be filed under Section
      13
      or 15(d) of the Exchange Act, during the past 12 months (or for such shorter
      period that the Issuer was required to file such reports), and (2) has been
      subject to such filing requirements for the past 90 days. x Yes o
      No





Check
      if
      there is no disclosure of delinquent filers in response to Item 405 of
      Regulation S-B is not contained in this form, and no disclosure will be
      contained, to the best of Issuer's knowledge, in definitive proxy or information
      statements incorporated by reference in Part III of this Form 10-KSB or any
      amendment to this Form 10-KSB. o Yes
x
      No









Indicate
      by check mark whether the registrant is a shell company o Yes x
      No





The
      Issuer's revenues for the fiscal year ended December 31, 2006 were $494,220.





The
      aggregate market value of the voting stock held by non-affiliates of the Issuer
      computed by reference to the price at which the stock was sold, or the average
      bid and ask prices of such stock as of May 14, 2007, was approximately $988,000
      based on the $0.04 per share closing price on May 14, 2007. Shares of common
      stock held by each executive officer and director and by certain persons who
      own
      5% or more of the outstanding common stock have been excluded in that such
      persons may be deemed to be affiliates. This determination of affiliate status
      is not necessarily a conclusive determination for other purposes.





On
      May
      15, 2007 we have 71,705,872 shares of common stock outstanding, $0.001 par
      value.





Documents
      Incorporated by Reference: NONE





Transitional
      Small Business Disclosure Format (Check one): Yes o; No x





The
      Registrant, by this Form 10-KSB has not been changed or updated to reflect
      any
      changes in information that may have occurred subsequent to the date of the
      reporting period that this Form 10-KSB.







**TABLE
        OF CONTENTS**
 
 PART
        I


Item
                  1.
              Business
              01Item
                  2.
              Description
                  of Property
              09Item
                  3.
              Legal
                  Proceedings
              10Item
                  4.
              Submission
                  of Matters to a Vote of Security Holders
              10PART
                  IIItem
                  5.
              Market
                  for Common Equity and Related Stockholder Matters.
              11Item
                  6.
              Management's
                  Discussion and Analysis of Financial Condition or Plan of
                  Operations.
              13Item
                  7.
              Financial
                  Statements
              18Item
                  8.
              Changes
                  in and Disagreements With Accountants on Accounting
                  and Financial Disclosure
              18Item
                  8A.
              Controls
                  and Procedures
              18Item
                  8B.
              Other
                  Information
              18PART
                  IIIItem
                  9.
              Directors,
                  Executive Officers, Promoters and Control Persons; Compliance With
                  Section
                  16(a) of the Exchange Act
              19Item
                  10.
              Executive
                  Compensation
              22Item
                  11.
              Security
                  Ownership of Certain Beneficial Owners and Management and Related
                  Stockholder Matters
              26Item
                  12
              Certain
                  Relationships and Related Transactions
              27Item
                  13.
              Exhibits
                  and Reports on Form 8-K
              30Item
                  14.
              Principal
                  Accountant Fees and Services
              35Signatures
              36








**PART
      I**





**ITEM
      1. BUSINESS**





**Organization
      and Background**





Cyber
      Defense Systems, Inc. (“Cyber Defense”, the “Company”, “we”, “us” and “our”) was
      incorporated in the State of Florida on August 19, 2004 and is the successor
      company to E-City Software, Inc. (“E-City”), a Nevada corporation, pursuant to a
      change of domicile merger which became effective on September 1, 2004. The
      change of domicile merger was preceded by another merger with On Alert Systems,
      Inc. (“On Alert”) which was also merged into Cyber Defense. On Alert was
      incorporated on March 17, 2003 in the State of Nevada and subsequently acquired
      a control position in our majority-owned subsidiary, Cyber Aerospace Corp.
      (“Cyber Aero”) in March 2004. As a result of the foregoing, we became the
      successor to E-City and our shares of common stock began trading on the OTC
      Bulletin Board under the symbol, “CYDF” on September 7, 2004. On March 31, 2005,
      our majority owned subsidiary, Cyber Aero, was merged into the Company in order
      to consolidate operations into one company, with one name, and one group of
      shareholders. On April 1, 2005, we formed Airship Leasing Co., LLC; an Oklahoma
      limited liability company (“Airship Leasing”) to conduct future commercial
      operations of Airship, as discussed below. On September 19, 2005, the Company
      consummated a transaction with Techsphere Systems International, LLC ("TSI")
      which resulted in TSI becoming the Company’s wholly owned subsidiary. Pursuant
      to a plan of reorganization and agreement of merger, dated September 19, 2005,
      Cyber Acquisition Sub, Inc (the “Sub”) merged into TSI, the separate existence
      of the Sub ceased, and TSI became the surviving corporation. In connection
      with
      the merger, the Company issued to the former TSI unit holders a total of
      23,076,923 shares of its Class A Common Stock and 245,455 shares of its Class
      B
      Common Stock for all of the issued and outstanding ownership interests of TSI.
      In 2005, TSI formed TSI Holdings Co, LLC ("TSI, LLC") a Georgia limited
      liability company. On January 30, 2007, TSI reactivated TSI, LLC, in order
      to raise funds in order deploy two (2) SA-60 Airships, as further described
      below. Currently, TSI, LLC is owned 95.5% by the Company and 4.5% by outside
      investors.





Today,
      the Company conducts its operations through the manufacture and sale or lease
      of
      its Cyber UAV line of products, and the manufacture and sale or lease of its
      lighter-than-air Airship, as discussed below.





**Overview**





The
      focus
      of our business is the design, development and marketing of a new generation
      of
      Unmanned Air Vehicles (“UAV’s”) and the design, development and marketing of
      lighter-than-air airship, both manned and unmanned. We have assembled and
      continue to build on our team of military experts and aerospace (and composite)
      engineers to accomplish this goal for the UAV’s. With the acquisition of TSI, we
      have acquired the global- government, military and non-exclusive commercial
      marketing rights from TSI, for its semi-spherical manned and unmanned,
      high-atmosphere airships (the “Airships” or “TechspheresTM”). The aerospace
      company, Sierra Nevada Corporation, or “SNC”, has the exclusive integration
      rights for the TSI Airships, whether sold or leased to U.S. Government end
      users. The current prototype SA60 has flown up to an altitude of approximately
      20,000 feet and it is anticipated that they will reach up to 65,000 feet, an
      altitude sufficient for communication and surveillance technologies. We plan
      to
      market these Airships to various branches of the U.S. government initially,
      then
      to other governments, friendly to the U.S., worldwide, and eventually to
      telecommunication companies that could reduce the need for expensive satellite
      technologies for communications and surveillance activities.





Our
      mission is to acquire and/or develop offensive and defensive security
      technologies that support a full line of interoperable protection disciplines.
      By acquiring a homogeneous suite of security products through teamed and
      licensed marketing and distribution agreements, we plan to introduce our new
      product line to multiple markets. We believe that prospective government and
      commercial clients that we are seeking all share similar needs: enhanced
      security, mobile communication platforms and increased surveillance
      capabilities .





**Cyber
      Defense UAV’s**





The
      Use of Unmanned Aerial Vehicles (“UAV’s”)




1




UAV's
      have been referred to in many ways: RPV's (remotely piloted vehicle), drones,
      robot planes, and pilot-less aircraft. The DoD defines UAV's as powered, aerial
      vehicles that do not carry a human operator, use aerodynamic forces to provide
      vehicle lift, are able to fly autonomously or be piloted remotely, can be
      expendable or recoverable, with the ability to carry a lethal or non-lethal
      payload. Ballistic or semi-ballistic vehicles, such as cruise missiles and
      artillery projectiles, are not considered UAV's by the DoD.





UAV's
      differ from RPV's in that some UAV's can fly autonomously. UAV's are either
      described as a single air vehicle (with associated surveillance sensors), or
      a
      UAV system, which usually consists of three to six air vehicles, a ground
      control station, and support equipment.





UAV's
      are
      thought to offer two main advantages over manned aircraft: they are arguably
      cheaper to procure, and they eliminate the risk to a pilot's life. UAV's protect
      the lives of pilots by performing the "3-D" missions - those that are "dull,
      dirty, or dangerous" and do not require a pilot in the cockpit. Furthermore,
      for
      those certain missions which require a very small aircraft, only a UAV can
      be
      deployed because there is no equivalent manned system small enough for the
      task.





We
      are
      currently engaged in final testing programs for our CyberScoutTM and have
      finalized designs and have sold and or producing 4 versions of the CyberBugTM
UAV’s. The Company continues to develop the M.A.R.S.TM high altitude airships and
      the TechspheresTM or similar products developed by us and TSI. We recently
      secured an International Trafficking and Arms Regulation or ITAR agreement
      allowing us to export our UAV's to countries approved by the U.S. Department
      of
      State. In addition, multiple arrangements and relationships have been formed
      with companies and individual representatives to identify potential buyers
      of
      the UAV’s in Europe, the Pacific Rim, and Israel. As part of the our efforts to
      make the UAV's available for sale, multiple patents protecting the many unique
      features of the CyberScoutTM, CyberBugTM and M.A.R.S.TM have been recently filed
      with the U.S. Patent and Trademark Office.





The
      CyberScoutTM is the first in a series of planned vehicles by Cyber Defense that
      employ a vertical take-off and landing technique (“VTOL”). Cyber Defense has
      recently completed a series of controlled flight tests with the CyberScoutTM, and
      its propulsion technology is evolving from utilizing gas power to a planned
      three-turbine, jet-fueled aircraft-less than 10 feet in overall dimensions
      and
      weighing in at under 80 pounds fully fueled with payload-which is considered
      unique among its peers in the industry.





To
      complement our UAV product offering, Cyber Defense has developed a smaller
      Unmanned Air Vehicle. ****** The
      CyberBug TM is one
      of the first in the UAV's to offer a low cost solution to law enforcement and
      the military, providing the capability to provide routine surveillance and
      communication in crowded or remote locations providing authorities the ability
      to provide cost effective surveillance over areas without the monetary burden
      that typically occurs when other airborne assets or people are used. Recent
      developments with the CyberBug TM include
      flights at altitude above 10,500 feet, interchangeable camera payload pods,
      improved ruggedizing to allow operations in most weather environments.





The
      scalable CyberBug TM is now
      produced in 4 sizes, the CyberBug TM MICRO
      weighing less that 3 lbs, CyberBug TM B,
      Large CyberBug TM and the
      newly developed CyberBug TM Grande
      with 12 lb payloads and flight times of up to 8 hours depending upon payload
      and
      fuel capacity. The system is truly unique in that the control station is based
      upon the Windows XP operating system. This system could be a driving force
      for
      the future development of UAV’s. The CYDF system provides the owner with the
      ability to control the camera and UAV from areas remote to the plane. An example
      is that one current proposal is CyberBug TM that
      would be provided to ground troops and used in preprogrammed missions. The
      observer could monitor for hostile activity from a remote location from inside
      the U.S. with the ability to notify forces in theater of potential areas of
      concern, providing control of the cameras as well as the operation of the
      vehicles from this location.  The product is scalable and provides camera
      solution on both the CyberBug TM BATMAV
      2.6 pound platform as well as significant sensor and cameras solutions for
      day
      and night missions on the larger CyberBug TM Grande,
      which also has the capability to fly on station in a programmed or manual mode
      from 1 hour to up to 3 hours, traveling at speeds of 30 MPH with a camera
      foot print of 300 x 300 depending on day or night view. The Company has
      tentative reseller agreements with several companies who provide cameras and
      or
      sensor products thus enabling the Company to “piggy-back” established sales
      channels of these reseller companies.




2




Our
      initial focus is to market our existing UAV products to the Department of
      Defense ("DoD"), homeland defense and intelligence agencies. Our management
      team
      believes that it has established viable contacts with the decision makers in
      these market segments. As this is a substantial market, understanding its future
      technology requires on-going analysis. We intend to further expand into other
      market segments that require enhanced security, mobile communication platforms
      and increased surveillance capabilities. Examples of market segments include,
      but are not limited to: industrial plants, chemical plants, nuclear sites,
      oil
      rigs, oil pipelines, and ports.





To
      date,
      Cyber Defense has sold 15 units to both military and law enforcement agencies
      in
      the U.S. and to aerospace firms abroad.




**Airships**





Use
      of
      Airships





The
      use
      of lighter-than-air airships (“airships”) to provide high altitude surveillance
      is not a new concept. For over one hundred years, balloons have been used by
      battlefield commanders to get a “big picture” perspective. We anticipate that a
      new generation of airship design will bring an enhanced potential to the field
      by integrating advanced communications with mobile platform stability. We
      believe airships can operate 25-30 percent cheaper than comparable rotary wing
      or fixed wing aircraft. The physical configuration of these Airships will allow
      the system to remain airborne in a set location longer than previously possible.
      Furthermore, in addition to providing "hovering" ability, the engines of the
      new
      generation of the Company’s Airships are designed to rotate, allowing the ship
      to fly, versus float, to its station. This design also permits the Company’s
      Airship to spin on its axis permitting greater mobility.





The
      Company’s Airships have significant potential military and security
      applications:





·
            Surveillance
                (the military, Drug Enforcement Agency/Customs, the Coast Guard,
                etc.) of
                movements 24 hours a day/ seven days a week in multiple
                environments;


·
            Quick
                replacement of obscure/destroyed technology infrastructures with
                on-board
                wireless communication capability;
                and


·
            Command
                and control of ground and airborne communications.





In
      addition, Airships have civilian applications, such as providing wireless
      solutions in the growing U.S. broadband market. We believe a byproduct of this
      technology will be the formation of mobile "Cell Towers" for remote locations
      or
      overloaded systems. Used both for planned and unplanned occurrences (Super
      Bowl,
      New Year's, and other major events), we believe that positioning one of these
      Airships above a city or area of interest could provide a mobile communications
      platform which would allow for cell, microwave, broadband and video technology.
      High above the area of concern or service, this platform could be put into
      place
      within three hours of an event and maintained for a long period of time to
      support core systems.





Existing
      Airship products include the TSI SA 60 Low Altitude Airship (“LAA”), the TSI SA
      90 Medium Altitude Airships (“MAA’s”). The Company plans to develop its TSI High
      Altitude Airships (“HAA’s”). The Airships are used primarily to provide
      persistent surveillance 24/7 and have been updated to include the latest
      tracking devices for troop and weapons movement. These Airships have unique
      capabilities such as the TSI SA 60 with altitude capabilities of up to 15,000
      feet and carry payload of up to 500 lbs, the TSI SA 90, with specifications
      including remaining airborne up to 48 hours, carrying payload up to 1,000 lbs,
      while maintaining station keeping at altitudes up to 20,000 feet.. The inventor
      and patent holder, Holken Colting, of 21 st Century
      Airships, holds the world’s attitude record for lighter-than-air airships with
      his successful flight reaching an altitude in excess of 20,000 feet. The U.S.
      Navy Naval Air Systems Command (NAVAIR) has historically awarded TSI with a
      series of technology proof of concept contracts.





Various
      U.S. Government agencies, including among others, the National Aeronautics
      and
      Space Administration, the Department Of Defense, and Department of Homeland
      Security have indicated interest and belief that the Airships can be
      instrumental in their respective future technology requirements. These interests
      were based upon testing demonstrations with the first operational prototype
      the
      TSI SA 60. Additionally, sensor and communication enhancements under development
      by outside contractors will be tested and ultimately fielded by the Company
      under joint ventures with external strategic partners to provide a fully
      integrated network from the ground to satellite.




3




As
      previously addressed, TSI under license from 21 st Century
      Airships has developed thus far two Airships. The first is the Low Altitude
      Airship (LAA). The LAA is a sixty foot airship for use in the commercial arena
      for product sponsorship. The second is the Mid Altitude Airship (MAA) which
      is
      90 feet in diameter and has an operational altitude of 10,000 to 20,000 feet,
      with a payload capacity of 1,000 pounds. The MAA has been developed for use
      by
      the government for surveillance, communications, and remote sensing. The MAA
      is
      in the prototype stage with completion scheduled for September 2007. The
      agencies that have requirements for the capabilities of this airship are as
      follows: Department of Defense, Department of Homeland Security, NASA, NOAA,
      Federal Bureau of Investigation, NSA, DEA, Department of Agriculture, Department
      of Commerce and the Merchant Marines. In addition, through our TSI subsidiary,
      it has an exclusive, worldwide license with 21st Century Airships, Inc. for
      the
      manufacture of its Airships.





Flying
      a
      21st Century Airships prototype, CEO Hokan Colting and co-pilot Tim Buss set
      an
      airship record for altitude, reaching 6,234 m (20,450 ft) on June 12, 2003,
      while flying between Alberta and Saskatchewan, Canada. The feat is certified
      by
      Federation Aeronautique Internationale,
      the governing body for aviation and space world records, as the absolute record
      in altitude for airships. In comparison, non-rigid, cigar-shaped airships can
      barely reach 1,500 m (5,000 ft). Eleven airships have been manufactured thus
      far
      by 21st Century and range from rudimentary prototypes to sophisticated, record
      breaking crafts





SNC
      issued to TSI the first purchase order for long lead items for the development
      project to build a high altitude airship. **** In
      addition, Naval Air Systems Command, or NAVAIR, has contracted with us to
      flight-test the SA-60 spherical Airship in order to evaluate its potential
      to
      satisfy future military and defense requirements. The SA-60 is manufactured
      by
      TSI. SNC has an exclusive agreement to be the sole integrator for the TSI
      Classified Government Airships which will provide technology, payload, and
      sensor integration for the ongoing project.





**Airship
      Leasing**





The
      Company’s purpose for Airship Leasing is to initially own, operate and conduct
      the Company’s future corporate sponsorship and additional commercial leasing
      activities through the Company (also the “Manager”) with its helium filled, Techspheres TM ,
      manufactured by TSI. It is contemplated that the Techspheres TM will be
      put into service under a corporate sponsorship agreement(s) to promote brand
      recognition as well as communication and other technology test operations.





The
      construction cost, to be performed by TSI, for the Low Altitude Techspheres TM is
      approximately $2.3 million each, including license fees owing to 12st Century
      Airships. In exchange for the Company’s two work-in-progress Airships, Cyber
      will receive Class II units and its contribution of TSI’s license rights
      pursuant to the 21 st Century
      Airship license agreement.





**Competition**





In
      2005,
      TSI formed TSI Holdings Co, LLC ("TSI, LLC") a Georgia limited liability
      company. On January 30, 2007, TSI reactivated TSI, LLC, in order to raise
      funds in order deploy two (2) SA-60 Airships. The Company’s intent is to sell an
      aggregate of twenty-five (25%) percent membership interest in TSI, LLC. Airship
      Leasing’s ownership structured shall consist of Class I Unit holders and the
      sole Class II Unit holder, Cyber Defense, Class I unit holders shall own,
      assuming the full subscription price of Units offered a total of 25 Units,
      for
      an aggregate subscription price of $2.5 million. Upon return from future
      positive net income of Class I Unit holder shall be entitled to twenty-five
      percent (25%) of future available net income for distribution, with the
      remaining seventy-five percent (75%) payable to the Class II Unit holder.




4




Cyber
      Defense UAV’s





We
      face
      competition from entities with far more substantial financial and human
      resources, together with far more access to procurement personnel in the
      military and the security industries. Our industry is highly competitive and
      characterized by rapid technological change. A number of UAV’s presently exist,
      both domestically and internationally. A buildup of domestic UAVs (promoted
      by
      the Department of Defense) occurred in the late 1980s and well into the 1990s.
      Depending on the mission requirements, UAVs may be classified in three
      categories: Close Range, Short Range and Endurance vehicles. Close Range is
      defined as within approximately 50 kilometers. Short Range is defined as within
      approximately 200 kilometers and Endurance is defined as anything beyond 200
      kilometers. Within these three categories of vehicles, approximately 22
      companies within the United States are or have been involved in UAV development.
      Our principal competitors include, but are not limited to: AAI Corporation,
      Lockheed Martin and Raytheon. Lockheed Martin has recently instituted a Skunk
      Works project with the Jet Propulsion Laboratory (JPL) and Raytheon also
      recently announced a UAV Program named Bike Shop. We do not anticipate that
      these companies will attempt to replicate the relatively inexpensive CyberBugTM
or CyberScoutTM because large multinational companies require a substantial
      return on investment prior to commencing any development efforts. Such companies
      will likely not be able to generate the types of returns necessary to consider
      entering the market. No assurance can be given, however, that these larger
      more
      resourceful competitors will not attempt to replicate our CyberBugTM or
      CyberScoutTM UAVs. If we do not continue to improve existing product lines,
      develop new products and technologies, our business could be materially
      adversely affected.





A
      number
      of UAV's presently exist, both domestically and internationally. Their payload
      weight carrying capability, accommodations (i.e., volume, environment, etc.),
      mission profile (i.e., altitude, range, duration, etc.) and their command,
      control and data acquisition capabilities vary significantly.





With
      the
      advent of newer technology, and with the demonstrated performance of the UAV's
      provided to the DoD by industry, the Close and Short Range categories have
      since
      been combined and a later separate Shipboard category has been added. The
      current classes or combinations of these type vehicles are presently called
      Tactical UAV followed by the Endurance category.





Within
      these three categories of vehicles, approximately 22 companies within the U.S.
      are or have been involved and represent approximately 45 different UAV
      configurations. See UAV characteristics chart for base platforms. Their known
      performance capabilities and payload accommodations are presented below. They
      range in size from hand-held to much larger vehicles with payload weight
      capabilities ranging from a few pounds to approximately 2000 pounds.


**UAV
      CHARACTERISTICS AVAILABLE**





UNMANNED
                AERIAL
              VEHICLE
            ENDURANCE
              (HOURS)
            PAYLOAD
                WEIGHT
              (POUNDS)
            ALTITUDE
                CAPABILITY
              (FEET)Aerosonde
            40.0
                hrs.
            2.2
                lbs.
            20,000
                ft.Altus2
            24.0
                hrs.
            330
                lbs.
            65,000
                ft.BQM-34
            1.25
                hrs.
            470
                lbs.
            60,000
                ft.Exdrone
            2.5
                hrs.
            25
                lbs.
            10,000
                ft.Global
                Hawk
            42
                hrs.
            1,960
                lbs.
            65,000
                ft.Gnat
                750
            48.0rs.
            140
                lbs.
            25,000
                ft.Pioneer
            5.5
                hrs.
            75.0
                lbs.
            12,000
                ft.Shadow
                200
            4.0
                hrs.
            50
                lbs.
            15,000
                ft.








We
      also
      face intense competition in the airship industry. Recently, manufacturers,
      such
      as Lockheed Martin, and certain research facilities, such as Johns Hopkins
      University, the University of Arizona and Georgia Tech Research Institute,
      have
      undertaken (through research grants from the U.S. Government and/or private
      funds) to develop mid to high altitude Airships. Without such grants or private
      financing, airship manufacturers would be unable to commence or complete
      research and development of high altitude Airships. Lockheed Martin recently
      received funding from the U.S. Government in the amount of $50 million via
      the
      HAA ACTD project. In addition, a start-up company, Sanswire Networks LLC, a
      subsidiary of GlobalTel Communications Corp., has unveiled a prototype Airship
      which it claims can fly to the near space above 65,000 foot altitude level.
      If
      our competition secures funding from the U.S. Government or other financing
      sources and completes prototypes of high altitude Airships before us, it could
      have a material, adverse effect on our business.




5




A
      lighter-than-air airship or dirigible is a buoyant lighter-than-air aircraft that can
      be steered and propelled through the air. Unlike aerodynamic vehicles such as fixed-wing
      aircraft and helicopters which
      stay aloft by moving an airfoil through
      the air in order to produce lift ,
      aerostatic craft such as airships and balloons stay
      aloft by filling a large cavity with lighter
      than air  gas .





Airships
      were the first aircraft to make controlled, powered flight. They were widely
      used prior to the 1940s .
      Their
      use decreased over time as their capabilities were surpassed by those of
      airplanes. A series of accidents, including the 1937 burning of the hydrogen -filled Hindenburg at
      Lakehurst, New Jersey, furthered their decline. Airships are still used today
      in
      certain niche applications however, including advertising and
      sightseeing.





There
      are
      numerous manufacturers of lighter-than-air, airships, many of which have greater
      financial resources that we do. A list of some of the industry participants
      include, among others, the following: 21st
      Century Airships , Advanced
      Hybrid Aircraft , Airship
      Management Services , American
      Blimp Corporation , Global
      Skyship Industries , Goodyear , Hua
      Jiao
      Airship Inc , Millennium
      Airship ,
      Ohio
      Airships, ROS
      Aero
      Systems , US
      LTA
      Corporation , Voliris , Varialift , WDL-Luftschiff
      GmbH ,
      World
      Skycat, World-Wide
      Aeros ,
      and Zeppelin .





As
      previously discussed, through TSI, the Company has acquired the world-wide
      right
      to license the proprietary technology of 21 st Century
      Airships. 21st Century Airships was founded in 1988 as a research and
      development company for lighter-than-air craft. Its primary objective is to
      improve traditional airship technology and develop modern, safe and
      cost-effective airships for a wide variety of applications. 21st Century’s most
      important achievement is the development of a new type of airship that is
      spherical and finless. An analogy would be the comparison of the traditional
      fixed wing aircraft verses the benefits in required environments for the rotary
      wing, helicopter. It features:





·
            An
                internal cabin for pilot and passenger(s), or in the case of unmanned
                flight - provides ability to carry payloads ranging from 400 to 4,000
                pounds;


·
            A
                hybrid diesel-electric power system with a low noise
                profile;


·
            The
                amphibious ability to land on and take-off from
                water;


·
            Internal
                illumination for spectacular visuals during night time
                flights;


·
            A
                basic design that is suitable for a number of diverse
                applications;


·
            Futuristic
                appearance;


·
            An
                outer envelope, or skin, made of Honeywell Corporation’s Spectra® fiber,
                one of the world’s strongest and lightest fibers. Spectra® is a bright
                white polyethylene and, pound-for-pound, ten times stronger than
                steel,
                and according to Honeywell, more durable than polyester and has a specific
                strength that is 40 percent greater than DuPont’s Aramid
                fiber;


·
            Unique
                ability to achieve high altitude quickly due to inner expandable
                envelope
                for Helium with air pressure differential against the outer Spectra®
                envelope wall;


o
            Inner
                envelope expansion factor provides for achieving altitudes in excess
                of
                60,000 feet, which traditional airships cannot
                achieve;


·
            The
                spherical structure with vectoring engines can lift off and land
                in a
                small confined space versus the landing field and manning requirements
                of
                the traditional airship; and


·
            Deployable
                in the field; a 5 to 6 person crew can off load, erect and deploy
                in the
                field within a day.





While
      many of the competitors mentioned above have designs and features unique to
      themselves, while there can be no assurances of success, the Company believe
      that the unique attributes of the 21 st Century
      Airship design mentioned above will position it well from a completive market
      environment.





**Sources
      and Availability of Raw Materials**





Raw
      materials for the production of the Company’s products are standard products and
      where necessary are selected from FAA certified venders. Certain of the
      Company’s venders require deposits which at times may negatively impact the
      Company’s operations based upon working capital constraints.





**Dependence
      on Major Customers**




6




For
      both
      the Cyber Defense and TSI business units, we expect that U.S. Government sales
      to agencies, such as Homeland Security, the Department of Defense and various
      U.S. intelligence services, will be the primary source of our revenue for the
      foreseeable future. Our ability to compete successfully for and retain business
      is highly dependent on technical excellence, management proficiency, strategic
      alliances, cost-effective performance and the ability to recruit and retain
      key
      personnel. U.S. Government programs are subject to uncertain future funding
      levels, which can result in the extension or termination of programs. Our
      business is also highly sensitive to changes in national and international
      priorities and U.S. Government budgets. Events like Operation Iraqi Freedom,
      the
      continued war on terrorism and nuclear proliferation in North Korea may
      positively or adversely affect funding for our programs or result in changes
      in
      U.S. Government programs or spending priorities. If the U.S. Government or
      other
      friendly countries with which we do business no longer consider the threat
      of
      terrorism a priority, no assurance can be given that our contracts with such
      governments will continue to be renewed. Accordingly, the loss of such contracts
      will have a material adverse affect on our business.





Assuming
      Airship Leasing is successful in its mission to secure commercial sponsorship
      agreements, it is contemplated that said agreements will provide for a term
      typically from between six to 12 months. It will be necessary for Airship
      Leasing to be able to secure alternative agreements in the event any then
      existing relationship is terminated either pursuant to a default or termination
      due to the non-renewal once a certain term expires.





**Intellectual
      Property**





We
      have
      filed for patent protection with the U.S. Patent and Trademark Office regarding
      the CyberBugTM, CyberScoutTM UAV’s and M.A.R.S.TM system. Our products rely on our
      proprietary technology, and we expect that future technological advancements
      made by us will be critical to sustain market acceptance of our products.
      Therefore, we believe that the protection of our intellectual property rights
      is, and will continue to be, important to the success of our business.
      Consequently, our ability to compete effectively will depend, in part, on our
      ability to protect our proprietary technology, system designs and manufacturing
      processes. Unauthorized parties may attempt to copy or otherwise obtain and
      use
      our products or technology. In particular, one of our competitors is attempting
      to develop a UAV which we believe replicates/copies the CyberBugTM and we served
      this company with notice requesting such company cease and desist from what
      we
      believe are activities that infringe upon our unique products. Monitoring
      unauthorized use of our intellectual property is difficult, and we cannot be
      certain that the steps we may take will prevent unauthorized use of our
      technology. In addition, the measures we undertake may not be sufficient to
      adequately protect our proprietary technology and may not preclude competitors
      from independently developing products with functionality or features similar
      to
      those of our product.





If
      the
      protection of our trademarks and proprietary rights is inadequate, our brand
      and
      reputation could be impaired and we could lose customers. The steps we take
      to
      protect our proprietary rights may be inadequate. We regard our copyrights,
      service marks, trademarks, trade dress, trade secrets and similar intellectual
      property as critical to our success. We rely on trademark and copyright law,
      trade secret protection and confidentiality or license agreements with our
      employees, customers, partners and others to protect our proprietary rights.
      The
      relationship between regulations governing domain names and laws protecting
      trademarks and similar proprietary rights is unclear. Therefore, we may be
      unable to prevent third parties from acquiring domain names that are similar
      to,
      infringe upon or otherwise decrease the value of our trademarks and other
      proprietary rights.





**Government
      Regulations**





U.S.
      Government agencies, such as the Defense Contract Audit Agency, or the DCAA,
      routinely audit and investigate government contractors. These agencies review
      a
      contractor’s performance under its contracts, cost structure and compliance with
      applicable laws, regulations and standards. The DCAA also reviews the adequacy
      of, and a contractor’s compliance with, its internal control systems and
      policies, including the contractor’s purchasing, property, estimating,
      compensation and management information systems. Any costs found to be
      improperly allocated to a specific contract will not be reimbursed, while such
      costs already reimbursed must be refunded. If an audit uncovers improper or
      illegal activities, we may be subject to civil and criminal penalties and
      administrative sanctions, including termination of contracts, forfeiture of
      profits, suspension of payments, fines and suspension or prohibition from doing
      business with the U.S. Government. In addition, we could suffer serious harm
      to
      our reputation if allegations of impropriety were made against us.




7




As
      a U.S.
      government contractor, we are subject to a number of procurement rules and
      regulations. We must comply with and are affected by laws and regulations
      relating to the formation, administration and performance of U.S. Government
      contracts. These laws and regulations, among other things:




·
            require
                certification and disclosure of all cost and pricing data in connection
                with contract negotiations;


·
            impose
                accounting rules that define allowable and unallowable costs and
                otherwise
                govern our right to reimbursement under certain cost-based U.S. Government
                contracts; and


·
            Restrict
                the use and dissemination of information classified for national
                security
                purposes and the exportation of certain products and technical
                data.


·
            We
                are currently engaged in final testing programs for both the TSI
                Airships,
                CyberScoutTM and CyberBugTM UAV’s and we plan future testing of the M.A.R.S.
                TM system or comparable systems currently being developed by the current
                the working airship group, such as, us, TSI and SNC. We recently
                secured
                an International Trafficking and Arms Regulation, or ITAR Agreement,
                from
                the U.S. Department of State. The ITAR Agreement will allow us to
                export
                our UAV’s to countries approved by the U.S. Government. We anticipate that
                a significant amount of our future revenues will be derived from
                overseas
                sales. If the ITAR Agreement is restricted in any way or revoked
                by the
                U.S. Government, we will be unable to expand our operations overseas
                and
                our business may be materially affected by such
                restrictions.


·
            Furthermore,
                licenses for the export of many of our products are required from
                government agencies in accordance with various statutory authorities,
                including the Export Administration Act of 1979, the International
                Emergency Economic Powers Act, the Trading with the Enemy Act of
                1917 and
                the Arms Export Control Act of 1976. We can give no assurance that
                we will
                be successful in obtaining these necessary licenses in order to conduct
                business abroad. In the case of certain sales of defense equipment
                and
                services to foreign governments, the U.S. Department of State must
                notify
                Congress at least 15 to 30 days, depending on the size and location
                of the sale, prior to authorizing these sales. During that time,
                Congress
                may take action to block the proposed sale.





Certain
      of the Company’s product are subject to the regulations of the FAA, specifically
      the UAV’s. Airships sold to the U.S. Government are not subject to said
      regulations as well as with prospective corporate sponsorship ventures in the
      commercial market.





With
      regard to UAV’s, FAA Advisory Circular 91-57 was issued in June of 1981. It
      spoke to the operation of model aircraft in the national air space (“NAS”). The
      requirement was that the vehicle stays below 400 feet AGL and in visual site
      of
      the operator or observer.




There
      was
      an AFS-400 memorandum (AFS-400 UAS Policy 05-01) dated September 16, 2005 that
      added clarification. While it addressed all UAV/UAS operations from ground
      to
      FL60 (60,000 feet), it did have specific direction for smaller UAV/UAS
      platforms. Paragraph 6.13 specifically stated that “UA (unmanned aircraft) that
      comply with the guidance in AC 91-57 are considered model aircraft and are
      not
      evaluated by the UA criteria in this policy”. AC 91-57 does not speak t
      commercial vs. hobby so it was interpreted that as long as the UA was flown
      in
      line of sight and below 400 feet, that compliance was addressed.




On
      February 13, 2007, the FAA issued Docket No. FAA 2006-25714; Notice No. 07-01.
      It clarified the FAA’s position regarding UAV/UAS/UA operations in the NAS. It
      states that either a Certificate of Authorization (COA) or A Special
      Airworthiness Certificate or compliance with AC 91-57 is required to operate
      in
      the NAS. It further states that 91-57 is not applicable to commercial
      enterprises.




The
      position that Cyber Defense took for flight for its own use was to pursue the
      Special Airworthiness Certificate. The Cyber Defense CyberBug UAV completed
      the
      first phase of a two phase program outline by the FAA. The first phase included
      a presentation of the company and vehicle. The plan is to complete all of the
      action items prior to the second FAA visit and be awarded an Airworthiness
      Certificate at that time. This will allow for restricted operation in the NAS
      of
      the CyberBug. It will also allow for acquisition of flight data to support
      adding additional flight privileges in the NAS. The next FAA visit is scheduled
      for June 14/15, 2007.




8




Government
      agencies such as law enforcement would want to apply for a COA to operate in
      their area of interest. In 2006 the U.S. Forestry Service obtained a COA to
      operate a CyberBug.





Our
      business is also subject to a wide range of general and industry specific
      environmental, health and safety and federal, state and local laws and
      regulations, including those relating to air emissions, wastewater discharges,
      solid and hazardous waste management and disposal and site remediation.
      Compliance with these laws and regulations is a significant factor in our
      business. We, as well as some of our competitors, may incur significant capital
      and operating expenditures to achieve and maintain compliance with applicable
      environmental laws and regulations. Our failure to comply with applicable
      environmental laws and regulations or permit requirements could result in
      substantial civil or criminal fines or penalties or enforcement actions,
      including regulatory or judicial orders enjoining or curtailing operations
      or
      requiring remedial or corrective measures, installation of pollution control
      equipment or other actions. We may be responsible under environmental laws
      and
      regulations for the investigation, remediation and monitoring, as well as
      associated costs, expenses and third party damages, including tort liability
      relating to past or present releases of hazardous substances on or from any
      properties in which we operate. Liability under these laws may be imposed
      without regard to whether we knew of, or were responsible for, the presence
      of
      those substances on our property and may not be limited to the value of the
      property. We may also be responsible under environmental laws and regulations
      for the investigation, remediation and monitoring, as well as associated costs,
      expenses and third party damages, including tort liability, related to
      facilities or sites to which we have sent hazardous waste materials. In
      addition, situations may give rise to material environmental liabilities that
      have not yet been discovered. New environmental laws (or regulations or changes
      in existing laws) may be enacted that require significant expenditures by us.
      If
      the resulting expenses significantly exceed our expectations, our business,
      financial condition and operating results might be materially affected.





**Research
      and Development**




Research
      and development costs for 2006 were $281,380 compared to $691,660 in 2005.
      The
      decrease is primarily due to reduced research and development efforts in 2006
      due primarily to reduced non-recurring engineering costs in the development
      of
      TSI’s airships.





**EMPLOYEES**





As
      of the
      date hereof, we have 12 full-time employees. Of these employees, 3 serve in
      management and administrative positions, 2 serve in research & development,
      5 serve in manufacturing, and 2 serve in business development.





None
      of
      our employees are covered by a collective bargaining agreement. We have never
      experienced a work stoppage and we believe that we have satisfactory working
      relations with our employees.





**ITEM
      2.**  **DESCRIPTION
      OF PROPERTY**





Cyber
      owns no real property. We are located at 10901 Roosevelt Boulevard Suite 100D
      in
      St. Petersburg, Florida. This facility is over 3,500 square feet and houses
      our
      corporate headquarters, R&D facilities and is being readied for final
      assembly of our CyberBugTM and CyberScout product. We currently pay rent of
      $3,596 per month. Techsphere leases office, warehouse and manufacturing space
      in
      Columbus, GA for $7,800 per month and that lease expired in February, 2007
      and
      is currently continuing on a month to month.basis.





All
      of
      our facilities are in good repair.





We
      believe that our existing facilities will be adequate to meet our needs for
      the
      foreseeable future. Should we need additional space, management believes it
      will
      be able to secure additional space at commercially reasonable
      rates.




9




We
      do not
      have any investment policies with respect to investments in (i) real estate
      or
      interests in real estate, (ii) investments in real estate mortgages and (iii)
      securities of or interests in persons primarily engaged in real estate
      activities .
      We have
      no policy with respect to investments in securities of or interests in persons
      primarily engaged in real estate activities.





**ITEM
      3.**  **LEGAL
      PROCEEDINGS**





We
      are
      not a party to any material legal proceedings, nor are any legal proceedings
      pending or threatened, other than those arising in the ordinary course of
      business. We are not aware of any legal proceedings contemplated by any
      governmental authorities involving us. None of our directors, officers or
      affiliates is an adverse party in any legal proceedings involving us or our
      subsidiaries, or has an interest in any proceeding which is adverse to us or
      our
      subsidiaries.





**ITEM
      4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS**





There
      were no matters submitted for stockholders' vote during the fiscal year 2006.





10





**PART
      II**





**ITEM
      5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS**





As
      of May
      15, 2007, there were approximately 246 record owners of our common stock, which
      is traded on the OTC Bulletin Board under the symbol CDF.OB Set forth below
      are
      the range of high and low bid quotations for the periods indicated as reported
      by the OTC Bulletin Board. The market quotations reflect interdealer prices,
      without retail mark-up, mark-down or commissions and may not necessarily
      represent actual transactions.


Quarter
                  Ending
              
              High
              
              Low3/31/02
              
              $
              3.30
              
              $
              0.356/30/02
              
              $
              0.35
              
              $
              0.049/30/02
              
              $
              0.10
              
              $
              0.0112/31/02
              
              $
              0.01
              
              $
              0.013/31/03
              
              $
              0.01
              
              $
              0.006/30/03
              
              $
              0.04
              
              $
              0.019/30/03
              
              $
              0.20
              
              $
              0.0112/31/03
              
              $
              0.15
              
              $
              0.063/31/04
              
              $
              0.10
              
              $
              0.046/30/04
              
              $
              0.06
              
              $
              0.029/30/04*
              
              $
              0.01
              
              $
              1.8112/31/04
              
              $
              2.50
              
              $
              1.503/30/05
              
              $
              3.65
              
              $
              2.006/30/05
              
              $
              0.52
              
              $
              0.279/30/05
              
              $
              0.52
              
              $
              0.2212/31/05
              
              $
              0.60
              
              $
              0.273/31/06
              
              $
              0.60
              
              $
              0.276/30/06
              
              $
              0.55
              
              $
              0.179/30/06
              
              $
              0.30
              
              $
              0.1212/31/06
              
              $
              0.20
              
              $
              0.11








*
      Reverse
      stock split 1:30 effected on September 1, 2004.





Holders
      of common stock are entitled to receive dividends as may be declared by our
      Board of Directors and, in the event of liquidation, to share pro rata in any
      distribution of assets after payment of liabilities. The Board of Directors
      has
      sole discretion to determine: (i) whether to declare a dividend; (ii) the
      dividend rate, if any, on the shares of any class of series of our capital
      stock, and if so, from which date or dates; and (iii) the relative rights of
      priority of payment of dividends, if any, between the various classes and series
      of our capital stock. We have not paid any dividends and do not have any current
      plans to pay any dividends.





The
      Company did not adopt a compensation plan or employee benefit plan in 2006;
      however, the 2005 Stock option Plan has been approved by the shareholders in
      2006.





11





**Recent
      Sales of Unregistered Securities**





We
      made
      the following unregistered sales of securities in 2006:




On
      April
      20, 2006, the Company issued an aggregate of 337,618 shares of its Class A
      common stock at a price of $0.53 valued at $178,938 to vendors in exchange
      for
      services and to settle existing obligations of the Company.




On
      April
      20, 2006 the Company issued 55,000 shares of its Class A common stock upon
      the
      conversion of $11,000 of accounts payable by David Barnes, its Chief Financial
      Officer at the price of $0.20 per share.




On
      April
      20, 2006 the Company issued an aggregate of 937,776 shares of its Class A common
      stock upon the conversion of related party convertible notes at a conversion
      price of $0.30 for a total amount of $281,333.




On
      April
      20, 2006 the Company issued an aggregate of 966,667 shares of its Class A common
      stock upon the conversion of unrelated convertible notes at a conversion price
      of $0.30 for a total amount of $290,000.




On
      June
      6, 2006 the Company issued 609,300 shares of its Class A common stock to AJW
      upon conversion of $114,487 of their convertible notes at a conversion price
      of
      $0.1879.




On
      June
      28, 2006 the Company issued 476,043 shares of its Class A common stock upon
      conversion of $142,813 of unrelated convertible notes at a conversion price
      of
      $0.30. On September 28, 2006 the Company issued an additional 317,362 shares
      of
      Class A common stock to relative to an agreement lowering the conversion price
      from $0.30 to $0.18.




On
      July
      21, 2006 the Company issued 46,666 shares of its Class A common stock upon
      the
      conversion of $7,000 of accounts payable by its Chief Financial Officer, David
      M. Barnes at a price of $0.15 per share.




On
      July
      21, 2006 the Company issued 616,000 shares of its Class A common stock at a
      price of $0.18 per share valued at $110,880 to vendors for services
      rendered.




On
      July
      21, 2006 the Company issued 106,000 shares of its Class A common stock to
      Equipment Depot in conversion of their Note and all related accrued interest
      of
      $26,500 at a conversion price of $0.25 per share.




On
      September 18, 2006 the Company issued 609,846 shares to AJW upon conversion
      of
      $63,424 of their Notes at a conversion price of $0.104 per share.




On
      September 28, 2006 the Company issued 300,097 shares of its Class A common
      stock
      upon conversion of $60,019 of unrelated convertible notes and related interest
      at a conversion price of $0.20.




On
      September 28, 2006 an aggregate of 4,496,162 shares were issued pursuant to
      the
      exercise of options as discussed above.




On
      September 28, 2006 the Company issued an additional 317,362 shares of Class
      A
      common stock valued at $57,125 to Mayo Hadden valued at $0.18 per share
      representing the market price as June 28, 2006, the date of the conversion
      of
      the remaining balance of his note.




12


**ITEM
      6. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION OR PLAN OF
      OPERATIONS**


**Forward
      Looking Statements**


*The
      Company is including the following cautionary statement in this Annual Report
      of
      Form 10-KSB to make applicable and take advantage of the safe harbor provisions
      of the Private Securities Litigation Reform Act of 1995 for any forward-looking
      statements made by, or on behalf of, the Company. Forward-looking statements
      include statements concerning plans, objectives, goals, strategies, future
      events or performance and underlying assumptions and other statements which
      are
      other than statements of historical facts. Certain statements contained herein
      are forward-looking statements and accordingly involve risks and uncertainties
      which could cause actual results or outcomes to differ materially from those
      expressed in the forward-looking statements. The Company's expectations, beliefs
      and projections are expressed in good faith and are believed by the Company
      to
      have a reasonable basis, including without limitation, management's examination
      of historical operating trends, data contained in the Company's records and
      other data available from third parties, but there can be no assurance that
      management's expectation, beliefs or projections will result or be achieved
      or
      accomplished. In addition to other factors and matters discussed elsewhere
      herein, the following are important factors that, in the view of the Company,
      could cause actual results to differ materially from those discussed in the
      forward-looking statements: technological advances by the Company's competitors,
      changes to regulatory requirements relating to DoD approvals, capital needs
      to
      fund any delays or extensions of development programs, delays in the manufacture
      of new and existing products by the Company or third party contractors, the
      loss
      of any key employees, the outcome of existing litigations, delays in obtaining
      federal, state or local regulatory clearance for new installations and
      operations, changes in governmental regulations, and availability of capital
      on
      terms satisfactory to the Company. The Company disclaims any obligation to
      update any forward-looking statements to reflect events or circumstances after
      the date hereof.*




**General**




The
      following discussion and analysis should be read in conjunction with the
      Consolidated Financial Statements and notes thereto appearing elsewhere in
      this
      Report. In addition, at December 31, 2005 and 2006, our auditors, Hansen,
      Barnett & Maxwell, the Company's Independent Registered Public Accounting
      Firm, raised substantial doubt about our ability to continue as a going concern.




**Results
      of Operations**




The
      Year
      Ended December 31, 2006 as compared to December 31, 2005




Revenues
      in 2006 were $494,220 in fiscal 2006 as compared to $461,244 in fiscal 2005.
      Sales for Cyber for fiscal 2006 were $250,188 compared to $137,256 for fiscal
      2005. The increase is primarily due to increased sales of the Cyber Bug. Sales
      in fiscal 2006 for TSI were $242,907 compared to $323,988 in 2005. Sales in
      fiscal 2005 were from the date of acquisition of September 19, 2005. The
      decrease is primarily due to a decrease in revenues from a major customer of
      TSI
      during fiscal 2006.




Cost
      of
      sales for fiscal 2006 totaled $223,388 as compared to $449,995 in 2005. Cost
      of
      sales for fiscal 2006 for Cyber totaled $117,299 as compared to $117,548 for
      fiscal 2005. The decrease is due primarily to manufacturing efficiencies during
      2006. Cost of sales for TSI for fiscal 2006 totaled $106,089 as compared to
      $332,447 for fiscal 2005 were from the date of acquisition of September 19,
      2005. The decrease is due to better cost management achieved from outsourcing
      certain functions in 2006.




Research
      and development costs for 2006 were $281,380 compared to $691,660 in 2005.
      The
      decrease is primarily due to reduced research and development efforts in 2006
      due primarily to reduced non-recurring engineering costs in the development
      of
      TSI’s airships




General
      and administrative expenses totaled $6,486,104 for the year ended December
      31,
      2006 as compared to $4,031,236 for the year ended December 31, 2005, a net
      increase of $2,454,868. The net increase is primarily due to $3,462,999 of
      expenses of TSI for fiscal 2006. In fiscal 2005, TSI incurred $928,055 from
      the
      date of acquisition of September 19, 2005 to December 31, 2005.




Stock
      option compensation expense for the fiscal 2006 totaled $2,271,687 relating
      to
      the fair value of stock options that vested or were accelerated during the
      period, an increase of $2,170,501 as compared to the fiscal 2005 expense of
      $$101,186. The increase is due to the normal and accelerated vesting of the
      options granted on September 19, 2005 effective September 28, 2006 that resulted
      in aggregate compensation expense of $1,681,412. In addition, the Company
      granted an additional 3,575,000 options during fiscal 2006 which vested upon
      grant resulting in compensation expense of $589,875.




13




The
      impairment loss of $11,330,674 for fiscal 2006 is related to the exclusive
      manufacturing license from 21st Century Airships. Management determined that
      the
      asset was impaired due to the reduced expected revenues and cash flows for
      the
      license, creating the impairment. The impairment of goodwill in the amount
      of
      $4,577,069 for the fiscal 2005 pertains to goodwill associated with the
      acquisition of Cyber Aerospace.




Other
      income and expense for the year ended December 31, 2006 and 2005 was comprised
      of interest expense, interest income and derivative valuation gains or losses.
      Interest expense for the year ended December 31, 2006 was $3,193,247, of which
      $$2,359,464 represents amortization of discounts on notes to AJW, Mr. Robinson,
      Mr. Lively and James Gardiner. Interest expense for fiscal 2005 was $2,459,269
      of which $1,237,667 represents amortization of discounts on notes to AJW. Other
      income and expense for the fiscal 2005 includes interest income of $4,689,
      for
      which no amount exists for the fiscal 2006.








The
      components of the derivative valuation gains (losses) for the years ended
      December 31, 2006 and 2005 are presented in the following table:


Year
                  ended December 31,2006
              
              2005Derivative
                  valuation (loss) on issuance of notes - AJW
              
              
              ($2,451,967
              )
              
              ($3,313,576
              )Derivative
                  valuation (loss) on issuance of warrants -AJW
              
              
              (663,080
              )
              
              (11,046,172
              )Derivative
                  valuation (loss) on conversion -AJW
              
              
              (58,489
              )
              
              (162,217
              )Derivative
                  valuation gain on conversion -Robinson
              
              
              20,010
              
              
              -Derivative
                  valuation gain on conversion -Lively
              
              
              4,193
              
              
              -Derivative
                  valuation gain on conversion -Gardiner
              
              
              840
              
              
              -Derivative
                  valuation (loss) on issuance of note - Gardiner
              
              
              (37,050
              )
              
              -Derivative
                  valuation (loss) on issuance of note- Robinson
              
              
              (368,608
              )
              
              -Derivative
                  valuation (loss) - beneficial conversion revaluation -
                  Robinson
              
              
              757,019
              
              
              -Derivative
                  valuation (loss) on issuance of notes - Lively
              
              
              (58,306
              )
              
              -Derivative
                  valuation (loss) - beneficial conversion revaluation -
                  Lively
              
              
              106,799
              
              
              -Derivative
                  valuation (loss) - beneficial conversion revaluation -
                  Gardiner
              
              
              (20,520
              )
              
              -Derivative
                  valuation gain (loss) - warrant revaluation AJW
              
              
              1,240,536
              
              
              10,634,976Derivative
                  valuation gain (loss)- beneficial conversion revaluation -
                  AJW
              
              
              2,563,741
              
              
              (2,295,177
              )$
              1,035,118
              
              
              ($6,182,166
              )




The
      derivative gain for the year ended December 31, 2006 relates primarily to the
      decrease in the value of the common stock for the year ended December 31, 2006.
      The stock price was $0.40 as of December 31, 2005 as compared to $0.155 as
      of
      December 31, 2006. As a result of the decrease of the stock price, the valuation
      of the underlying derivatives decreased significantly. As a result, since the
      Company recognizes a gain or loss dependant upon the change in valuation at
      each
      reporting date, the decrease in the liability related to this value as of
      December 31, 2006 when compared to the December 31, 2005 resulted in gains,
      most
      notably in the AJW and Robinson Note beneficial conversion valuation.




14




**Legal
      Contingencies**




We
      may be
      subject to proceedings, lawsuits and other claims, including proceedings under
      laws and government regulations related to the environment, labor, product
      and
      other matters. We are required to assess the likelihood of any adverse judgments
      or outcomes to these matters, as well as potential ranges of probable losses.
      A
      determination of the amount of reserves required, if any, for these
      contingencies is based on a careful analysis of each individual issue with
      the
      assistance of outside legal counsel. The required reserves may change in the
      future due to new developments in each matter or changes in approach such as
      a
      change in settlement strategy in dealing with these matters. On December 31,
      2006, there are no outstanding legal proceedings, nor are there any reserves
      established.




**Liquidity
      and Capital Resources**




The
      Company's primary needs for liquidity and capital resources are the funding
      of
      salaries, and other administrative expenses related to the management of the
      Company as well as for payment of the cost of products sold and
      inventory.




The
      Company's cash and cash equivalents of $86,703 as of December 31, 2006 are
      not
      sufficient to support current levels of operations for the next twelve months
      and it will be necessary for the Company to seek additional
      financing.




Subsequent
      to year end, on May 8, 2007, the Company received $335,000 pursuant to a
      Securities Purchase Agreement dated May 8, 2007 with AJW in exchange for 6%
      Callable Secured Convertible Notes and issued five year warrants to purchase
      20,033,500 shares of common stock priced at $0.07. The Notes are convertible
      into common stock of the Company at a 60% discount to market pursuant to the
      terms of the Secured Convertible Note agreements. The conversion of the Notes
      is
      subject to an effective Registration Statement. The Notes are secured by all
      of
      the Company's assets, except for its accounts receivable and proceeds of
      inventory. This financing is not considered adequate to sustain the Company’s
      operations.




The
      Company is in negotiations with a potential lending source, but there can be
      no
      assurance that these negotiations will be successful or that the Company will
      obtain sufficient financing or that financing(s) will be structured on agreeable
      terms.




Subject
      to the realization of certain financings as described above we should be in
      a
      position to fund the anticipated level of operations for at least one year.
      However, there can be no assurances that this will be the case. If we are unable
      to obtain sufficient financing, the Company will be forced to severely curtail
      or even cease operations.




**Critical
      Accounting Policies**




Our
      discussion and analysis of its financial condition and results of operations
      are
      based upon Cyber Defense's financial statements, which have been prepared in
      accordance with accounting principles generally accepted in the United States.
      The preparation of these financial statements requires the use of estimates
      that
      affect the reported amounts of assets, liabilities and expenses. We evaluate
      our
      estimates on an ongoing basis, including estimates for income tax assets and
      liabilities and the impairment of the value of investments. We base our
      estimates on historical experience and on actual information and assumptions
      that are believed to be reasonable under the circumstances at that time. Actual
      results may differ from these estimates under different assumptions or
      conditions. We believe that the following critical accounting policies affect
      its more significant estimates used in the preparation of its financial
      statements.




**Accounting
      for Income Taxes**




No
      income
      taxes have been paid or accrued because the Company had no net income for the
      fiscal year ended December 31, 2006 or 2005. The Company recognizes the amount
      of income taxes payable or refundable for the current year and recognizes
      deferred tax assets and liabilities for the future tax consequences attributable
      to differences between the financial statement amounts of certain assets and
      liabilities and their respective tax bases. Deferred tax assets and deferred
      tax
      liabilities are measured using enacted tax rates expected to apply to taxable
      income in the years those temporary differences are expected to be recovered
      or
      settled. Deferred tax assets are reduced by a valuation allowance to the extent
      that uncertainty exists as to whether the deferred tax assets will ultimately
      be
      realized.




15




**Impairment
      of Investments**




Long-lived
      assets are reviewed for impairment quarterly or when events or changes in
      circumstances indicate that the carrying amount may not be recoverable.
      Recoverability of assets to be held and used is measured by comparison of the
      carrying amount of an asset to future net cash flows expected to be generated
      by
      the asset. If such assets are considered to be impaired, the impairment to
      be
      recognized is measured by the amount that the carrying amount of the assets
      exceeds the fair value of the assets.




On
      March
      31, 2005, the Company acquired the 6.19% minority interest in its majority
      owned
      subsidiary, Aerospace, and merged Aerospace into Cyber Defense. As part of
      the
      acquisition, the goodwill arising from the required purchase accounting in
      the
      amount of $4,577,069 was impaired and recorded in the financial statements
      for
      the year ended December 31, 2005.




With
      the
      acquisition of TSI in September, 2005 the Company acquired an exclusive,
      worldwide license with 21st Century Airships, Inc. for the manufacture of its
      airships. The value recorded for the license was $14,255,649 pursuant to an
      independent valuation which was originally being amortized over the 18 year
      life
      of the license, resulting in monthly amortization of $65,998 through September
      30, 2006. On September 30, 2006 management determined that the value of this
      asset was impaired. As a result of this determination, the Company recorded
      an
      impairment loss for $11,330,674 for the year ended December 31, 2006. In
      addition, management determined the estimated remaining useful life to be 7
      years from September 30, 2006. The book value of the asset was reduced to
      $2,100,000.




**Derivative
      Securities**




The
      Company does not hold or issue derivative instruments for trading purposes.
      However, the Company has convertible notes payable that contain embedded
      derivatives that require separate valuation from the convertible notes under
      Emerging Issues Task Force Abstract (EITF) 00-19, Accounting for Derivative
      Financial Instruments Indexed to, and Potentially Settled in, a Company's Own
      Stock. The Company recognizes these derivatives as liabilities in the
      accompanying balance sheet and measures them at estimated fair value each
      quarter, and recognizes changes in estimated fair value in the statement of
      operations in the respective period. The Company has estimated the fair value
      of
      these embedded derivatives using the Black-Scholes model.




**Recent
      Accounting Pronouncements**




In
      February 2006, the FASB issued Statement of Financial Accounting Standards
      No.
      155, "Accounting for Certain Hybrid Financial Instruments," referred to as
      SFAS
      No. 155. This statement amends SFAS No. 133 "Accounting for Derivative
      Instruments and Hedging Activities" and SFAS No. 140 "Accounting for Transfers
      and Servicing of Financial Assets and Extinguishments of Liabilities." SFAS
      No.
      155 permits fair value remeasurement for hybrid financial instruments that
      contain embedded derivatives that would require separate accounting. In
      addition, the statement establishes a requirement to evaluate interests in
      securitized financial assets to identify interests that are freestanding
      derivatives or that are hybrid financial instruments that contain embedded
      derivatives. SFAS No. 155 is effective for all financial instruments acquired
      or
      issued beginning after an entity's fiscal year beginning on or after September
      15, 2006 with earlier adoption permitted. Management believes this Statement
      will have no impact on the financial statements of the Company once
      adopted.




In
      March
      2006, the FASB issued FASB Statement No. 156, which amends FASB Statement No.
      140. This Statement establishes, among other things, the accounting for all
      separately recognized servicing assets and servicing liabilities. This Statement
      amends Statement 140 to require that all separately recognized servicing assets
      and servicing liabilities be initially measured at fair value, if practicable.
      This Statement permits, but does not require, the subsequent measurement of
      separately recognized servicing assets and servicing liabilities at fair value.
      An entity that uses derivative instruments to mitigate the risks inherent in
      servicing assets and servicing liabilities is required to account for those
      derivative instruments at fair value. Under this Statement, an entity can elect
      subsequent fair value measurement to account for its separately recognized
      servicing assets and servicing liabilities. By electing that option, an entity
      may simplify its accounting because this Statement permits income statement
      recognition of the potential offsetting changes in fair value of those servicing
      assets and servicing liabilities and derivative instruments in the same
      accounting period. This Statement is effective for financial statements for
      fiscal years beginning after September 15, 2006. Earlier adoption of this
      Statement is permitted as of the beginning of an entity's fiscal year, provided
      the entity has not yet issued any financial statements for that fiscal year.
      Management believes this Statement will have no impact on the financial
      statements of the Company once adopted.




16




In
      June,
      2006 the FASB issued FIN 48, "Accounting for Uncertainty in Income Taxes--an
      interpretation of FASB Statement No. 109". This Interpretation clarifies, among
      other things, the accounting for uncertainty in income taxes recognized in
      an
      enterprise's financial statements in accordance with FASB Statement No. 109,
      Accounting for Income Taxes. This Interpretation prescribes a recognition
      threshold and measurement attribute for the financial statement recognition
      and
      measurement of a tax position taken or expected to be taken in a tax return.
      This Interpretation also provides guidance on derecognition, classification,
      interest and penalties, accounting in interim periods, disclosure, and
      transition and is effective for fiscal years beginning after December 15, 2006.
      Earlier application is encouraged if the enterprise has not yet issued financial
      statements, including interim financial statements, in the period the
      Interpretation is adopted. FIN 48, Accounting for Uncertainty in Income
      Taxes--an interpretation of FASB Statement No. 109, is effective for fiscal
      years beginning after December 15, 2006. Earlier application is encouraged
      if
      the enterprise has not yet issued financial statements, including interim
      financial statements, in the period the Interpretation is adopted. Management
      believes this Statement will have no impact on the financial statements of
      the
      Company once adopted.




In
      September 2006, the FASB issued SFAS No. 157, "Fair Value Measures" ("SFAS
      157"). SFAS 157 defines fair value, establishes a framework for measuring fair
      value, and expands disclosures about fair value measurements. This statement
      applies under other accounting pronouncements that require or permit fair value
      measurements. However, it does not apply to SFAS 123(R). This statement shall
      be
      effective for financial statements issued for fiscal years beginning after
      November 15, 2007, and interim periods within those fiscal years. Earlier
      application is encouraged, provided that the reporting entity has not issued
      financial statements for that fiscal year, including any financial statements
      for an interim period within that fiscal year. The provisions of this statement
      should be applied prospectively as of the beginning of the fiscal year in which
      this Statement is initially applied, except in some circumstances where the
      statement shall be applied retrospectively. The Company is currently evaluating
      the effect, if any, of SFAS 157 on its financial statements.




In
      September 2006, the FASB issued SFAS No. 158, "Employers' Accounting for Defined
      Benefit Pension and Other Postretirement Plans--an amendment of FASB Statements
      No. 87, 88, 106, and 132(R)" ("SFAS 158"). This Statement requires recognition
      of the overfunded or underfunded status of a defined benefit postretirement
      plan
      (other than a multiemployer plan) as an asset or liability in its statement
      of
      financial position and to recognize changes in that funded status in the year
      in
      which the changes occur through comprehensive income. It also requires an
      employer to measure the funded status of a plan as of the date of its year-end
      statement of financial position. The statement is effective as of the end of
      the
      fiscal year ending after December 15, 2006. Management believes that adoption
      of
      this standard will not have a material impact on the Company's financial
      statements.




In
      September, 2006 the Securities and Exchange Commission issued Staff Accounting
      Bulletin 108 ("SAB 108"), "Considering the Effects of Prior year Misstatements
      When Quantifying Misstatements in Current Year Financial Statements." SAB 108
      clarifies the staff's views regarding the process of quantifying financial
      statement misstatements. More specifically, the staff noted that certain
      registrants do not consider the effects of prior year errors on current year
      financial statements, thereby allowing improper assets or liabilities to remain
      unadjusted. The staff believes this approach is not in the best interests of
      the
      users of the financial statements. SAB 108 is effective for fiscal years ending
      on or after November 15, 2006 with earlier adoption encouraged. The Company
      is
      currently evaluating the impact that the adoption of SAB 108 will have, if
      any,
      on its financial statements and notes thereto.




In
      December 2006, the FASB issued EITF 00-19-2, “Accounting for Registration
      Payment Arrangements.” This FASB Staff Position (FSP) addresses an issuer’s
      accounting for registration payment arrangements. This FSP specifies that the
      contingent obligation to make future payments or otherwise transfer
      consideration under a registration payment arrangement, whether issued as a
      separate agreement or included as a provision of a financial instrument or
      other
      agreement, should be separately recognized and measured in accordance with
      FASB
      Statement No. 5, “Accounting for Contingencies.” The guidance in this FSP
      amends FASB Statements No. 133, “Accounting for Derivative Instruments and
      Hedging Activities,” and No. 150, “Accounting for Certain Financial
      Instruments with Characteristics of both Liabilities and Equity,” and FASB
      Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements
      for Guarantees, Including Indirect Guarantees of Indebtedness of Others,” to
      include scope exceptions for registration payment arrangements. This FSP further
      clarifies that a financial instrument subject to a registration payment
      arrangement should be accounted for in accordance with other applicable
      generally accepted accounting principles (GAAP) without regard to the
      contingent obligation to transfer consideration pursuant to the registration
      payment arrangement.




17




In
      February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
      Financial Assets and Financial Liabilities”, including an amendment of FASB
      Statement No. 115 (“SFAS 159”). This pronouncement permits entities to choose to
      measure many financial instruments and certain other items at fair value that
      are not currently required to be measured at fair value and to recognize the
      resulting gains and losses in the results of operations. SFAS 159 is effective
      as of the beginning of an entity’s first fiscal year that begins after November
      15, 2007. The impact of adopting SFAS 159 on the Company’s consolidated
      financial statements, if any, has not yet been determined.





**ITEM
      7. FINANCIAL STATEMENTS**





The
      Consolidated Financial Statements are included after the Exhibit Index beginning
      on page F-1 of this Annual Report.





**ITEM
      8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
      DISCLOSURE**





None.





**ITEM
      8A. CONTROLS AND PROCEDURES**





The
      Company's principal executive officer and principal financial officer, based
      on
      his evaluation of the Company's disclosure controls and procedures (as defined
      in Rules 13a-14(c) and 15d-14(c) of the Securities Exchange Act of 1934, as
      amended) as of December 31, 2006 have concluded that the Company's disclosure
      controls and procedures are adequate and effective to ensure that material
      information relating to the Company are recorded, processed, summarized and
      reported within the time periods in which this Annual Report has been prepared.





The
      Company's principal executive officer, who is also our principal financial
      officer, has concluded that there were no significant changes in the Company's
      internal controls or in other factors that could significantly affect these
      controls for the year ended December 31, 2006, the date of his most recent
      evaluation of such controls, and that there were no significant deficiencies
      or
      material weaknesses in the Company's internal controls.





**ITEM
      8B. OTHER INFORMATION**





None




18





**PART
      III**





**ITEM
      9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE
      WITH
      SECTION 16(A) OF THE EXCHANGE ACT.**





**Directors
      and Executive Officers**





As
      of May
      15, 2007, the Directors and executive officers of the Company are presented
      below.


NAME
              AGE
              TITLEWilliam
                  C. Robinson
              51
              Director,
                  Chairman, CEO,Secretary
                  & TreasurerJoseph
                  A. Grace, Jr.
              48
              DirectorStephen
                  I. Johnson RADM USN (ret.)
              59
              DirectorMichael
                  Lawson
              50
              Director,
                  President TSIFrank
                  Lively
              71
              DirectorMarinko
                  Vekovic
              53
              DirectorJames
                  Alman
              45
              Vice
                  President EngineeringDavid
                  Barnes
              64
              CFO





The
      principal occupations and brief summary of the background of each Director
      and
      executive officer of Cyber Defense during the past five years is as follows:





**William
      C. Robinson - Founder/CEO/CFO, and Chairman of the Board of Directors**





Mr.
      Robinson has more than 20 years experience in the public equity markets,
      including management positions at Paine Webber, and Prudential Securities.
      Mr.
      Robinson has performed as a successful start-up entrepreneur, and as a corporate
      officer and director of eight public companies. He brings seasoned operational,
      fund-raising, and merger and acquisition skills to the Cyber Defense team.
      As a
      principal, he has been responsible for initiating and negotiating more than
      $100,000,000 worth of merger and acquisition transactions and has developed,
      bought, and sold more than 20 companies, eight of which were from inception
      to
      full public company status. From April 2000 until October 2003, Mr. Robinson
      was
      CEO/CFO/President of Trivia Group, Inc. From April 2001 until October 2003,
      Mr.
      Robinson was CEO/CFO/President of Computer Support Associates, Inc. From March
      2003 until April 2005, Mr. Robinson was CEO/CFO of Cyber Aero, our former
      subsidiary.





Mr.
      Robinson is also the CEO/CFO and Chairman of the Board of Directors of Proxity.
      Proxity specializes in the deployment and integration of security protection
      technology and government contract fulfillment. Trading in the Common Stock
      of
      Proxity is reported in the inter-dealer quotation system maintained by the
      National Quotation Bureau, Inc. and the Pink Sheets under the symbol "PRXT."
      Mr.
      Robinson is also the General Partner of Cherokee Raiders, L.P., a family limited
      partnership.





Both
      Proxity and Cherokee are affiliates of the Company.





**Joseph
      A. Grace, Jr. - Director**





Mr.
      Grace
      is a 1980 graduate of the United States Naval Academy. He received his MBA
      from
      the University of New Orleans. After serving almost nine years as a nuclear
      submarine officer, he left the active duty Navy to take a position with a
      Fortune 500 Electronics firm in California, where he held various positions
      in
      sales and sales management. He returned to Louisiana in November of 1994 to
      become the founding President of the LTC, a technical trade association
      committed to transforming the Louisiana Technology Industry. Mr. Grace has
      remained active as a Captain in the United States Naval Reserve. In 2001 Captain
      Grace assumed the Reserve position of Special Projects officer and spokesperson
      for the Navy's $8 Billion enterprise rollout of the Navy Marine Corps Intranet.
      He has since been fully recalled to Active Duty in support of Operation Enduring
      Freedom, as the Chief Information Officer for Navy Medicine. His
      responsibilities include all operational Information Management and Information
      Technology in support of the Bureau of Medicine and Surgery for the Surgeon
      General. He is active on many Boards and Committees and is a recognized leader
      of the business community of Louisiana. **.** Mr.
      Grace has been President and a Director of Proxity since May 2001.




19





**Stephen
      I. Johnson, RADM U.S. Navy (Retired) - Director**





Rear
      Admiral Johnson's 30-year Navy career included command of the Nuclear Fast
      Attack Submarine U.S. CITY OF CORPUS CHRISTI (SSN-705); service as Major
      Acquisition Program Manager for Submarine Electronic Systems (PMS-401), Naval
      Sea Systems Command (NAVSEA); Program Director, Information Support Systems
      (PD-15), Space and Naval Warfare Systems Command (SPAWAR); and Project Director,
      Navy Year 2000 Project (CNO-N6Y). From June 1999 until April 2001, Rear Admiral
      Johnson has been a Vice-President of Business Development for Integration
      Partners, Inc. Since January 2001, January 2002 and June 2003, Rear Admiral
      Johnson has acted as a consultant to SBS Consulting, Inc., UCSD Jacobs School
      of
      Engineering and Asher Training, Inc., respectively.




Subsequent
      to his Naval service, Admiral Johnson has served commercial industry, government
      program offices, and educational institutions as a senior management consultant.
      Admiral Johnson is a Managing Director of Source Companies LLC, an investment
      banking and value growth consulting company providing debt capitalization and
      growth advisory services to medium-sized, closely-held businesses. He is the
      founder of SBS Consulting, Inc., providing strategic planning, senior program
      management, subject matter expert, and sales and marketing consulting services
      to commercial customers, government organizations, and educational institutions.
      Admiral Johnson also serves as a Technology and Business Advisor to the William
      J. von Liebig Center for Entrepreneurism and Technology Advancement at the
      Jacobs School of Engineering, University of California, San Diego.





Admiral
      Johnson is a graduate of Duke University (Physics) and the Major Program
      Managers Course, Defense Systems Management College. He is certified and served
      as a Department of Defense Major Acquisition Program Manager (Level III). He
      resides in San Diego, California.





**Michael
      Lawson - Director, President of TSI**





Mr.
      Lawson has been involved with the international aerospace community for 15
      years. In 1989, Mr. Lawson founded Space Marketing, Inc., which successfully
      worked with the NASA and Russian Space Agency on commercialization of space
      program initiatives. SMI was responsible for creating a national promotion
      for
      the Pepsi-Cola Company in a 1990 “Take Flight with Ideas” campaign with NASA.
      Mr. Lawson also participated in President George Bush’s Outreach Program to
      evaluate the return to the Moon and ultimately a manned landing on Mars. Mr.
      Lawson was involved with the Lunar Prospector project that landed on the Moon
      in
      mid 1997. In 1992, Mr. Lawson’s company created two International Space
      Exhibits, a Space Station Tour with NASA exhibits and a full scale Lunar
      Habitat. The two exhibits toured 50 cities throughout the United States and
      Canada and were visited by more than 20 million people between 1992 and 1996.
      Mr. Lawson was responsible for executing a contract with Pepsi-Cola to film
      the
      first commercial in space outside the Mir Space Station. Pepsi and Mr. Lawson’s
      success led to other promotional space campaigns with corporations such as
      Frito-Lay and MTV.





**Frank
      Lively-Director**





Mr.
      Lively received a Bachelor of Arts Degree from the University of Richmond in
      1956. He went to work for as maintenance Repair Specialist at General Electric
      Co in 1956. In 1958, he became a Property Claims Adjuster for Federated Mutual
      Implement and Hardware Insurance Co. in Richmond, VA. He was promoted to Claims
      Supervisor in 1960. In 1967, he accepted a job to open a new office for Western
      Salvage and Appraisal Co., in Atlanta, GA. Frank began as a field rep for that
      company until in 1974 he was promoted to the position of Manager of the
      Southeastern Region. During that period of time, from 1974 until 1980, and
      with
      the growth of the company, there were three satellite offices opened in the
      Southeastern Region.




20




In
      1981,
      Frank was offered and he accepted a position with Underwriters Salvage Co.,
      of
      Chicago, as Regional Vice President. Underwriters Salvage was the largest
      salvage company in the nation owned by a cartel of insurance companies. In
      1983,
      Frank was offered a position with Blackmon Mooring Co., as a V P of Marketing
      and Sales for their catastrophe company. In 1985, Mr. Lively founded the
      Restoration Company (TRC), which was to be headquartered in
      Atlanta.





Frank
      served as President and CEO of TRC from 1985 until 1994 when he sold his
      partnership in TRC. During that period of time, TRC grew from a start-up to
      sales of $20 million and had three branch offices. The company was called to
      serve the insurance industry all over the world, including Italy, the UK, Fiji
      Islands, Australia, Singapore, Canada, Mexico, and others. The largest
      restoration job ever in the USA was the restoration of the World Trade Center
      in
      New York in 1993 when terrorists attacked it. Because of the company’s
      reputation the port authority hired TRC, immediately without the job going
      out
      for bid. TRC with 110 supervisors worked 3,400 laborers 24 hours per day and
      completed the job in 16 days.





**Marinko
      Vekovic - Director**





Mr.
      Vekovic is the President of a management consulting company, Alpha Medicals,
      located in Irvine, California. From 1999 to 2002, he was the Senior VP Marketing
      and Sales at ICN Pharmaceuticals (NYSE: VRX) He is also President of MVC
      Consulting, and had over ten years with Eli Lilly (NYSE: LLY) from US to Latin
      America and Europe as Director of Operations: Europe, Middle -East, Africa
      Region. Since 2002, Mr. Vekovic has been the owner of a consulting firm, Alpha
      Medical Consulting. Mr. Vekovic has over 25 years of multidimensional expertise,
      both domestic and international, in general management, business development,
      strategic planning, marketing and sales, and experience with Global and start
      up
      companies. He has managed $3 million to $850 million businesses, and has started
      Companies on the London Stock Exchange, the NYSE, and NASDAQ. Mr. Vekovic has
      an
      MBA in General Management from IMD -Lausanne Switzerland and a B.S. in Economics
      from London University UK.





**James
      Alman - Vice President Engineering**





Mr.
      Alman
      has a Bachelor of Science degree in Aerospace Engineering from Boston
      University. Before joining Cyber Defense, from November 1999 to July 2004,
      Mr.
      Alman served as the Director of Engineering for AirTran Airways and led a group
      of engineers in the technical support of AirTran. Mr. Alman has worked on the
      Electromagnetic Interference (EMI) project, Secure Cockpit Doors project, the
      Autoland project, and various new aircraft introduction projects. As a test
      engineer for the NASA Langley Research Center, Mr. Alman designed various types
      of wind tunnel research hardware. He was a team member on the Daedalus Project,
      a MIT-based group that designed, built and flew three 114-foot span composite
      human powered aircraft that holds three world records for human powered distance
      flying





**David
      Barnes, CFO**





Mr.
      Barnes was appointed as a Chief Financial Officer in August 2005. Mr. Barnes
      is
      currently Chief Financial Officer of Cyber Defense Systems, Inc. (Symbol:
      CYDFE.OB) and sits on the board of several non-related companies as Audit
      Committee Chairman and Financial Expert. David previously served as COO/CFO
      of
      several other companies on both a full time and consultative basis including,
      Nextron, Beefsteak Charlies, American Complex Care, Legend Foods, Intelcom
      Data
      Systems, and Superior Care, Inc.




Mr.
        Barnes was the CFO of American United Global, Inc. from April, 1996 to July,
        2006. He has been the CFO of Neah Power (NWPS) since April,
        2006.





**SECTION
      16(A) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE**





Section
      16(a) of the Securities Exchange Act of 1934 requires our directors, executive
      officers and any person who owns more than 10% of our common stock (the
      "Reporting Persons") to file with the Securities and Exchange Commission reports
      of ownership and reports of changes in ownership of our common stock. Under
      Securities and Exchange Commission rules, we receive copies of all Section
      16(a)
      forms that these Reporting Persons file. We have reviewed copies of these
      reports and written representations from the Reporting Persons. We believe
      all
      Reporting Persons complied with their Section 16(a) reporting obligations during
      2006.





21





**CODE
      OF ETHICS**





We
      have
      adopted a Code of Ethics within the meaning of Item 406(b) of Regulation S-B.
      This Code of Ethics applies to our principal executive officer, our principal
      financial officer and principal accounting officer, as well as all other
      employees, and is filed herewith. If we make substantive amendments to this
      Code
      of Ethics or grant any waiver, including any implicit waiver, we will disclose
      the nature of such amendment or waiver on our website or in a report on Form 8-K
      within four days of such amendment or waiver.




**ITEM
      10. EXECUTIVE COMPENSATION**





**Executives
      and Directors Compensation**





*The
      following table sets forth summary information concerning the compensation
      received for services rendered to the Company during the year ended December
      31,
      2006 by our Chairman of the Board, William C. Robinson, President, Chief
      Executive Officer, and our Directors, and Officers*




**Summary
      Compensation Table**




**Annual
                Compensation**
            
            **Long
                Term Compensation****Name
                and Position**
            
            **Year**
            
            **Salary**
              **($)**
            
            **Bonus**
              **($)**
            
            **Other**
              **($)**
            
            **Restricted
                Stock Awards**
            
            **Options**
            
            **L/Tip**
              **($)**
            
            **All**
              **Other**William
                C. Robinson CEO/President
            
            
            2006
            
            
            187,500*
            
            
            0
            
            $
            20,700
            
            
            -
            
            
            -
            
            
            -
            
            
            -Michael
                Lawson President (Techsphere)
            
            
            2006
            
            
            100,000
            
            
            -
            
            $
            12,000
            
            
            *-*
            
            
            *-*
            
            
            *-*
            
            
            *-*James
                Alman Vice President
            
            
            2006
            
            
            130,000
            
            
            0
            
            
            *-*
            
            
            *-*
            
            
            *-*
            
            
            *-*
            
            
            *-*Johnny
                Youngbeck
            
            
            2006
            
            
            100,000
            
            
            -
            
            $
            12,000
            
            
            *-*
            
            
            *-*
            
            
            *-*
            
            
            *-*




*
      Mr.
      Robinson quit receiving his salary as of 10-01-06 ($250,000 under a certain
      Employment Agreement)




The
      following tables outline grants of options made during fiscal 2006 and
      2005.






**Options/SAR
      Grants Table**




2006
      Option Grants


**Name
                  and Principle Position**
              
              **Number
                  Securities Underlying Options**
                **(Common
                  Stock Shares)**
              
              **%
                  of Total Options Granted To Employees in 2006**
              
              **Exercise
                  Price**
              
              **Expiration
                  Date**William
                  C. Robinson CEO/President
              
              
              500,000
              
              
              13.8
              %
              $
              0.17
              
              
              9/29/2016Michael
                  Lawson President (Techsphere)
              
              
              500,000
              
              
              13.8
              %
              $
              0.17
              
              
              9/29/2016James
                  Alman Vice President
              
              
              500,000
              
              
              13.8
              %
              $
              0.17
              
              
              9/29/2016Total
              
              
              
              
              
              41.4
              %




22




2005
      Options Grants


**Name
                  and Principle Position**
              
              **Number
                  Securities Underlying Options**
                **(Common
                  Stock Shares)**
              
              **%
                  of Total Options Granted To Employees in 2005**
              
              **Exercise
                  Price**
              
              **Expiration
                  Date**William
                  C. Robinson CEO/President
              
              
              1,750,000
              
              
              13.8
              %
              $
              0.20
              
              
              9/19/2015Michael
                  Lawson President (Techsphere)
              
              
              750,000
              
              
              6.6
              %
              
              0.20
              
              
              9/19/2015James
                  Alman Vice President
              
              
              1,250,000
              
              
              11.0
              %
              
              0.20
              
              
              9/19/2015Johnny
                  Youngbeck
              
              
              675,000
              
              
              5.9
              %
              
              0.20
              
              
              9/19/2015Total
              
              
              
              
              
              37.3
              %


Outstanding
      Options at December 31, 2006




**Option
                  Awards**
              
              **Stock
                  Awards****Number
                  of Securities Underlying Unexercised Options (#)
                  Exerciseable**
              
              **Number
                  of Securities Underlying Unexercised Options (#)
                  Unexerciseable**
              
              **Equity
                  Incentive Plan Awards: Number of Securities Underlying Unexercised
                  Unearned Options (#)**
              
              **Option
                  Exercise Price ($)**
              
              **Option
                  Expiration Date**
              
              **Number
                  of Shares or Units of Stock That Have Not Vested
                  (#)**
              
              **Market
                  Value of Shares or Units of Stock That Have Not Vested
                  ($)**
              
              **Equity
                  Incentive Plan Awards: Number of Unearned Shares, Units or Other
                  Rights
                  That Have Not Vested (#)**
              
              **Equity
                  Incentive Plan Awards: Market or Payout Value of Unearned Shares,
                  Units or
                  Other Rights That Have Not Vested ($)****Name**William
                  C. Robinson CEO/President
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -
              
              
              -Michael
                  Lawson President (Techsphere)
              
              
              495,143
              
              
              -
              
              
              -
              
              
              0.20
              
              
              9/19/2015
              
              
              -
              
              
              -
              
              
              -
              
              
              -Michael
                  Lawson President (Techsphere)
              
              
              500,000
              
              
              -
              
              
              -
              
              
              0.17
              
              
              9/29/2016
              
              
              -
              
              
              -
              
              
              -
              
              
              -James
                  Alman Vice President
              
              
              378,318
              
              
              -
              
              
              -
              
              
              0.20
              
              
              9/19/2015
              
              
              -
              
              
              -
              
              
              -
              
              
              -James
                  Alman Vice President
              
              
              500,000
              
              
              -
              
              
              -
              
              
              0.17
              
              
              9/29/2016
              
              
              -
              
              
              -
              
              
              -
              
              
              -Johnny
                  Youngbeck
              
              
              290,359
              
              
              
              
              
              
              
              
              0.20
              
              
              9/19/2015
              
              
              -
              
              
              -
              
              
              -
              
              
              -




23




**Employment
      Arrangements - Directors**





**Compensation
      for Board Services and Reimbursement of Expenses**





The
      following table summarizes data concerning the compensation of our directors
      for
      the fiscal year ended December 31, 2006





Name
            Fees
              Earned
                or Paid in Cash
              ($)
            Stock
                Awards
              ($)
            Option
              Awards
                ($)
            Non-Equity
                Incentive Plan Compensation ($)
            Nonqualified
                Deferred Compensation Earnings
              ($)
            All
                Other Compensation
              ($)
            Total
              ($)William
                Robinson
            $12,050
            -
            $82,500
            -
            -
            -
            $94,550Michael
                Lawson
            12,050
            -
            $82,500
            -
            -
            -
            $94,550Stephen
                Johnson
            12,050
            -
            $82,500
            -
            -
            -
            $94,550Frank
                Lively
            12,050
            -
            $82,500
            -
            -
            -
            $94,550Joseph
                A. Grace
            12,050
            -
            $82,500
            -
            -
            -
            $94,550Marinko
                Vekovic
            12,050
            -
            $82,500
            -
            -
            -
            $94,550James
                Alman
            6,050
            -
            -
            -
            -
            -
            $6,050





**Compensation
      of Directors**





The
      Company’s policy for compensation of Directors is as follows:





50,000
      shares as an initial award for being a Board Member, Minimum of 1 year term
      that
      is renewable. As per our discussions, Cyber Defense Systems will pay for any
      tax
      burden that arises from the awarding of stock through either over issuance,
      payment set aside or other methods yet to be determined issued now. Shares
      will vest 50% on the first annual anniversary of the date hereof and the balance
      will vest on the second annual anniversary thereof.





·
            Vesting
                of the one time issuance of shares immediately for existing board
                only.





·
            $1,000
                per day for Board meetings, $500 per day of travel with all reasonable
                expenses related to Cyber business and travel being reimbursed by
                the
                Company.





·
            $175
                per hour for committee time not to include the board meeting, phone
                conferences or other required duties as defined by the Board or at
                the
                request of the CEO.





·
            $5,000
                per year to be the Chair of a committee. Each Member is a Chair of
                at
                least one Committee.





·
            500,000
                options per year for being a Board Member for the reconstituted TSI
                members and existing Cyber members.





During
      the calendar year ended December 31, 2006, the Directors received the
      following:





Other
      than the $1,000 attendance fee paid to each Director for each meeting attended
      and an annual honorarium of 25,000 shares of our Class A Common Stock granted
      to
      each Director, Directors who are employees of the Company are not paid any
      other
      fees or additional compensation for services as members of the Company's Board
      of Directors or any committee thereof.




24




**Employment
      Arrangements - Executives and Key Employees**




On
      January 1, 2006 we entered into a new employment agreement with Mr. Robinson.
      The new agreement supersedes the agreement discussed above. The term of this
      agreement is for a period of one year subject to renewal for successive one
      year
      periods, unless 14 days prior written notice is provided by either party. Mr.
      Robinson will receive an annual salary of not less than $250,000. The agreement
      provides for standard benefits, vacation and participation in the Company's
      bonus pool as defined in the agreement. In addition, the Company shall issue
      to
      Employee options to purchase shares of Company stock (Shares) in accordance
      with
      the Company's Stock Option Plan. The agreement may be terminated for due cause,
      upon death, upon disability, voluntary termination by him, or us, without due
      cause by providing 14 days prior written notice. Mr. Robinson is subject to
      a
      non-compete and non-solicitation provision during the employment term and during
      a specified Post-Employment Period (as defined in the employment
      agreement).




On
      January 1, 2006, The Company entered into an employment agreement with Keith
      Vierela as Chief Operating Officer. The new agreement supersedes the agreement
      discussed above. The term of this agreement is one year, subject to renewal
      for
      successive one year periods, unless 14 days prior written notice is provided
      by
      either party. Mr. Vierela will receive an annual salary of not less than
      $150,000. The agreement provides for standard benefits, vacation and
      participation in the Company's bonus pool as defined in the agreement. In
      addition, the Company shall issue to Employee options to purchase shares of
      Company stock (Shares) in accordance with the Company's Stock Option Plan.
      The
      Agreement may be terminated for due cause, upon death, upon disability,
      voluntary termination by him, or us without due cause by providing 14 days
      prior
      written notice. Mr. Vierela is subject to a non-compete and non-solicitation
      provision during the employment term and during a specified Post-Employment
      Period. On November 15, 2006 Mr. Vierela and the Company terminated the contract
      under an agreement as of that date. Under the terms of the agreement, Mr.
      Vierela was released from all restrictive covenants of his employment agreement
      in exchange for the return and cancellation of 500,000 shares of Class A common
      stock held by Mr. Vierela.




On
      April
      1, 2006, TSI entered into a new employment agreement with John Youngbeck as
      Executive Vice President. The term of this agreement is one year, subject to
      renewal for successive one year periods, unless 14 days prior written notice
      is
      provided by either party. Mr. Youngbeck will receive an annual salary of not
      less than $100,000. The agreement provides for standard benefits, vacation
      and
      participation in the Company's bonus pool as defined in the agreement. In
      addition, the Company shall issue to Employee options to purchase shares of
      Company stock (Shares) in accordance with the Company's Stock Option Plan.
      The
      Agreement may be terminated for due cause, upon death, upon disability,
      voluntary termination by him, or the Company without due cause by providing
      14
      days prior written notice. Mr. Youngbeck is subject to a non-compete and
      non-solicitation provision during the employment term and during a specified
      Post-Employment Period.




On
      April
      1, 2006, TSI entered into a new employment agreement with Michael Lawson as
      Corporate Marketing Officer. The term of this agreement is one year, subject
      to
      renewal for successive one year periods, unless 14 days prior written notice
      is
      provided by either party. Mr. Lawson will receive an annual salary of not less
      than $100,000. The agreement provides for standard benefits, commissions of
      2%
      of all gross sales less costs registered by the employee, vacation and
      participation in the Company's bonus pool as defined in the agreement. In
      addition, the Company shall issue to Employee options to purchase shares of
      Company stock (Shares) in accordance with the Company's Stock Option Plan.
      The
      Agreement may be terminated for due cause, upon death, upon disability,
      voluntary termination by him, or the Company without due cause by providing
      14
      days prior written notice. Mr. Lawson is subject to a non-compete and
      non-solicitation provision during the employment term and during a specified
      Post-Employment Period.




On
      January 1, 2006, the Company entered into an hourly consulting agreement with
      Frank Lively. The consulting agreement provides for the cancellation of Mr.
      Lively's prior employment agreement. Fees due under the consulting agreement
      are
      convertible into Class A common shares of the Company by Mr. Lively at the
      lesser of $0.30 per share or the closing price on the date of conversion. This
      contract was terminated on July 15, 2006.





The
      Company does not have any annuity, retirement, pension or deferred compensation
      plan or other arrangements under which an executive officer is entitled to
      participate without similar participation by any other employees.




25




**ITEM
      11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
      STOCKHOLDER MATTERS.**





As
      of May
      15, 2007, there were (i) 71,705,872 shares of our Class A Common Stock issued
      and outstanding; (ii) 545,455 shares of our Class B Common Stock issued and
      outstanding; and (iii) 2 shares of our Class C Common Stock issued and
      outstanding.





The
      following table sets forth certain information as of December 31, 2006,
      regarding (i) each person known by the Company to be the beneficial owner of
      more than 5% of the outstanding shares of our common stock, (ii) each director,
      and named executive officer of the Company, and (iii) all officers and directors
      as a group:





**Name/Address
                of Beneficial Owner***
            
            **Position
                with Company**
            
            **Common
                Stock Owned**
            
            **Options
                exerciseable**
            
            **Convertible
                Debt**
            
            **Total**
            
            **%
                of**
              **Class**William
                C. Robinson(4)
            
            
            Chairman
                and CEO
            
            
            9,152,352
            
            
            -
            
            
            3,226,124
            
            
            12,378,476
            
            
            18.6
            %James
                Alman
            
            
            Vice-President
            
            
            1,696,682
            
            
            878,318
            
            
            -
            
            
            2,575,000
            
            
            3.9
            %David
                M. Barnes
            
            
            CFO
            
            
            151,666
            
            
            695,000
            
            
            -
            
            
            846,666
            
            
            1.3
            %Michael
                Lawson
            
            
            Director
                and President of Techsphere
            
            
            5,026,464
            
            
            995,143
            
            
            -
            
            
            6,021,607
            
            
            9.0
            %Frank
                Lively
            
            
            Director
            
            
            4,346,963
            
            
            745,635
            
            
            -
            
            
            5,092,598
            
            
            7.6
            %Stephen
                I. Johnson RADM
              USN
                (ret.)
            
            
            Director
            
            
            75,837
            
            
            949,163
            
            
            -
            
            
            1,025,000
            
            
            1.5
            %Joseph
                A. Grace, Jr.
            
            
            Director
            
            
            85,250
            
            
            939,750
            
            
            -
            
            
            1,025,000
            
            
            1.5
            %Marinko
                Vekovic
            
            
            Director
            
            
            29,564
            
            
            1,000,000
            
            
            -
            
            
            1,029,564
            
            
            1.5
            %Keith
                Vierela
            
            
            5%
                Holder
            
            
            4,091,452
            
            
            791,433
            
            
            -
            
            
            4,882,885
            
            
            7.3
            %Edward
                W. Pickett
            
            
            5%
                Holder
            
            
            3,711,706
            
            
            312,762
            
            
            -
            
            
            4,024,468
            
            
            6.0
            %John
                M. Youngbeck
            
            
            5%
                Holder, Vice President of TSI
            
            
            4,042,526
            
            
            290,359
            
            
            -
            
            
            4,332,885
            
            
            6.5
            %Cherokee
                Raiders, L.P. (2)
            
            
            
            
            
            8,690,220
            
            
            0
            
            
            1,850,149
            
            
            10,540,369
            
            
            15.8
            %5146
                South Harvard Ave.Suite
                138Tulsa,
                OK 74135Proxity
                Digital Networks, Inc.
              (3)
                and (4)
            
            
            
            
            
            14,598,217
            
            
            0
            
            
            1,473,878
            
            
            16,072,095
            
            
            24.1
            %1600
                Canal St., Suite 1418New
                Orleans, LA 70112All
                executive officers and
              Directors
                as a group (8 persons)
            
            
            
            
            
            20,564,778
            
            
            6,203,009
            
            
            3,226,124
            
            
            29,993,911
            
            
            45.0
            %





*
      Address
      of all holders is c/o Cyber Defense Systems, Inc., 10901 Roosevelt Boulevard,
      St. Petersburg, Florida 33716.





(1)
      Pursuant to the rules of the Securities and Exchange Commission, a person is
      deemed to "beneficially own" shares of common stock over which the person has
      or
      shares investment or voting power, or has the right to acquire such power within
      60 days. The percentage of common stock owned is calculated based on the number
      of shares of common stock outstanding, plus in the case of each person the
      number of shares of common stock issuable only to such person upon the exercise
      of options or warrants and the conversion of convertible debt securities.




26




(2)
      55%
      of the Class B Common Stock is held by Cherokee Raiders, LP (300,000 shares)
      and
      50% of the issued and outstanding shares of our Class C Common Stock are held
      by
      Cherokee Raiders, LP (1 share) and (1 share) is held by Proxity. 45% of the
      Class B shares are held by the former shareholders of TSI.





(3)
      Includes all of the shares held by Cherokee Raiders, L.P., a family limited
      partnership, as to which Mr. Robinson has 10% ownership.





(4)
      Mr.
      Robinson, the CEO and CFO of Proxity, and his family and affiliates own and
      have
      voting control of a majority position of the capital stock of Proxity. These
      shares along with the Cherokee and shares owned by Mr. Robinson gives 33.1%
      voting control. Additional shares pledged on loans in the amount of 8.4% of
      the
      outstanding shares of the Company are still under voting control of Mr. Robinson
      for total voting control of approximately 41.5% and ownership will revert back
      to Mr. Robinson or his affiliates upon payment of said loans.





**ITEM
      12.****CERTAIN
      RELATIONSHIPS AND RELATED PARTY TRANSACTIONS**




Cyber
      Aerospace - Prior to March 31, 2005, Cyber Aerospace ("Aerospace") had
      previously been consolidated with the Company as it was a 93.8% owned
      subsidiary. All transactions and account balances between the Company and
      Aerospace were eliminated during consolidation. On March 31, 2005, the Company
      purchased the minority interest so that Aerospace became a wholly owned
      subsidiary and was then merged with and into the Company.




Cherokee
      Raiders - Cherokee's general partner is William C. Robinson. Cherokee also
      owns
      300,000 Class B common shares, each of which entitles the holder to 1,000 votes.
      As a result, Cherokee is the controlling shareholder of the
      Company.




William
      C. Robinson - Mr. Robinson is President, CEO and Chairman of the Company and
      has
      significant ownership and control in Proxity and Cherokee Raiders.




During
      the year ended December 31, 2006, Mr. Robinson advanced an aggregate of $249,796
      and converted an aggregate of $485,000 to Class A common stock under his
      $1,000,000 line of credit to the Company. In addition, Mr. Robinson paid the
      January 17, 2006 unsecured note in the principal amount of $74,523 to a vendor.
      See Note 6. Mr. Frank Lively, a director of the Company advanced an additional
      $16,722. All of Mr. Lively's loans to the Company have been converted to Class
      A
      common stock as of December 31, 2006.




On
      April
      20, 2006 David Barnes, the Company's Chief Financial Officer utilized $11,000
      of
      fees due him to exercise options for 55,000 shares of the Company's Class A
      common stock at the exercise price of $0.20 per share. On July 21, 2006 the
      Board approved Mr. Barnes conversion of an additional $7,000 in fees into 46,666
      shares of Class A common stock at a price of $0.15. The price was determined
      based on the market pricing as of the date of conversion.




During
      the year ended December 31, 2005, Billy Robinson loaned the Company funds to
      be
      used for working capital purposes which were payable on demand. On August 12,
      2005 Mr. Robinson agreed to extend their note and, as additional consideration
      for extending the due date of the loans, the Company issued 20,465 shares of
      its
      Class A common stock valued at $28,631 to Mr. Robinson based on the bid price
      as
      of that date. The Company recorded the value of the shares as additional
      interest expense related to the note. The Company issued Mr. Robinson a
      Convertible Promissory Note in the amount of $460,851 on December 31, 2005.
      The
      note bears interest at the rate of 12%, is unsecured and convertible into the
      Company's Class A common stock at a price of $0.30 per share. The conversion
      price approximated the market price on the date of the note. The note is due
      on
      December 31, 2007.





On
      April
      19th, 2006, the Board approved a $1,000,000 line of credit with Mr. Robinson.
      On
      April 19, 2006 pursuant to the line of Credit, the Company entered into a
      convertible variable promissory note in the principal amount as of March 31,
      2006 of $565,188 including all related accrued interest. The note bears interest
      at the rate of 12% per annum, is unsecured and is convertible into Class A
      common stock at $0.30 per share. The note is due on December 31, 2007. During
      the year ended December 31, 2006, Mr. Robinson advanced cash in the aggregate
      amount of $249,796 and converted an aggregate of $485,000 to Class A common
      stock under his $1,000,000 line of credit to the Company.




27




On
      April
      20, 2006, Mr. Robinson converted $50,000 of the balance at the stated conversion
      rate into 166,667 shares of Class A common stock. On September 28, 2006 Mr.
      Robinson utilized the $350,000 of the balance owed to him under the note to
      exercise 1,750,000 vested options priced at $0.20 and $85,000 of the balance
      owed to him under the note to exercise 500,000 vested options priced at $0.17
      under the 2005 Stock Option Plan. An aggregate of 2,250,000 shares were issued.




At
      December 31, 2005 the Company issued Convertible Promissory Notes aggregating
      $124,343 to Frank Lively, a director of the Company in lieu of deferred salaries
      and for working capital advances made to the Company. The notes were subject
      to
      a 10% loan transaction fee and bear interest at the rate of 12%, are unsecured
      and convertible into the Company's Class A common stock at a price of $0.30
      per
      share. The conversion price approximated the market price on the date of the
      note. The notes are due on December 31, 2007.




On
      April
      19, 2006, the Board approved two convertible promissory notes for amounts as
      of
      April 17th, 2006, of $83,726 and $13,056, respectively with Frank Lively for
      cash advanced for working capital plus fees and interest. The notes bear
      interest at the rate of 12% per annum, are unsecured and are convertible into
      Class A common stock at $0.30 per share. The notes are due on December 31,
      2007.
      The Company paid $15,000 of principal and accrued interest in July 2006 to
      Mr.
      Lively.




On
      September 29, 2006 Mr. Lively utilized the balance owed to him under the notes,
      including principal and all related interest of $92,973 to exercise vested
      options at an exercise price of $0.20 per share under the 2005 Stock Option
      Plan. An aggregate of 464,465 shares were issued to him and the Notes were
      cancelled.




During
      the year ended December 31, 2005, Cherokee converted a $600,000 portion of
      their
      debt to Class A common shares at the rate of $0.20 per share into 3,000,000
      Class A common shares. The conversion rate was determined based on the fair
      value of the common stock on the date of the note of September 16, 2005 of
      $0.18
      per share. On August 12, 2005 Cherokee agreed to extend their note and, as
      additional consideration for extending the due date of the loans, the Company
      issued 73,553 shares of its Class A common stock valued at $102,974 to Cherokee
      based on the bid price as of that date. The Company recorded the value of the
      shares as additional interest expense related to the note. In addition, on
      December 31, 2005 the Company issued a Convertible Promissory Note in the amount
      of $312,255 to Cherokee which replaced the two notes outstanding at December
      31,
      2004. The new note bears interest at the rate of 12%, is unsecured and
      convertible into the Company's Class A common stock at a price of $0.30 per
      share. The conversion price approximated the market price on the date of the
      note. The notes are due on December 31, 2007.




On
      April
      19, 2006, the Board approved a convertible promissory note for an aggregate
      amount as of April 17th, 2006 in the amount of $312,255 plus accrued interest
      with Cherokee Raiders, LP, by way of cash advanced for working capital plus
      fees
      and interest. The note bears interest at the rate of 12% per annum, is unsecured
      and is convertible into Class A common stock at $0.30 per share. The note is
      due
      on December 31, 2007. This note replaces the note dated December 31, 2005 on
      identical terms.




The
      three
      notes discussed above provide for acceleration of payment from amounts in excess
      of a minimum of $7,000,000 that are raised in any type of financing. Such
      prepayments would be made on a pro rata basis among certain note holders. As
      a
      result of this acceleration provision, the notes have all been treated as
      current liabilities.




On
      April
      20, 2006 the Company issued an aggregate of 937,776 shares upon exercise of
      the
      conversion rights to Class A common stock at a conversion price of $0.30 per
      share associated with Convertible Notes in the aggregate amount of $281,333.
      The
      four executive employees converted an aggregate of $131,419, Frank Lively
      converted one of his notes representing deferred salary in the amount of
      $41,914, and Mr. Robinson and Cherokee each converted $50,000.




28




During
      the year ended December 31, 2005, Jim Alman converted $50,000 of the balance
      of
      his loan at December 31, 2004 to Class A common shares at the rate of $0.20
      per
      share and received 250,000 Class A common shares. The conversion rate was
      determined based on the fair value of the common stock on the date of the note
      of September 16, 2005 of $0.18 per share. In addition, the Company issued a
      Convertible Promissory Note to Mr. Alman in the amount of $50,000.The note
      bears
      interest at the rate of 12%, is unsecured and convertible into the Company's
      Class A common stock at a price of $0.30 per share. The conversion price
      approximated the market price on the date of the note. The note is due on
      December 31, 2007. On September 29, 2006 James Alman utilized the balance owed
      to him under his note, including principal and all related interest of $68,286
      to exercise 341,432 vested options under the 2005 Stock Option Plan. An
      aggregate of 341,432 shares were issued to him and the Note was cancelled.
      There
      was no beneficial conversion feature recognized on this note.




During
      the year ended December 31, 2005, Proxity loaned the Company funds to be used
      for working capital purposes which were payable on demand. On August 12, 2005
      Proxity agreed to extend their note and, as additional consideration for
      extending the due date of the loans, the Company issued 25,000 shares of its
      Class A common stock valued at $35,000 to Cherokee based on the bid price as
      of
      that date. The Company recorded the value of the shares as additional interest
      expense related to the note. The Company issued Proxity a Convertible Promissory
      Note in the amount of $351,600 on December 31, 2005. The note bears interest
      at
      the rate of 12%, is unsecured and convertible into the Company's Class A common
      stock at a price of $0.30 per share. The conversion price approximated the
      market price on the date of the note. The note is due on December 31, 2007.
      During the year ended December 31, 2006 the Company paid an aggregate of $50,000
      of the principal balance of the Convertible Note payable to Proxity,
      Inc.




At
      December 31, 2005 the Company issued Convertible Promissory Notes aggregating
      $263,266 to four executive employees of the Company in lieu of deferred
      salaries. The notes bear interest at the rate of 12%, are unsecured and
      convertible into the Company's Class A common stock at a price of $0.30 per
      share. The conversion price approximated the market price on the date of the
      note. The notes are due on December 31, 2007. On September 29, 2006 the
      remaining balance due to the executive employees, John Youngbeck and Keith
      Vierela utilized the balances owed to them under their notes including principal
      and all related interest of $55,096 and $80,062, respectively to exercise
      398,317 and 280,474 vested options, respectively under the 2005 Stock Option
      Plan. An aggregate of 678,791 shares were issued and the Notes were cancelled.




29




**ITEM
      13. EXHIBITS AND REPORTS ON FORM 8-K**





All
      references to the Company's Forms 8-K, 10-K, 10-QSB and 10-KSB include reference
      to File No. 333-46424.


(a)Exhibits





Exhibit
                No.
            Document3.1
            Articles
                of Incorporation of Cyber Defense Systems, Inc. (incorporated by
                reference
                to Exhibit 3.1 filed with Company's Form 8-K on February 23, 2005
                ("February 2005 Form 8-K")).4.1(a)
            $242,216.00
                Corporate Promissory Note from On Alert to 9145-6442 Quebec, Inc
                (incorporated by reference to Exhibit 10.8(a) filed with the February
                2005
                Form 8-K).4.1(a)(1)
            Addendum
                dated February 9, 2005, to the Note dated August 23, 2004 (incorporated
                by
                reference to Exhibit 10.8(a)(1) filed with the February 2005 Form
                8-K).4.2
            Intercreditor
                Agreement between On Alert, Equipment Depot, Inc. and 9145-6442 Quebec,
                Inc., dated September 21, 2004 (incorporated by reference to Exhibit
                10.8(d) filed with the February 2005 Form 8-K).4.3(a)
            $100,000.00
                Corporate Promissory Note from On Alert (Maker) to Proxity (Holder)
                dated
                March 13, 2004; due on or before November 30, 2004 (incorporated
                by
                reference to Exhibit 10.11(a) filed with the February 2005 Form 8-K).4.3(b)
            Re-stated
                $100,000.00 Corporate Promissory Note from On Alert (Maker) to Proxity
                (Holder) Originally dated March 13, 2004 due on or before November
                30,
                2004 - Now dated February 1, 2005, and due November 30, 2005 (incorporated
                by reference to Exhibit 10.11(b) filed with the February 2005 Form
                8-K).4.4
            $500,000.00
                Corporate Promissory Note from Cyber Aero (Maker) to On Alert (Holder)
                dated March 10, 2004; due on or before November 30, 2005 (incorporated
                by
                reference to Exhibit 10.12 filed with the February 2005 Form 8-K).4.5
            Notice
                of Conversion dated September 1, 2004 Cherokee (Holder) elects to
                be
                issued 6,750,000 shares of Common Stock of On Alert (Maker) in
                satisfaction of $400.000.00 in debt evidenced by Convertible Corporate
                Promissory Note from On Alert in the amount of $400,425.00 (incorporated
                by reference to Exhibit 10.13 filed with the February 2005 Form 8-K).4.6
            $400,000.00
                Corporate Promissory Note from On Alert (Maker) to Cherokee (Holder)
                dated
                March 13, 2004 due on or before November 30, 2004 (incorporated by
                reference to Exhibit 10.14 filed with the February 2005 Form 8-K).4.7
            $675,000.00
                Corporate Promissory Note from On Alert (Maker) to Cherokee (Holder)
                dated
                July 15, 2004 due on or before November 30, 2005 (incorporated by
                reference to Exhibit 10.15 filed with the February 2005 Form 8-K).




30







4.8
            $675,000.00
                Corporate Promissory Note from Cyber Aero (Maker) to On Alert (Holder)
                dated July 15, 2004 due on or before November 30, 2005 (incorporated
                by
                reference to Exhibit 10.16 filed with the February 2005 Form 8-K).4.9
            $374,169.30
                Corporate Promissory Note from On Alert (Maker) to Proxity (Holder)
                dated
                March 13, 2004 due on or before November 30, 2004 (incorporated by
                reference to Exhibit 10.17 filed with the February 2005 Form 8-K).4.10
            Notice
                of Conversion dated April 12, 2003 Proxity (Holder) elects to be
                issued
                18,750,000 shares of Common Stock of On Alert (Maker) in satisfaction
                of
                $18,750.00 in debt evidenced by Convertible Corporate Promissory
                Note from
                On Alert in the amount of $18,750.00 (incorporated by reference to
                Exhibit
                10.18 filed with the February 2005 Form 8-K).4.11
            $194,200.00
                Corporate Promissory Note from On Alert (Maker) to Cherokee (Holder)
                dated
                September 28, 2004 due on or before November 30, 2005 (incorporated
                by
                reference to Exhibit 10.19 filed with the February 2005 Form 8-K).4.12
            Form
                of Secured Convertible Term Note issued to AJW Partners, LLC, dated
                as of
                April 1, 2005 (incorporated by reference to Exhibit 10.1 filed with
                the
                Company's Form 8-K on April 6, 2005 (the "April 2005 Form 8-K")).4.13
            Security
                Agreement in favor of AJW Partners, LLC, dated as of April 1, 2005
                (incorporated by reference to Exhibit 10.3 filed with the April 2005
                Form
                8-K).4.14
            Intellectual
                Property Security Agreement with AJW Partners, LLC, dated as of April
                1,
                2005 (incorporated by reference to Exhibit 10.4 filed with the April
                2005
                Form 8-K).4.15
            Guaranty
                and Pledge Agreement in favor of AJW Partners, LLC, dated as of April
                1,
                2005 (incorporated by reference to Exhibit 10.5 filed with the April
                2005
                Form 8-K).4.16
            Amended
                Convertible Promissory Note Issued to Joseph Theismann in the Amount
                of
                $117,000 due September 30, 2005.4.17
            Form
                of Subscription Agreement dated November 4, 2005 by and between the
                Company and Equipment Depot Inc. (incorporated by reference to Exhibit
                10.23 filed with the November 10, 2005 on a Form 8-K)4.1810.1(a)
            Original
                Traptec Licensing Agreement between On Alert and the Traptec Corporation,
                dated November 10, 2003, with subsequent modifications (incorporated
                by
                reference to Exhibit 10.1(a) filed with the February 2005 Form 8-K).10.1(b)
            First
                Modification to Traptec Licensing Agreement (incorporated by reference
                to
                Exhibit 10.1(b) filed with the February 2005 Form 8-K).10.1(c)
            Second
                Modification Traptec Licensing Agreement (incorporated by reference
                to
                Exhibit 10.1(c) filed with the February 2005 Form 8-K).10.2(a)
            Asset
                Purchase Agreement Between Cyber Aero And James Alman, dated March
                5, 2004
                (incorporated by reference to Exhibit 10.2(a) filed with the February
                2005
                Form 8-K).10.2(b)
            Amendment
                dated January 11, 2005 to Alman Asset Purchase Agreement dated March
                5,
                2004 (incorporated by reference to Exhibit 10.2(b) filed with the
                February
                2005 Form 8-K).




31




10.3
            Original
                TSI Asset Purchase Agreement between Cyber Aero and Techsphere Systems
                International, LLC, dated as of March 10, 2004 with addendum (incorporated
                by reference to Exhibit 10.3 filed with the February 2005 Form 8-K).10.4
            Marketing
                and Sales Agreement between On Alert and Techsphere Systems International,
                LLC, dated May 1, 2004 (incorporated by reference to Exhibit 10.4
                filed
                with the February 2005 Form 8-K).10.5
            Modification
                of the Original TSI Asset Purchase Agreement between Cyber Aero and
                Techsphere Systems International, LLC, Dated June 15, 2004 (incorporated
                by reference to Exhibit 10.5 filed with the February 2005 Form 8-K).10.6(a)
            Equipment
                Purchase Agreement between On Alert Systems, Inc, and Equipment Depot,
                Inc., dated as of May 31, 2004, with Addendums And Subordination
                Agreement
                (incorporated by reference to Exhibit 10.6(a) filed with the February
                2005
                Form 8-K).10.6(a)(1)
            Addendum
                dated June 30, 2004, to the Equipment Purchase Agreement between
                On Alert
                Systems, Inc, and Equipment Depot, Inc., dated as of May 31, 2004
                (incorporated by reference to Exhibit 10.6(a)(1) filed with the February
                2005 Form 8-K).10.6(a)(2)
            Amendment
                #1 of August 6, 2004 to the Addendum dated June 30, 2004 (incorporated
                by
                reference to Exhibit 10.6(a)(2) filed with the February 2005 Form
                8-K).10.6(a)(3)
            Addendum
                dated September 28, 2004, to the Equipment Purchase Agreement between
                On
                Alert Systems, Inc, and Equipment Depot, Inc., dated as of May 31,
                2004
                (incorporated by reference to Exhibit 10.6(a)(3) filed with the February
                2005 Form 8-K).10.6(a)(4)
            Amendment
                dated February 8, 2005, to the Equipment Purchase Agreement between
                On
                Alert Systems, Inc, and Equipment Depot, Inc., dated as of May 31,
                2004
                (incorporated by reference to Exhibit 10.6(a)(4) filed with the February
                2005 Form 8-K).10.6(b)
            Money
                Purchase Contract between On Alert Systems, Inc, and Equipment Depot,
                Inc., dated as of May 31, 2004 (incorporated by reference to Exhibit
                10.6(b) filed with the February 2005 Form 8-K).10.6(b)(1)
            Addendum
                dated July 28, 2004, to Money Purchase Contract dated May 31, 2004
                (incorporated by reference to Exhibit 10.6(b)(1) filed with the February
                2005 Form 8-K).10.6(c)
            Registration
                Rights Agreement between On Alert Systems, Inc, and Equipment Depot,
                Inc.,
                dated as of May 31, 2004 (incorporated by reference to Exhibit 10.6(c)
                filed with the February 2005 Form 8-K).10.7(a)
            Stock
                Purchase Agreement between On Alert Systems. Inc. and Allstars Marketing,
                Inc., dated as of August 19, 2004 (incorporated by reference to Exhibit
                10.7(a) filed with the February 2005 Form 8-K).




32


10.7(a)(1)
              Amendment
                  #1 dated August 30, 2004 to the Stock Purchase Agreement between
                  On Alert
                  and Allstars Marketing, Inc., dated August 19, 2004 (incorporated
                  by
                  reference to Exhibit 10.7(a)(1) filed with the February 2005 Form
                  8-K).10.7(a)(2)
              Amendment
                  #2 dated September 28, 2004 to the Stock Purchase Agreement between
                  On
                  Alert and Cyber Defense and Allstars, dated as of August 19, 2004
                  (incorporated by reference to Exhibit 10.7(a)(2) filed with the
                  February
                  2005 Form 8-K).10.7(a)(3)
              Amendment
                  #3 dated February 8, 2005, to the Stock Purchase Agreement between
                  On
                  Alert and Cyber Defense and Allstars, dated as of August 19, 2004
                  (incorporated by reference to Exhibit 10.7(a)(3) filed with the
                  February
                  2005 Form 8-K).10.7(b)
              Registration
                  Rights Agreement between On Alert Systems. Inc. and Allstars Marketing,
                  Inc., dated as of August 19, 2004 (incorporated by reference to
                  Exhibit
                  10.7(b) filed with the February 2005 Form 8-K).10.8(a)
              Assignment
                  of Loan Proceeds (incorporated by reference to Exhibit 10.8(a)
                  filed with
                  the February 2005 Form 8-K).10.8(b)
              Assignment
                  of Funding Proceeds to Repay Loan (incorporated by reference to
                  Exhibit
                  10.8(b) filed with the February 2005 Form 8-K).10.9
              Plan
                  of Merger between On Alert and Cyber Defense Systems, dated August
                  24,
                  2004 (incorporated by reference to Exhibit 10.9 filed with the
                  February
                  2005 Form 8-K).10.10
              Plan
                  of Merger between On Alert Cyber and E-City Software, Inc., dated
                  August
                  24, 2004 (incorporated by reference to Exhibit 10.10 filed with
                  the
                  February 2005 Form 8-K).10.20(a)
              Employment
                  Agreement between Cyber Defense and James Alman (incorporated by
                  reference
                  to Exhibit 10.20(a) filed with the February 2005 Form 8-K).10.20(b)
              Employment
                  Agreement between Cyber Defense and Andrea Facchinetti (incorporated
                  by
                  reference to Exhibit 10.20(b) filed with the February 2005 Form
                  8-K).10.20(c)
              Employment
                  Agreement between Cyber Defense and Barry Nelsen (incorporated
                  by
                  reference to Exhibit 10.20(c) filed with the February 2005 Form
                  8-K).10.20(d)
              Employment
                  Agreement between Cyber Defense and William C. Robinson (incorporated
                  by
                  reference to Exhibit 10.20(d) filed with the February 2005 Form
                  8-K).10.20(e)
              Employment
                  Agreement between Cyber Defense and Jaffray Stephens (incorporated
                  by
                  reference to Exhibit 10.20(e) filed with the February 2005 Form
                  8-K).10.21
              $110,000.00
                  Corporate Promissory Note from Cyber Defense to Joseph Theismann
                  dated
                  December 10, 2004; due on or before February 28, 2005 (incorporated
                  by
                  reference to Exhibit 10.21 filed with the February 2005 Form 8-K).


33


10.22
              Agreement
                  between Cyber Defense and Cyber Aero and Brayton Energy, LLC, dated
                  September 27, 2004 (incorporated by reference to Exhibit 10.22
                  filed with
                  the February 2005 Form 8-K).10.23
              $2,000,000
                  Form of Subscription Agreement dated November 4, 2005 by and between
                  the
                  Company and Equipment Depot Inc. (incorporated by reference to
                  Exhibit
                  10.23 filed with the November 2005 on Form 8-K).10.24
              Securities
                  Purchase Agreement, dated as of April 1, 2005, by and among Cyber
                  Defense
                  Systems, Inc. (the "Company"), and AJW Partners, LLC.("Partners"),
                  AJW
                  Offshore, Ltd. ("Offshore"), AJW Qualified Partners ("Qualified")
                  and New
                  Millenium Capital Partners, II, LLC ("Millenium") (incorporated
                  by
                  reference to Exhibit 10.24 filed with the March 20, 2005 on Form
                  8-K).
 10.25
                Line
                    of Credit offered and promissory Note (Incorporated by reference
                    as
                    Exhibit to a Form 8-K filed with the SEC on April 24,
                    2006).10.26
                Agreement
                    with Sierra Nevada Corp. and Techsphere Systems, International,
                    Inc. dated
                    April 25, 2006 (Incorporated by reference in Form 8-K dated May
                    2,
                    2006).10.27
                10QSB
                    - March 31, 2006, filed on May 15, 2006.10.28
                Acquisition
                    of Techsphere Systems International, Inc. (Incorporated by reference
                    are
                    the Combined Financial Statements of TSA and the Pro Forma Financials
                    of
                    the Company subsidiaries on form 8-K1A dated June 22,
                    2006).10.29
                10-QSB
                    for the period ended June 30, 2006, filed on August 21,
                    2006.10.30
                Revised
                    payment schedule dated August 25, 2006, with 21stCentury Airships, Inc. (Incorporated by reference as Exhibit
                    10.1 on Form
                    8-K filed on August 30, 2006).10.31
                Advance
                    Agreement on Proceeds with AJW Partners, LLC, AJW Offshore, Ltd,
                    AJW
                    Qualified Partners, LLC and New Millennium Capital Partners II,
                    LLC
                    (Incorporated by reference as Exhibits on Form 8-K dated September
                    15,
                    2006).10.32
                Resell
                    Agreement for CyberBugTM (Incorporated by reference are the CyberBugTM
                    Agreements and a press release filed on Form 8-K dated October
                    10,
                    2006).10.33
                Revised
                    payment schedule of the License Agreement with Techsphere Systems
                    International, Inc. and 21stCentury Airship, Inc. (Incorporated by reference as Exhibit to
                    a Form 8-K
                    dated October 26, 2006).10.34
                10-QSB
                    for the quarter ended September 30, 2006, filed on November 20,
                    2006.10.35
                Resignation
                    of Mr. Viereda as Director of the Company (Incorporated by reference
                    is
                    the “End of Employment Statement” filed as Exhibit 17.1 on Form 8-K dated
                    November 22, 2006).10.36
                Resignation
                    of Mr. Robinson as President of Techsphere Systems International,
                    Inc.
                    (“TSI”) announced on Form 8-K dated December 21,
                    2006.
 10.37
              On
                  February 5th , 2007, Registrant raised $250,000 for an aggregate
                  of 2.5%
                  membership interest in the TSI, LLC, leaving Cyber Defense Systems,
                  Inc
                  with an aggregate interest membership of 97.5% in TSI, LLC (incorporated
                  by reference to Exhibit 10.25 filed with the SEC on February
                  9,2007)10.38
              Contract
                  award from Sierra Nevada Corporation (Incorporated by reference
                  to this
                  Exhibit 10.26 filed with the SEC on March 5,2007)10.39
              Repayment
                  of an Officer loan (Incorporated by reference to this Exhibit filed
                  with
                  the SEC on an 8-K filed on April 5, 2007.)10.40
              Adoption
                  of the 2005 Stock Option Plan (Incorporated by reference to this
                  Exhibit
                  10.27 filed with the SEC on a registration statement on Form S-8
                  on March
                  27, 2007.)21
              List
                  of Company's subsidiaries31.1*
              Rule
                  13a-14(a)/15d-14(a) Certification32.1*
              Section
                  1350 - Certification





*
      Filed
      herewith.





34




**ITEM
      14. PRINCIPAL ACCOUNTANT FEES AND SERVICES.**





The
      following is a summary of the aggregate fees billed to us by Hansen Barnett
      and
      Maxwell, P.C. for the fiscal years ended December 31, 2006 and
      2005:





**2006**
            
            **2005**Audit
                fees
            
            $
            93,280
            
            $
            80,560Audit
                related fees
            
            
            44,703
            
            
            17,633Tax
                fees
            
            
            4,450
            
            
            3,500Other
                fees
            
            
            -
            
            
            -Total
                fees
            
            $
            142,433
            
            $
            101,693





35


**SIGNATURES**





Pursuant
      to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
      1934, as amended, the Company has duly caused this amended report to be signed
      on its behalf by the undersigned, thereunto duly authorized on the
      18 th day of
      May 2007.




**CYBER
              DEFENSE SYSTEMS, INC.**By:
            /s/ *William
              C. Robinson**William C. Robinson, Chairman, CEO,*
              *and *Principal
                Executive Officer**





Pursuant
      to the requirements of the Securities Exchange Act of 1934, as amended, this
      amended report has been signed by the following persons in the capacities and
      on
      the dates indicated.






Signature
              
              Title
              
              Date/s/
                  William C. Robinson
              
              Chairman,
                  Chief Executive Officer,
              
              May
                  18, 2007William
                  C. Robinson
              
              Principal
                  Executive Officer/s/
                  David M. Barnes
              
              Chief
                  Financial Officer
              
              May
                  18, 2007David
                  M. Barnes/s/
                  Stephen I. Johnson RADM USN (ret.)
              
              Director
              
              May
                  18, 2007Stephen
                  I. Johnson RADM USN (ret.)/s/
                  Joseph A. Grace, Jr.
              
              Director
              
              May
                  18, 2007Joseph
                  A. Grace, Jr./s/
                  Marinko Vekovic
              
              Director
              
              May
                  18, 2007Marinko
                  Vekovic/s/
                  Frank Lively
              
              Director
              
              May
                  18, 2007Frank
                  Lively/s/
                  Mike Lawson
              
              Director
              
              May
                  18, 2007Mike
                  Lawson
  36




**CYBER
      DEFENSE SYSTEMS, INC.**


INDEX
  PagePART
                  II.Report
                  of Independent Registered Public Accounting Firm
              F-1Consolidated
                  Balance Sheets as of December 31, 2006 and 2005
              F-2Consolidated
                  Statements of Operations for the Years Ended December 31, 2006
                  and
                  December 31, 2005
              F-3Consolidated
                  Statements of Stockholders' Deficit for the Years Ended December
                  31, 2006
                  and December 31, 2005
              F-4Consolidated
                  Statements of Cash Flows for the Years Ended December 31, 2006
                  and
                  December 31, 2005
              F-5Notes
                  to the Consolidated Financial Statements
              F-7











**H****ANSEN****,
                B****ARNETT****&
                M****AXWELL
                P.C.**A
                Professional CorporationCERTIFIED
                PUBLIC ACCOUNTANTS5
                Triad Center, Suite 750
            
            **Registered
                with the Public Company**Salt
                Lake City, UT 84180-1128
            
            **Accounting
                Oversight Board**Phone:
                (801) 532-2200Fax:
                (801) 532-7944www.hbmcpas.com





**REPORT
      OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**




To
      the
      Board of Directors and Stockholders Cyber Defense Systems, Inc. St. Petersburg,
      Florida





We
      have
      audited the accompanying consolidated balance sheets of Cyber Defense Systems,
      Inc. and Subsidiary as of December 31, 2006 and 2005, and the related
      consolidated statements of operations, stockholders’ deficit, and cash flows for
      the years ended December 31, 2006 and 2005. These financial statements are
      the
      responsibility of the Company’s management. Our responsibility is to express an
      opinion on these financial statements based on our audits.





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





In
      our
      opinion, based on our audits, the financial statements referred to above present
      fairly, in all material respects, the consolidated financial position of Cyber
      Defense Systems, Inc. and Subsidiary as of December 31, 2006 and 2005, and
      the
      results of its operations and its cash flows for the years ended December 31,
      2006 and 2005, in conformity with U.S. generally accepted accounting
      principles.




The
      accompanying consolidated financial statements have been prepared assuming
      that
      the Company will continue as a going concern. The Company had losses and working
      capital deficits for 2006 and 2005. As discussed in Note 1 to the financial
      statements, there is substantial doubt about the Company's ability to continue
      as a going concern. Management's plans concerning these matters are also
      described in Note 1. The consolidated financial statements do not include any
      adjustments that might result from the outcome of this uncertainty.




/s/
              HANSEN, BARNETT & MAXWELL P.C.HANSEN, BARNETT & MAXWELL
              P.C.Salt Lake City, UtahMay 18,
              2007











F-1


**CYBER
      DEFENSE SYSTEMS, INC. AND SUBSIDIARY**


**CONSOLIDATED
      BALANCE SHEETS**


**December
      31, 2006 and 2005**


**ASSETS****2006**
              
              **2005**Current
                  assetsCash
                  and cash equivalents
              
              $
              86,703
              
              $
              476Accounts
                  receivable
              
              
              35,870
              
              
              364,299Inventories
              
              
              1,170,557
              
              
              336,523Prepaid
                  expenses
              
              
              60,000
              
              
              32,580Total
                  current assets
              
              
              1,353,130
              
              
              733,878Non-current
                  assetsProperty
                  and equipment, net of accumulated depreciation of $26,426 and $10,173,
                  respectively
              
              
              66,357
              
              
              91,973Deposits
                  on equipment
              
              
              —
              
              
              150,976Loan
                  costs, net of accumulated amortization of $940,099 and 364,697,
                  respectively
              
              
              900,683
              
              
              1,228,897Security
                  deposits
              
              
              7,371
              
              
              7,371Airship
                  manufacturing licenses, net of accumulated amortizationof
                  $75,000 and $230,933, respectively
              
              
              2,025,000
              
              
              14,024,656Intangible
                  assets, net of accumulated amortization of $94,449 and $61,113,
                  respectively
              
              
              5,551
              
              
              38,887Total
                  assets
              
              $
              4,358,092
              
              $
              16,276,638**LIABILITIES
                  AND STOCKHOLDERS’ DEFICIT**Current
                  liabilitiesAccounts
                  payable and accrued liabilities
              
              $
              1,506,139
              
              $
              2,714,646Accrued
                  royalties
              
              
              1,150,000
              
              
              282,181Accrued
                  interest
              
              
              912,910
              
              
              329,626Accounts
                  payable - related parties
              
              
              —
              
              
              53,337Refundable
                  customer deposit
              
              
              2,760,000
              
              
              —Deferred
                  revenue
              
              
              416,667
              
              
              450,000Notes
                  payable - related parties
              
              
              744,916
              
              
              1,562,315Notes
                  payable - third parties
              
              
              1,572,875
              
              
              1,728,075Embedded
                  derivative liability
              
              
              11,291,671
              
              
              10,057,733Total
                  current liabilities
              
              
              20,355,178
              
              
              17,177,913Long
                  term notes payable, net of discounts  of $3,160,382 and $2,762,333,
                  respectively
              
              
              2,079,398
              
              
              655,358Deferred
                  taxes
              
              
              —
              
              
              217,325Total
                  liabilities
              
              
              22,434,576
              
              
              18,050,596Commitments
                  and contingencies
              
              
              —
              
              
              —Stockholders’
                  deficit:Class
                  A Preferred stock, $0.001 par value 10,000,000 shares authorized,
                  none
                  issued andoutstanding
              
              
              —
              
              
              —Class
                  A, $0.001 par value, 200,000,000 shares authorized,66,657,316
                  and 56,912,893 shares issued and outstanding, respectively
              
              
              66,657
              
              
              56,913Class
                  B, $0.001 par value, 200,000,000 shares authorized, 545,455 shares
                  issued
                  and outstanding
              
              
              545
              
              
              545Class
                  C, $0.001 par value, 200,000,000 shares authorized, 2 shares issued
                  and
                  outstanding
              
              
              —
              
              
              —Additional
                  paid in capital
              
              
              20,372,513
              
              
              14,644,966Accumulated
                  deficit
              
              
              (38,516,199
              )
              
              (16,476,382
              )Total
                  stockholders’ deficit
              
              
              (18,076,484
              )
              
              (1,773,958
              )Total
                  liabilities and stockholders’ deficit
              
              $
              4,358,092
              
              $
              16,276,638





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





F-2





**CYBER
      DEFENSE SYSTEMS, INC. AND SUBSIDIARY**


**CONSOLIDATED
      STATEMENTS OF OPERATIONS**


**For
      the Years ended December 31, 2006 and 2005**


**Years
                  Ended December 31,****2006**
              
              **2005**Revenues
              
              $
              494,220
              
              $
              461,244Cost
                  of goods sold
              
              
              223,388
              
              
              449,995Gross
                  profit
              
              
              270,832
              
              
              11,249Operating
                  expenses:Research
                  and development
              
              
              281,380
              
              
              691,660General
                  and administrative
              
              
              6,486,104
              
              
              4,031,236Stock
                  option compensation
              
              
              2,271,687
              
              
              101,186Impairment
                  of license
              
              
              11,330,674
              
              
              —Impairment
                  of goodwill
              
              
              —
              
              
              4,577,069Total
                  expenses
              
              
              20,369,845
              
              
              9,401,151Loss
                  from operations
              
              
              (20,099,013
              )
              
              (9,389,902
              )Other
                  income (expense):Interest
                  income
              
              
              —
              
              
              4,689Interest
                  expense
              
              
              (3,193,247
              )
              
              (2,459,269
              )Derivative
                  valuation gain (loss)
              
              
              1,035,118
              
              
              (6,182,166
              )Total
                  other income (expense)
              
              
              (2,158,129
              )
              
              (8,636,746
              )Loss
                  before provision for income taxes
              
              
              (22,257,142
              )
              
              (18,026,648
              )Income
                  tax benefit
              
              
              217,325
              
              
              2,447,624Net
                  loss
              
              $
              (22,039,817
              )
              $
              (15,579,024
              )Basic
                  and diluted loss per share
              
              $
              (0.36
              )
              $
              (0.47
              )Weighted-average
                  common shares outstanding
              
              
              60,949,571
              
              
              33,397,028




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





F-3





**CYBER
      DEFENSE SYSTEMS, INC. AND SUBSIDIARY**


**CONSOLIDATED
      STATEMENTS OF STOCKHOLDERS’ DEFICIT**


**For
      the Period from December 31, 2004 through December 31,
      2006**





**Class
                A**
            
            **Class
                B**
            
            **Class
                C**
            
            
            
            **Other**
            
            **Additional**
            
            **Total****Common
                Stock**
            
            **Common
                Stock**
            
            **Common
                Stock**
            
            **Accumulated**
            
            **Comprehensive**
            
            **Paid
                in**
            
            **Stockholders’****Shares**
            
            **Amount**
            
            **Shares**
            
            **Amount**
            
            **Shares**
            
            **Amount**
            
            **Deficit**
            
            **Loss**
            
            **Capital**
            
            **Deficit**Balance
                at December 31, 2004
            
            
            25,921,562
            
            $
            25,921
            
            
            150,000
            
            $
            150
            
            
            2
            
            $
            -
            
            $
            (897,358
            )
            $
            (7,064
            )
            $
            461,762
            
            $
            (416,589
            )Class
                A and B stockissued
                for acquisitions
            
            
            24,726,923
            
            
            24,728
            
            
            395,455
            
            
            395
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            9,918,754
            
            
            9,943,877Class
                A shares issued for:Conversion
                of unrelated notes payable
            
            
            4,858,000
            
            
            4,858
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            1,494,659
            
            
            1,499,517Cash
            
            
            217,391
            
            
            217
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            249,783
            
            
            250,000Exercise
                of stock options
            
            
            88,000
            
            
            88
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            5,121
            
            
            5,209Services
            
            
            1,101,017
            
            
            1,101
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            667,648
            
            
            668,749Conversions
                of derivative securities
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            1,746,053
            
            
            1,756,053Stock
                option compensation
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            101,186
            
            
            101,186Net
                loss for the year
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (15,579,024
            )
            
            
            
            
            
            
            
            (15,579,024
            )Currency
                translation adjustment
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            7,064
            
            
            
            
            
            7,064Comprehensive
                loss
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (15,571,960
            )Balance
                at December 31, 2005
            
            
            56,912,893
            
            $
            56,913
            
            
            545,455
            
            $
            545
            
            
            2
            
            $
            -
            
            $
            (16,476,382
            )
            $
            -
            
            $
            14,644,966
            
            $
            (1,773,958
            )Class
                A Common Stock issued for:Services
            
            
            1,425,170
            
            
            1,425
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            380,370
            
            
            381,795Conversion
                of related party notethrough
                the exercise of options
            
            
            3,735,088
            
            
            3,735
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            728,282
            
            
            732,017Debt
                conversion - related parties
            
            
            937,776
            
            
            938
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            288,395
            
            
            289,333Debt
                conversion - unrelated parties
            
            
            3,067,953
            
            
            3,068
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            694,175
            
            
            697,243Exercise
                of options
            
            
            761,074
            
            
            761
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            151,454
            
            
            152,215Unrelated
                party debt
            
            
            317,362
            
            
            317
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            56,808
            
            
            57,125Cancellation
                of stock previously issued
            
            
            (500,000
            )
            
            (500
            )
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            500
            
            
            --Stock
                option compensation
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            2,271,687
            
            
            2,271,687Warrants
                issued for services
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            419,760
            
            
            419,760Conversions
                of derivative securities
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            736,116
            
            
            736,116Net
                loss for the year
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (22,039,817
            )
            
            
            
            
            
            
            
            (22,039,817
            )Balance
                at December 31, 2006
            
            
            66,657,316
            
            
            66,657
            
            
            545,455
            
            $
            545
            
            
            2
            
            $
            -
            
            
            (38,516,199
            )
            $
            -
            
            
            20,372,513
            
            
            (18,076,484
            )





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





F-4





**CYBER
      DEFENSE SYSTEMS, INC. AND SUBSIDIARY**


**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**


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





**Years
                  Ended December 31,****2006**
              
              **2005**Cash
                  flows from operating activities:Net
                  loss
              
              $
              (22,039,817
              )
              $
              (15,579,024
              )Adjustments
                  to reconcile net loss to net cash from operating
                  activitiesStock
                  option compensation
              
              
              2,271,687
              
              
              101,186Depreciation
                  and amortization
              
              
              1,293,973
              
              
              694,265Impairment
                  of license
              
              
              —
              
              
              4,577,069Impairment
                  of goodwill
              
              
              11,330,674
              
              
              —(Gain)
                  loss from derivative
              
              
              (1,035,118
              )
              
              6,182,866Interest
                  expense from loan discount amortization
              
              
              2,443,190
              
              
              1,774,667Issuance
                  of stock for services
              
              
              389,793
              
              
              818,750Issuance
                  of warrant for services
              
              
              419,760
              
              
              —Issuance
                  of note payable for services
              
              
              351,192
              
              
              —Income
                  tax benefit
              
              
              (217,325
              )
              
              (2,447,624
              )Write
                  off of deposit on assets
              
              
              150,976
              
              
              —Write
                  off of intangible assets
              
              
              —
              
              
              5,543Changes
                  in assets and liabilities:Accounts
                  receivable
              
              
              328,429
              
              
              620,634Inventories
              
              
              (834,034
              )
              
              (255,002
              )Prepaid
                  interest
              
              
              (27,420
              )
              
              (27,173
              )Security
                  deposits
              
              
              —
              
              
              (215
              )Accounts
                  payable and accrued liabilities
              
              
              (809,869
              )
              
              (367,771
              )Accrued
                  royalties
              
              
              867,819
              
              
              282,181Accrued
                  interest
              
              
              672,907
              
              
              —Refundable
                  customer deposit
              
              
              2,760,000
              
              
              —Deferred
                  revenue
              
              
              (33,333
              )
              
              (16,667
              )Net
                  cash flows from operating activities
              
              
              (1,716,516
              )
              
              (3,636,315
              )Cash
                  flows from investing activities:Purchases
                  of equipment
              
              
              (2,636
              )
              
              (12,000
              )Change
                  in related party payables
              
              
              —
              
              
              (420,246
              )Cash
                  received in acquisition
              
              
              —
              
              
              25,010Net
                  cash flows from investing activities
              
              
              (2,636
              )
              
              (407,236
              )Cash
                  flows from financing activities:Payment
                  on loan costs
              
              
              (160,000
              )
              
              (290,833
              )Proceeds
                  from notes payable
              
              
              2,082,000
              
              
              4,275,000Proceeds
                  from notes payable - related parties
              
              
              341,518
              
              
              1,426,764Payments
                  on notes payable - related parties
              
              
              (75,000
              )
              
              (373,542
              )Payments
                  on notes payable
              
              
              (383,139
              )
              
              (347,342
              )Payments
                  on debt assumed from subsidiary
              
              
              —
              
              
              (33,337
              )Issuance
                  of common stock
              
              
              —
              
              
              250,000Proceeds
                  from issuance of stock options
              
              
              —
              
              
              5,209Loan
                  to TSI
              
              
              —
              
              
              (1,074,162
              )Net
                  cash flows from financing activities
              
              
              1,805,379
              
              
              3,837,757Net
                  change in cash and cash equivalents
              
              
              86,227
              
              
              (205,794
              )Cash
                  and cash equivalents, beginning of year
              
              
              476
              
              
              206,270Cash
                  and cash equivalents, end of year
              
              $
              86,703
              
              $
              476





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





F-5





**CYBER
      DEFENSE SYSTEMS, INC. AND SUBSIDIARY**


**CONSOLIDATED
      STATEMENTS OF CASH FLOWS (Continued)**


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


Supplemental
                  disclosure of cash flow information:Cash
                  paid for interest
              
              $
              21,445
              
              $
              217,484Cash
                  paid for income taxes
              
              
              --
              
              
              --Supplemental
                  disclosure of non-cash investing and financinginformation:Issued
                  stock for debt
              
              $
              --
              
              $
              1,499,517





The
      accompanying notes are an integral part of these consolidated financial
      statements





F-6


**CYBER
      DEFENSE SYSTEMS, INC. AND SUBSIDIARY**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**


**DECEMBER
      31, 2006 AND 2005**




**NOTE
      1 - ORGANIZATION, ACQUISITIONS AND MERGERS AND CONTROLLING
      SHAREHOLDERS**




Cyber
      Defense Systems, Inc. ("the Registrant" or "Cyber Defense" or "the Company")
      was
      incorporated on August 19, 2004 in Florida. E-City Software, Inc. ("E-City")
      was
      organized in Nevada on May 12, 2000. On Alert Systems, Inc. ("On Alert") was
      incorporated on March 17, 2003 in Nevada and acquired a control position in
      E-City in May of 2003 and in Cyber Aerospace Corp. ("Cyber Aerospace") in March
      2004. On Alert was merged with and into Cyber Defense on September 1, 2004.
      On
      September 1, 2004 E-City was also merged with and into Cyber Defense following
      the On Alert merger. As a result of the aforementioned, Cyber Defense became
      the
      successor to E-City and its shares of class A common stock began trading on
      the
      Over the Counter Bulletin Board ("OTC:BB") under the symbol CYDF on September
      7,
      2004. Due to the nature of the mergers, the fiscal year end of the Company
      was
      changed to December 31 effective for Fiscal 2003 and the historical financial
      statements of the Company are now those of On Alert and include results of
      operations for Cyber Aerospace from its date of inception in March 2004, as
      it
      was previously a subsidiary of On Alert, and includes the results of operations
      of E-City from it's date of merger, September 1, 2004. Cyber Aerospace was
      merged with and into Cyber Defense effective March 31, 2005 with the acquisition
      of the 6.19% minority interest in Cyber Aerospace for 1,650,000 shares of class
      A common stock and 150,000 shares of class B common stock. In addition, on
      September 19, 2005, the Company acquired its wholly owned subsidiary Techsphere
      Systems International, Inc. ("TSI") for 23,076,923 Class A common shares and
      245,455 Class B common shares.




The
      controlling shareholders of the company are Proxity, Inc. ("Proxity"), a
      publicly traded company ("PRXT") and Cherokee Raiders, a partnership,
      ("Cherokee") owning approximately 21.9% and13.0% of the Class A common shares
      of
      the Company, respectively. In addition, the former shareholders of TSI also
      own
      21,219,111 shares or 31.8% of the Class A common stock and 245,455 or 45%,
      of
      the issued and outstanding shares of Class B common stock as of December 31,
      2006. Cherokee owns 300,000 or 55% of such class B shares which allow for 1,000
      votes per share and as a result, Cherokee is the controlling shareholder of
      the
      Company. Cherokee and Proxity each own one share of the two shares of Class
      C
      common stock issued and outstanding which have certain liquidation preference
      rights. The Chief Executive Officer of both Proxity and Cherokee is Mr.
      Robinson, the Chief Executive Officer of the Company.




Consolidation
      -- The accompanying condensed consolidated financial statements include the
      accounts and transactions of Cyber Defense Systems, Inc. for all periods
      presented and the accounts and transactions of Cyber Defense, and its TSI wholly
      owned subsidiary from its date of acquisition on September 19, 2005,
      (collectively the "Company"). Intercompany accounts and transactions have been
      eliminated in consolidation.




Use
      of
      Estimates -- The preparation of financial statements in conformity with
      accounting principles generally accepted in the United States of America
      requires management to make estimates and assumptions that affect the reported
      amounts of assets and liabilities, disclosure of contingent assets and
      liabilities and the reported amounts of revenues and expenses during the
      reporting period. Actual results could differ from those estimates.




Business
      Condition -- The accompanying financial statements have been prepared on a
      going
      concern basis, which contemplates the realization of assets and the satisfaction
      of liabilities in the normal course of business. For the year ended December
      31,
      2006 the Company recorded revenues of $494,220 and incurred a net loss of
      $22,039,817. For the year ended December 31, 2005, the Company recorded revenues
      of $461,244 and incurred a net loss of $15,579,024. As of December 31, 2006
      and
      2005 the net working capital deficit was $19,002,048 and $16,444,035,
      respectively. The lack of sufficient revenues and the losses from operations
      raise substantial doubt about the Company's ability to continue as a going
      concern for a reasonable period of time. The financial statements do not include
      any adjustments relating to the recoverability and classification of recorded
      assets or the amount and classification of liabilities which might be necessary
      should the Company be unable to continue as a going concern. The Company's
      continuation as a going concern is dependent upon its ability to generate
      sufficient cash flows to meet its obligations on a timely basis, to obtain
      additional financing as further discussed in Notes 5, 6 and 10 as may be
      required, and ultimately to attain successful operations.




F-7




Cash
      and
      Cash Equivalents -- Cash equivalents include highly liquid short-term
      investments with original maturities of three months or less, readily
      convertible to known amounts of cash. At December 31, 2006 and 2005 the Company
      had no cash in excess of federally insured limits.




Inventory
      -- At December 31, 2006 and December 31, 2005, inventory of $1,170,557 and
      $336,523, respectively primarily consists of parts for the airships and Unmanned
      Aerial Vehicles ("UAV's") that the Company sells, leases and
      services.




Property
      and Equipment -- Property and equipment is recorded at cost. Depreciation is
      computed using the straight-line method over the estimated useful lives of
      the
      assets ranging from 3 to 5 years. Expenditures for maintenance, repairs, and
      renewals are charged to expense as incurred. Expenditures for major renewals
      and
      betterments that extend the useful lives of existing equipment are capitalized
      and depreciated. On retirement or disposition of property and equipment, the
      cost and accumulated depreciation are removed and any resulting gain or loss
      is
      recognized in the statement of operations.




Long-lived
      assets are reviewed for impairment when events or changes in circumstances
      indicate that the carrying amount may not be recoverable. Recoverability of
      assets to be held and used is measured by comparison of the carrying amount
      of
      an asset to future net cash flows expected to be generated by the asset. If
      such
      assets are considered to be impaired, the impairment to be recognized is
      measured by the amount that the carrying amount of the assets exceeds the fair
      value of the assets. Assets to be disposed of are reported at the lower of
      the
      carrying amount or fair value less costs to sell. During the year ended December
      31, 2006, management determined an impairment of its long lived assets was
      required. Management determined that the value of the license from 21st Century
      Airships was impaired. As a result of this determination, the Company recorded
      an impairment loss for $11,330,674. This loss has been recorded under the
      caption “Impairment of license” in the accompanying Statement of Operations for
      the year ended December 31, 2006. In addition, management determined that the
      estimated remaining useful life to be 7 years. For the year ended December
      31,
      2005, goodwill of $4,577,069 relating to the acquisition of the 6.19% minority
      interest in Cyber Aerospace as of March 31, 2005 was impaired and has been
      recorded under the caption “Impairment of Goodwill” on the accompanying
      Statement of Operations for the year ended December 31, 2005.




Manufacturing
      License -- The Company acquired an exclusive manufacturing license initially
      valued at $14,255,649 with the acquisition of TSI in September, 2005. The
      Company evaluated the carrying value of the license to determine if the carrying
      amount warranted revision or may not be recoverable. In management's opinion,
      an
      adjustment was required during the year ended December 31, 2006. The adjustment
      was to reduce the carrying value of the asset to $2,100,000 based upon
      management's estimate of the fair value of the asset at September 30, 2006.
      In
      addition, the estimated remaining useful life was reduced from 18 years from
      the
      date of acquisition to 7 years from September 30, 2006. Management believes
      that
      no further impairment to this asset is required at December 31,
      2006.




Fair
      Values of Financial Instruments -- The carrying amounts reported in the balance
      sheet for notes payable approximate their fair values because the interest
      rates
      approximate current interest rates to be charged on similar
      borrowings.




Revenue
      Recognition - The Company recognizes service revenues when the services, as
      specified by the customer and agreed to by the Company, have been performed
      and
      the customer accepts the services, and the services are billed. Airship and
      UAV
      sales are recognized when contract specifications are met, the price is
      determined, title passes to the customer and the customer is billed. Lease
      revenue on airships is recognized over the term of the lease. Reasonableness
      of
      collectibility of all revenue transactions is a key element before the
      transactions are recorded.




Share
      Based Payments - In December 2004, the Financial Accounting Standards Board
      issued Statement Number 123 ("FAS 123 (R)"), Share-Based Payments, which was
      adopted by the Company on January 1, 2006. The Company recognizes compensation
      expense in an amount equal to the fair value of share based payments such as
      stock options granted to employees. The Company has elected to apply FAS 123
      (R)
      using the modified prospective method. Under this method, the Company records
      compensation expense as awards that were outstanding at the date of adoption
      continue to vest for the unvested portion of the awards. If the Company had
      accounted for share based payments under the provisions of FAS 123(R) for the
      year ended December 31, 2005 approximately $674,568 in additional expense would
      have been recorded for the stock options issued on September 19,
      2005.




F-8




Prior
      to
      January 1, 2006 the Company used Statement of Financial Accounting Standards
      No.
      148 "Accounting for Stock-Based Compensation - Transition and Disclosure" (SFAS
      No. 148) to account for stock based compensation arrangements. This statement
      amended the disclosure provision of FASB statement No. 123 to require prominent
      disclosure about the effects on reported net income of an entity's accounting
      policy decisions with respect to stock-based employee compensation. As permitted
      by SFAS No. 123 and amended by SFAS No. 148, we continued to apply the intrinsic
      value method under Accounting Principles Board ("APB") Opinion No. 25,
      "Accounting for Stock Issued to Employees," to account for our stock-based
      employee compensation arrangements.




Derivative
      Instruments - The Company does not hold or issue derivative instruments for
      trading purposes. However, the Company has convertible notes payable that
      contain embedded derivatives that require separate valuation from the
      convertible notes under Emerging Issues Task Force Abstract (EITF) 00-19,
      "Accounting for Derivative Financial Instruments Indexed to, and Potentially
      Settled in, a Company's Own Stock". The Company recognizes these derivatives
      as
      liabilities in the accompanying balance sheet and measures them at estimated
      fair value each quarter, and recognizes changes in estimated fair value in
      the
      statement of operations in the respective period. The Company has estimated
      the
      fair value of these embedded derivatives using the Black-Scholes
      model.




Income
      Taxes -- No income taxes have been paid or accrued because the Company has
      had
      no net taxable income since inception. The Company recognizes the amount of
      income taxes payable or refundable for the current year and recognizes deferred
      tax assets and liabilities for the future tax consequences attributable to
      differences between the financial statement amounts of certain assets and
      liabilities and their respective tax bases. Deferred tax assets and deferred
      liabilities are measured using enacted tax rates expected to apply to taxable
      income in the years those temporary differences are expected to be recovered
      or
      settled. Deferred tax assets are reduced by a valuation allowance to the extent
      that uncertainty exists as to whether the deferred tax assets will ultimately
      be
      realized.




Earnings
      (Loss) Per Share --Basic earnings (loss) per share is calculated by dividing
      earnings (loss) available to Class A common shareholders by the weighted-average
      number of Class A common shares outstanding during each period. Fully diluted
      income (loss) per share for the years ended December 31, 2006 and 2005 is the
      same as basic due to losses sustained by the Company for those
      years.




The
      following potentially dilutive common shares are excluded from the computation
      of diluted net loss per share for all periods presented because the effect
      is
      anti-dilutive:


**Years
                  ended December 31,****2006**
              
              **2005**Shares
                  underlying warrants
              
              
              7,200,000
              
              
              4,400,000Shares
                  underlying options
              
              
              9,156,838
              
              
              11,379,900Shares
                  underlying convertible debt
              
              
              71,581,534
              
              
              21,983,325Shares
                  underlying convertible debt - related parties
              
              
              2,483,053
              
              
              5,207,717Total
                  potentially dilutive securities
              
              
              90,421,425
              
              
              42,970,942




Advertising
      Costs -- The Company expenses advertising costs as incurred. These costs
      amounted to $75,494 and $42,482 in 2006 and 2005, respectively.




Concentrations
      Of Risk - At December 31, 2006, three customers account for 40%, 32% and 28%
      of
      accounts receivable, respectively. In addition, three customers accounted for
      49%, 14% and 11% of sales for the year ended December 31, 2006, respectively.
      At
      December 31, 2005, a total of 94% of accounts receivable is due from one
      customer. In addition, two customers comprised 61% and 21% of sales,
      respectively for the year ended December 31, 2005.




F-9




Recently
      Issued Accounting Pronouncements -- In February 2006, the FASB issued Statement
      of Financial Accounting Standards No. 155, "Accounting for Certain Hybrid
      Financial Instruments," referred to as SFAS No. 155. This statement amends
      SFAS
      No. 133 "Accounting for Derivative Instruments and Hedging Activities" and
      SFAS
      No. 140 "Accounting for Transfers and Servicing of Financial Assets and
      Extinguishments of Liabilities." SFAS No. 155 permits fair value remeasurement
      for hybrid financial instruments that contain embedded derivatives that would
      require separate accounting. In addition, the statement establishes a
      requirement to evaluate interests in securitized financial assets to identify
      interests that are freestanding derivatives or that are hybrid financial
      instruments that contain embedded derivatives. SFAS No. 155 is effective for
      all
      financial instruments acquired or issued beginning after an entity's fiscal
      year
      beginning on or after September 15, 2006 with earlier adoption permitted.
      Management believes this Statement will have no impact on the financial
      statements of the Company once adopted.




In
      March
      2006, the FASB issued FASB Statement No. 156, which amends FASB Statement No.
      140. This Statement establishes, among other things, the accounting for all
      separately recognized servicing assets and servicing liabilities. This Statement
      amends Statement 140 to require that all separately recognized servicing assets
      and servicing liabilities be initially measured at fair value, if practicable.
      This Statement permits, but does not require, the subsequent measurement of
      separately recognized servicing assets and servicing liabilities at fair value.
      An entity that uses derivative instruments to mitigate the risks inherent in
      servicing assets and servicing liabilities is required to account for those
      derivative instruments at fair value. Under this Statement, an entity can elect
      subsequent fair value measurement to account for its separately recognized
      servicing assets and servicing liabilities. By electing that option, an entity
      may simplify its accounting because this Statement permits income statement
      recognition of the potential offsetting changes in fair value of those servicing
      assets and servicing liabilities and derivative instruments in the same
      accounting period. This Statement is effective for financial statements for
      fiscal years beginning after September 15, 2006. Earlier adoption of this
      Statement is permitted as of the beginning of an entity's fiscal year, provided
      the entity has not yet issued any financial statements for that fiscal year.
      Management believes this Statement will have no impact on the financial
      statements of the Company once adopted.




In
      June,
      2006 the FASB issued FIN 48, "Accounting for Uncertainty in Income Taxes--an
      interpretation of FASB Statement No. 109". This Interpretation clarifies, among
      other things, the accounting for uncertainty in income taxes recognized in
      an
      enterprise's financial statements in accordance with FASB Statement No. 109,
      Accounting for Income Taxes. This Interpretation prescribes a recognition
      threshold and measurement attribute for the financial statement recognition
      and
      measurement of a tax position taken or expected to be taken in a tax return.
      This Interpretation also provides guidance on derecognition, classification,
      interest and penalties, accounting in interim periods, disclosure, and
      transition and is effective for fiscal years beginning after December 15, 2006.
      Earlier application is encouraged if the enterprise has not yet issued financial
      statements, including interim financial statements, in the period the
      Interpretation is adopted. FIN 48, Accounting for Uncertainty in Income
      Taxes--an interpretation of FASB Statement No. 109, is effective for fiscal
      years beginning after December 15, 2006. Earlier application is encouraged
      if
      the enterprise has not yet issued financial statements, including interim
      financial statements, in the period the Interpretation is adopted. Management
      believes this Statement will have no impact on the financial statements of
      the
      Company once adopted.




In
      September 2006, the FASB issued SFAS No. 157, "Fair Value Measures" ("SFAS
      157"). SFAS 157 defines fair value, establishes a framework for measuring fair
      value, and expands disclosures about fair value measurements. This statement
      applies under other accounting pronouncements that require or permit fair value
      measurements. However, it does not apply to SFAS 123(R). This statement shall
      be
      effective for financial statements issued for fiscal years beginning after
      November 15, 2007, and interim periods within those fiscal years. Earlier
      application is encouraged, provided that the reporting entity has not issued
      financial statements for that fiscal year, including any financial statements
      for an interim period within that fiscal year. The provisions of this statement
      should be applied prospectively as of the beginning of the fiscal year in which
      this Statement is initially applied, except in some circumstances where the
      statement shall be applied retrospectively. The Company is currently evaluating
      the effect, if any, of SFAS 157 on its financial statements.




F-10




In
      September 2006, the FASB issued SFAS No. 158, "Employers' Accounting for Defined
      Benefit Pension and Other Postretirement Plans--an amendment of FASB Statements
      No. 87, 88, 106, and 132(R)" ("SFAS 158"). This Statement requires recognition
      of the overfunded or underfunded status of a defined benefit postretirement
      plan
      (other than a multiemployer plan) as an asset or liability in its statement
      of
      financial position and to recognize changes in that funded status in the year
      in
      which the changes occur through comprehensive income. It also requires an
      employer to measure the funded status of a plan as of the date of its year-end
      statement of financial position. The statement is effective as of the end of
      the
      fiscal year ending after December 15, 2006. Management believes that adoption
      of
      this standard will not have a material impact on the Company's financial
      statements.




In
      September, 2006 the Securities and Exchange Commission issued Staff Accounting
      Bulletin 108 ("SAB 108"), "Considering the Effects of Prior year Misstatements
      When Quantifying Misstatements in Current Year Financial Statements." SAB 108
      clarifies the staff's views regarding the process of quantifying financial
      statement misstatements. More specifically, the staff noted that certain
      registrants do not consider the effects of prior year errors on current year
      financial statements, thereby allowing improper assets or liabilities to remain
      unadjusted. The staff believes this approach is not in the best interests of
      the
      users of the financial statements. SAB 108 is effective for fiscal years ending
      on or after November 15, 2006 with earlier adoption encouraged. The Company
      is
      currently evaluating the impact that the adoption of SAB 108 will have, if
      any,
      on its financial statements and notes thereto.




In
      December 2006, the FASB issued EITF 00-19-2, “Accounting for Registration
      Payment Arrangements.” This FASB Staff Position (FSP) addresses an issuer’s
      accounting for registration payment arrangements. This FSP specifies that the
      contingent obligation to make future payments or otherwise transfer
      consideration under a registration payment arrangement, whether issued as a
      separate agreement or included as a provision of a financial instrument or
      other
      agreement, should be separately recognized and measured in accordance with
      FASB
      Statement No. 5, “Accounting for Contingencies.” The guidance in this FSP
      amends FASB Statements No. 133, “Accounting for Derivative instruments and
      Hedging Activities,” and No. 150, “Accounting for Certain Financial
      Instruments with Characteristics of both Liabilities and Equity,” and FASB
      Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements
      for Guarantees, Including Indirect Guarantees of Indebtedness of Others,” to
      include scope exceptions for registration payment arrangements. This FSP further
      clarifies that a financial instrument subject to a registration payment
      arrangement should be accounted for in accordance with other applicable
      generally accepted accounting principles (GAAP) without regard to the
      contingent obligation to transfer consideration pursuant to the registration
      payment arrangement. The Company does have obligations related to registration
      rights for certain warrants and options granted to AJW, but the penalties
      pertaining to these agreements have been waived by agreement with AJW dated
      September 28, 2006 upon the reduction of the price of 4,000,000
      warrants.





In
      February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for
      Financial Assets and Financial Liabilities”, including an amendment of FASB
      Statement No. 115 (“SFAS 159”). This pronouncement permits entities to choose to
      measure many financial instruments and certain other items at fair value that
      are not currently required to be measured at fair value and to recognize the
      resulting gains and losses in the results of operations. SFAS 159 is effective
      as of the beginning of an entity’s first fiscal year that begins after November
      15, 2007. The impact of adopting SFAS 159 on the Company’s consolidated
      financial statements, if any, has not yet been determined.




**NOTE
      2 - RELATED PARTY TRANSACTIONS**




Cyber
      Aerospace - Prior to March 31, 2005, Cyber Aerospace ("Aerospace") had
      previously been consolidated with the Company as it was a 93.8% owned
      subsidiary. All transactions and account balances between the Company and
      Aerospace were eliminated during consolidation. On March 31, 2005, the Company
      purchased the minority interest so that Aerospace became a wholly owned
      subsidiary and was then merged with and into the Company.




F-11




Cherokee
      Raiders - Cherokee's general partner is William C. Robinson. Cherokee also
      owns
      300,000 Class B common shares, each of which entitles the holder to 1,000 votes.
      As a result, Cherokee is the controlling shareholder of the
      Company.




William
      C. Robinson - Mr. Robinson is President, CEO and Chairman of the Company and
      has
      significant ownership and control in Proxity and Cherokee Raiders.




During
      the year ended December 31, 2006, Mr. Robinson advanced an aggregate of $249,796
      and converted an aggregate of $485,000 to Class A common stock under his
      $1,000,000 line of credit to the Company. In addition, Mr. Robinson paid the
      January 17, 2006 unsecured note in the principal amount of $74,523 to a vendor.
      See Note 6. Mr. Frank Lively, a director of the Company advanced an additional
      $16,722. All of Mr. Lively's loans to the Company have been converted to Class
      A
      common stock as of December 31, 2006.




On
      April
      20, 2006 David Barnes, the Company's Chief Financial Officer utilized $11,000
      of
      fees due him to exercise options for 55,000 shares of the Company's Class A
      common stock at the exercise price of $0.20 per share. On July 21, 2006 the
      Board approved Mr. Barnes conversion of an additional $7,000 in fees into 46,666
      shares of Class A common stock at a price of $0.15 per share. The price was
      determined based on the market pricing as of the date of
      conversion.




**NOTE
      3 - ACQUISITIONS**




**Acquisition
      of TSI**




On
      September 19, 2005, Cyber Defense Systems, Inc. acquired all 100,000 common
      shares of the outstanding stock of TSI in exchange for 23,076,923 shares of
      Cyber Class A common stock and 245,455 shares of Cyber Class B common stock
      valued at $5,340,226 collectively, and TSI became a subsidiary of Cyber. The
      transaction was accounted for as a purchase business combination in accordance
      with FAS 141, "Business Combinations". An independent valuation was obtained
      for
      both the Cyber stock and TSI's exclusive manufacturing license. In connection
      with the acquisition by Cyber, TSI underwent a reorganization intended to
      qualify as a reorganization within the meaning of Section 368(a)(1)(A) and
      (a)(1)(D) of the Internal Revenue Code of 1986, as amended resulting in TSI
      becoming a regular corporation from a limited liability corporation. The 100,000
      shares of TSI stock were then exchanged for the Cyber stock mentioned above.
      Negative goodwill was not recognized in connection with the acquisition of
      Techsphere. Instead, the excess of the fair value of the net assets over the
      purchase price was allocated as a pro rata reduction of the amounts that
      otherwise would have been assigned to the long-term assets.




At
      September 19, 2005, the purchase price was allocated to the assets acquired
      and
      the liabilities assumed as follows:


**Assets
                  Acquired**Cash
              
              $
              25,010Accounts
                  receivable
              
              
              236,028Miscellaneous
                  receivable
              
              
              1,750Inventory
              
              
              81,521Prepaid
                  expenses
              
              
              5,407Property,
                  plant & equipment, net
              
              
              82,40521st
                  Century manufacturing license
              
              
              14,255,649Liabilities
                  assumed
              
              
              -6,682,456Deferred
                  Taxes
              
              
              -2,665,088Net
                  assets acquired
              
              $
              5,340,226
 F-12




The
      following pro-forma combined condensed statements of operations present what
      such results of operations would have been had the acquisition of TSI been
      consummated on January 1, 2005.




**Year
                  ended December 31, 2005****TSI**
              
              **Cyber**
              
              **Adjustments**
              
              **Combined**Revenues
              
              $
              2,272,108
              
              $
              137,256
              
              $
              (128,467
              )
                  (a)
              $
              2,280,897Cost
                  of sales
              
              
              2,151,684
              
              
              117,548
              
              
              -
              
              
              2,269,202Gross
                  margin
              
              
              120,424
              
              
              19,708
              
              
              (128,467
              )
              
              11,695General
                  & administrative expense
              
              
              2,223,396
              (b)
              
              3,895,278
              
              
              (128,467
              )
              
              5,990,207Impairment
                  loss
              
              
              -
              
              
              4,577,069
              
              
              -
              
              
              4,577,069Total
                  expenses
              
              
              4,375,050
              
              
              8,589,895
              
              
              (128,467
              )
              
              12,836,478Loss
                  from operations
              
              
              (2,102,942
              )
              
              (8,452,639
              )
              
              -
              
              
              (10,555,581
              )Other
                  expenses
              
              
              (399,818
              )
              
              (2,305,153
              )
              
              -
              
              
              (2,704,971
              )Derivative
                  valuation loss
              
              
              -
              
              
              (6,182,166
              )
              
              -
              
              
              (6,182,166
              )Income
                  taxes
              
              
              (1,615,116
              )
              
              4,062,740
              
              
              -
              
              
              2,447,624Net
                  loss
              
              $
              (4,117,876
              )
              $
              (12,877,218
              )
              
              
              
              $
              (16,995,094
              )Basic
                  and diluted loss per share
              
              
              
              
              
              
              
              
              
              
              $
              (0.33
              )Weighted
                  average shares outstanding
              
              
              
              
              
              
              
              
              
              
              
              51,858,567




**Footnotes
      to Pro Forma Condensed Statement of Operations**




(a)
      -
      Includes the adjustment for amortization of the value of the license with 21st
      Century Airships, Inc. of $417,301for fiscal 2005 as if the transaction had
      occurred as of January 1, 2005.




(b)
      - To
      eliminate the inter-company transaction related to the sale of the license
      for
      marketing and integration rights of Airships by TSI to Cyber.




**Acquisition
      of Minority Interest in Subsidiary**




On
      March
      31, 2005, the Company acquired the 6.19% minority interest in its majority
      owned
      subsidiary, Aerospace, and merged Aerospace into Cyber Defense. The merger
      was
      accounted for by the purchase method of accounting and was completed in order
      to
      consolidate operations into one company, with one name, and one group of
      shareholders, as well as to avoid what had become unnecessary bookkeeping
      expenses associated with maintaining Aerospace as a separate entity. For each
      share of Aerospace, the beneficial owner received one share of Cyber Defense.
      As
      a result, 1,650,000 shares of class A common stock were issued for the 6.19%
      ownership, along with 150,000 shares of class B common stock.




Aerospace
      had been a majority owned subsidiary of On Alert from the date of its inception
      in March 2004 through September 1, 2004 at which time it became a majority
      owned
      subsidiary of Cyber Defense pursuant to the Domicile merger between Cyber
      Defense, On Alert and E-City.




The
      purchase price for the acquisition of the Cyber Aerospace minority interest
      was
      $4,603,650, comprised of 1,650,000 shares of common stock valued at $2.79 per
      share. The share price was determined by the average price for shares sold
      in
      the market for the months of February and March discounted at 10% for a block
      sale. A nominal value was given to the 150,000 Class B shares
      issued.




F-13




The
      purchase price was accounted for in accordance with FAS 141, "Business
      Combinations". Subsequent to the acquisition and merger, the goodwill was
      impaired. Cyber allocated all but $24,593 of the purchase price to goodwill,
      which was impaired on the date of acquisition. As a result of the losses
      incurred through March 31, 2005, the minority interest had been eliminated.
      There were no net assets attributable to the minority shareholders. All shares
      of Class A common stock and Class B common stock that comprised the purchase
      price were treated as if they were issued at March 31, 2005.




The
      assets acquired and liabilities assumed were as follows:




Assets
                  Acquired:Accounts
                  receivable
              
              $
              13,386Deposits
                  on airships for resale
              
              
              21,051Intangible
                  assets:Plans
                  & designs
              
              
              1,145Techsphere
                  marketing rights
              
              
              7,403Net
                  Intangibles
              
              
              8,548Goodwill
              
              
              4,577,069Total
                  Assets Acquired
              
              $
              4,620,054Liabilities
                  Assumed:Accounts
                  payable & accrued expenses
              
              $
              14,168Notes
                  payable - related parties
              
              
              2,236Total
                  Liabilities Assumed
              
              
              16,404Net
                  Assets Acquired
              
              $
              4,603,650




**NOTE
      4 - PROPERTY AND EQUIPMENT**




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




**Year
                  ended December 31,****2006**
              
              **2005**Machinery
                  and Equipment
              
              $
              92,783
              
              $
              90,146Automobile
              
              
              
              
              
              12,00092,783
              
              
              102,146Less
                  accumulated depreciation
              
              
              (26,426
              )
              
              (10,173
              )Net
                  fixed assets
              
              $
              66,357
              
              $
              91,973




Depreciation
      expense for the years ended December 31, 2006 and 2005 was $21,253 and $6,748
      respectively. During the year ended December 31, 2005, the Company purchased
      an
      automobile for $12,000 and acquired machinery and equipment valued at $82,405
      as
      part of the acquisition of TSI. The automobile was sold during the year ended
      December 31, 2006 to our CEO Mr. Robinson for its book value which approximated
      market value of $7,000.




**NOTE
      5- INTANGIBLE ASSETS AND MANUFACTURING LICENSE**




With
      the
      acquisition of TSI in September, 2005 the Company acquired an exclusive,
      worldwide license with 21st Century Airships, Inc. for the manufacture of its
      airships. The value recorded for the license was $14,255,649 pursuant to an
      independent valuation which was originally being amortized over the 18 year
      life
      of the license, resulting in monthly amortization of $65,998 through September
      30, 2006. Amortization expense for the nine months ended September 30, 2006
      was
      $593,982. On September 30, 2006 management determined that the value of this
      asset was impaired. As a result of this determination, the Company recorded
      an
      impairment loss for $11,330,674 as of September 30, 2006. In addition,
      management determined the estimated remaining useful life to be 7 years. The
      book value of the asset was reduced to $2,100,000 and the monthly amortization
      is $25,000.




F-14




The
      license agreement stipulates royalty payments relating to the sales of airships
      ranging from $450,000 for a low altitude airship, $600,000 for a medium altitude
      airship, 10% of the gross sales price of a high altitude airship and $400,000
      for the manufacture of a low altitude airship used for commercial advertising
      purposes. Payments are to be made on any royalties due upon receipt of payment
      from the customer on a proportionate basis as defined in the agreement and
      in
      full within 120 days of completion of the manufacturing process.




The
      license agreement calls for a minimum annual royalty payment of $1,000,000
      for
      the period of January 17, 2005 through January 16, 2006 and each annual period
      thereafter ending January 16. If payments under this license should come into
      default, it is the intent of 21st Century to terminate the License Agreement
      and, as a result, TSI may be unable to manufacture its spherical airship
      products. TSI has paid an aggregate of $400,000 through April 30,
      2007.




The
      Company granted permission to 21st Century Airships, Inc. to sell two Low or
      Medium altitude airships to be used for surveillance or similar applications
      outside the United States.





In
      2004,
      the Company purchased designs and plans for unmanned air vehicles (UAV's) which
      have a useful life of 3 years. The cost was $100,000 and the monthly
      amortization is $2,778. Amortization expense was $33,336 and $33,336,
      respectively for the years ended December 31, 2006 and 2005.




**NOTE
      6 - NOTES PAYABLE**




On
      April
      1, 2005, the Company entered into a Securities Purchase agreement with AJW
      Partners, LLC, AJW Offshore, Ltd., AJW Qualified Partners, LLC, and New
      Millennium Capital Partners II, LLC ("AJW") to issue up to $4,000,000 of 8%
      Callable Secured Convertible Notes (the "Notes") with warrants to purchase
      4,000,000 shares of common stock at $4.25 per share (the "Warrants") for a
      total
      offering price of $4 million. Between April and August, 2005, under the terms
      of
      the agreement, the Company issued the Notes and the Warrants. The Company
      incurred $1,575,453 in fees as part of the offering which consisted of cash
      payments of $270,833, as well as issuing 61,538 shares of common stock valued
      at
      $200,000 and warrants to purchase 400,000 shares of common stock at $4.25 per
      share valued at $1,104,620. Each Note entitles the holder to convert the Note
      into the number of shares of common stock resulting from dividing the amount
      of
      the Note to be converted by the conversion price. The conversion price is the
      lesser of $3.65 or 60% of the average of the lowest three intra-day trading
      prices for the Company's common stock during the 20 trading days immediately
      preceding the conversion date. The Warrants and the exercise price are subject
      to equitable adjustment in connection with a stock split, stock dividend or
      similar transaction. The Warrants have a term of five years from the date of
      issuance. In connection with that sale, the Company also entered into a
      Registration Rights Agreement with AJW, requiring it to file a registration
      statement with the Securities and Exchange Commission registering the shares
      of
      common stock issuable upon conversion of the Notes and exercise of the Warrants.
      In September, 2006 the Company reduced the price on the warrants issued under
      this agreement from $4.25 per share to $0.45 per share and extended the lives
      for each warrant for 2 years from its issuance date in exchange for the waiver
      of any deficiencies in the agreements in existence as of that date.




The
      Notes
      are secured by all of the Company's assets, except for its accounts receivable
      and proceeds of inventory.




The
      Notes
      described above contain embedded derivatives in the form of the Warrants and
      the
      beneficial conversion feature. The Warrants were valued at $11,046,200 on the
      dates of issuance and was recorded as a derivative liability. An aggregate
      of
      $1,104,620 was recognized as loan costs and $9,941,950 was recognized as a
      derivative valuation loss on issuance of the warrants. The beneficial conversion
      feature was valued at $7,313,576, which was recorded as a derivative liability.
      An aggregate of $4,000,000 was allocated to discounts on the individual notes,
      representing 100% of the face value of the notes, with the remaining $3,313,576
      recognized as a derivative valuation loss.




F-15




The
      Company valued the derivatives using the Black Scholes method. There are
      multiple methods of valuation available and the choice of any individual method
      may result in significant valuation variances. An analysis of the individual
      tranches issued during fiscal 2005 under the April 1, 2005 Agreement and the
      significant assumptions used to value the warrants and the beneficial conversion
      feature are contained in the following table:


**Tranche
                  1**
              
              **Tranche
                  2**
              
              **Tranche
                  3**
              
              **Total**Issue
                  date
              
              4/1/2005
              
              5/25/2005
              
              8/3/2005Aggregate
                  note amounts
              
              $
              1,500,000
              
              $
              1,300,000
              
              $
              1,200,000
              
              $
              4,000,000Conversion
                  price on issue dates
              
              $
              1.95
              
              $
              1.69
              
              $
              0.97Term
                  of notes at issuance
              
              
              3
                  years
              
              
              3
                  years
              
              
              3
                  yearsShares
                  issuable upon conversion
              
              
              769,231
              
              
              769,231
              
              
              1,242,236Warrants
                  issued
              
              
              1,650,000
              
              
              1,430,000
              
              
              1,320,000
              
              
              4,400,000Exercise
                  price of warrants
              
              $
              4.25
              
              $
              4.25
              
              $
              4.25Term
                  of warrants at issuance
              
              
              5
                  years
              
              
              5
                  years
              
              
              5
                  yearsMarket
                  Price on issue dates
              
              $
              3.60
              
              $
              2.75
              
              $
              2.10Risk
                  free interest rate on issuance date
              
              
              3.90
              %
              
              3.68
              %
              
              4.07
              %Volatility
                  on dates of issuance
              
              
              255.05
              %
              
              240.63
              %
              
              234.17
              %Fair
                  value per share of conversion shares
              
              
              3.53
              
              
              2.68
              
              
              2.04Beneficial
                  conversion feature fair value
              
              $
              2,717,000
              
              $
              2,057,693
              
              $
              2,538,883
              
              $
              7,313,576Note
                  discount amount
              
              $
              1,500,000
              
              $
              1,300,000
              
              $
              1,200,000
              
              $
              4,000,000Fair
                  value of derivative allocated to beneficialconversion
                  feature
              
              $
              1,217,000
              
              $
              757,693
              
              $
              1,338,883
              
              $
              3,313,576Warrant
                  fair value per share at issuance
              
              $
              3.50
              
              $
              2.63
              
              $
              1.98Fair
                  values of warrants at issuance dates
              
              $
              5,775,000
              
              $
              3,761,472
              
              $
              2,614,260
              
              $
              12,150,732Value
                  of warrants allocable to loan costs
              
              $
              525,000
              
              $
              341,960
              
              $
              237,660
              
              $
              1,104,620Fair
                  value of derivative related to warrants
              
              $
              5,250,000
              
              $
              3,419,512
              
              $
              2,376,600
              
              $
              11,046,112Aggregate
                  fair value allocated to derivative instruments
              
              $
              6,992,000
              
              $
              4,519,165
              
              $
              3,953,143
              
              $
              14,359,688




On
      March
      15, 2006, the Company entered into a Securities Purchase Agreement, dated as
      of
      March 14, 2006 with AJW Partners, LLC, AJW Offshore, Ltd., AJW Qualified
      Partners, LLC, and New Millennium Capital Partners II, LLC ("AJW") whereby
      the
      Company authorized the sale of an aggregate of $2,000,000 of 6% Callable Secured
      Convertible Notes and warrants to purchase 2,000,000 shares of common stock
      for
      a total offering price of $2,000,000. The $2,000,000 is to be funded in three
      tranches ($1,000,000 on March 15, 2006, $500,000 upon filing a Registration
      Statement and $500,000 upon effectiveness of the Registration Statement). The
      conversion price is the lesser of $3.00 or 55% of the average of the lowest
      three intra-day trading prices for the Company's common stock during the 20
      trading days immediately preceding the conversion date. The warrants to purchase
      Class A common stock are priced at $1.25 per share. The warrants are exercisable
      for a period of five years from the date of issuance. In connection with the
      sale, the Company also entered into a Registration Rights Agreement with AJW,
      requiring it to file a registration statement with the Securities and Exchange
      Commission registering the shares of common stock issuable upon conversion
      of
      the Notes and exercise of the Warrants. The Notes are secured by all of the
      Company's assets, except for its accounts receivable and proceeds of inventory.
      In addition, the lenders have agreed to subordinate to an institutional lender.
      On March 15, 2006 the Company received $1,000,000 and issued warrants for
      1,100,000 shares of common stock valued at $542,190 on the date of issuance
      which was recorded as a derivative liability. An aggregate of $49,290 was
      recognized as loan costs and $492,900 was recognized as a derivative valuation
      loss on issuance of the warrants. The beneficial conversion feature was valued
      at $2,599,655 and was recorded as a derivative liability. An aggregate of
      $1,000,000 was allocated to discounts on the individual notes, representing
      100%
      of the face value of the notes which will accrete over the three year life
      of
      the notes, with the remaining $1,599,655 recognized as a derivative valuation
      loss. The Company incurred loan costs totaling $134,290 in conjunction with
      the
      above which consisted of fees paid in cash of $85,000 and a warrant to purchase
      100,000 shares of Class A common stock valued at $49,290 which will be amortized
      over the three year term of the notes.




F-16




On
      June
      30, 2006 the Company filed a Registration Statement with the Securities and
      Exchange Commission and, accordingly on July 6, 2006 the Company received
      $500,000 representing the second tranche of the March 14, 2006 Securities
      Purchase Agreement in exchange for 6% Callable Secured Convertible Notes and
      issued five year warrants to purchase 550,000 shares of common stock priced
      at
      $1.25 valued at $81,180 on the date of issuance which was recorded as a
      derivative liability. An aggregate of $7,380 was recognized as loan costs and
      $73,800 was recognized as a derivative valuation loss on issuance of the
      warrants. The beneficial conversion feature was valued at $867,984 and was
      recorded as a derivative liability. An aggregate of $500,000 was allocated
      to
      discounts on the individual notes, representing 100% of the face value of the
      notes which will accrete over the three year life of the notes, with the
      remaining $367,984 recognized as a derivative valuation loss. The Company
      incurred loan costs totaling $32,380 which consists of fees to be paid in cash
      of $25,000 and a five year warrant to purchase 50,000 shares of common stock
      priced at $1.25 valued at $7,380 on the date of issuance which will be amortized
      over the three year term of the notes.




On
      September 11, 2006 AJW made an advance of $200,000 related to the $500,000
      third
      tranche of financing pursuant to the March 14, 2006 Securities Purchase
      Agreement in exchange for 6% Callable Secured Convertible Notes and issued
      five
      year warrants to purchase 220,000 shares of common stock priced at $1.25 valued
      at $47,674 on the date of issuance which was recorded as a derivative liability.
      An aggregate of $4,334 was recognized as loan costs and $43,340 was recognized
      as a derivative valuation loss on issuance of the warrants. The beneficial
      conversion feature was valued at $359,664 and was recorded as a derivative
      liability. An aggregate of $200,000 was allocated to discounts on the individual
      notes, representing 100% of the face value of the notes which will accrete
      over
      the three year life of the notes, with the remaining $159,664 recognized as
      a
      derivative valuation loss. The Company incurred loan costs totaling $14,334
      which consists of fees to be paid in cash of $10,000 and a five year warrant
      to
      purchase 20,000 shares of common stock priced at $1.25 valued at $4,334 on
      the
      date of issuance which will be amortized over the three year term of the notes.
      On September 8, 2006, in conjunction with this advance, the Company executed
      a
      Letter Agreement with AJW which, among other things reduced the price of the
      4,400,000 warrants issued under the April 1, 2005 Securities Purchase Agreement
      from $4.25 per share to $0.45 per share and extended the term of the warrants
      by
      two years. The aggregate value of the warrants increased as a result of the
      exercise price reduction and the extension of the expiration date resulting
      in
      the recognition of additional derivative valuation loss of $66,374 determined
      by
      the fair value of the warrants immediately before the changes compared to the
      fair value immediately after the changes. On October 19, 2006, the Company
      received an additional advance of $300,000 pursuant to the fourth tranche of
      financing from the March 14, 2006 Securities Purchase Agreement with AJW in
      exchange for 6% Callable Secured Convertible Notes and issued five year warrants
      to purchase 330,000 shares of common stock priced at $1.25 valued at $58,344
      on
      the date of issuance which was recorded as a derivative liability. An aggregate
      of $5,304 was recognized as loan costs and $53,040 was recognized as a
      derivative valuation loss on issuance of the warrants. The beneficial conversion
      feature was valued at $624,664 and was recorded as a derivative liability.
      An
      aggregate of $300,000 was allocated to discounts on the individual notes,
      representing 100% of the face value of the notes which will accrete over the
      three year life of the notes, with the remaining $324,664 recognized as a
      derivative valuation loss. The Company incurred loan costs totaling $25,704
      which consists of fees of $15,000 to be paid in cash, 30,000 shares of Class
      A
      common stock valued at $5,400 based on the $0.18 market price on the date of
      issuance and a five year warrant to purchase 30,000 shares of common stock
      priced at $1.25 valued at $5,304 using the Black Scholes method on the date
      of
      issuance which will be amortized over the three year term of the
      notes.




The
      Company has granted certain registration rights with respect to the Securities
      Purchase Agreements dated April 1, 2005 and March 14, 2006. These registration
      rights agreements call for penalties for failure to have an effective
      registration statement covering the securities under these agreements of 2.0%
      per month of the outstanding principal balance of the notes under said
      agreements. As part of the September 8, 2006 Letter Agreement discussed in
      the
      previous paragraph, AJW waived any deficiencies in the above mentioned
      Securities Purchase Agreements dated April 1, 2005 and March 14, 2006 including
      the penalties for failure to have the registration statement declared effective.
      If AJW chooses to assess these penalties, the Company would have a liability
      for
      said penalty as of December 31, 2006 of approximately $390,000.




F-17




An
      analysis of the four tranches of issuances under the March 14, 2006 Securities
      Purchase Agreement and the significant assumptions used to value the warrants
      and the beneficial conversion feature are contained in the following
      table:


3/14/2006
              
              3/14/2006
              
              3/14/2006
              
              3/14/2006Agreement
              
              Agreement
              
              Agreement
              
              AgreementTranche
                  1
              
              Tranche
                  2
              
              Tranche
                  3
              
              Tranche
                  4Issue
                  date
              
              
              3/14/2006
              
              
              7/6/2006
              
              
              9/11/2006
              
              
              10/19/2006Aggregate
                  note amounts
              
              $
              1,000,000
              
              $
              500,000
              
              $
              200,000
              
              $
              300,000Conversion
                  price on issue dates
              
              $
              0.19
              
              $
              0.08
              
              $
              0.12
              
              $
              0.08Term
                  of notes at issuance
              
              
              3
                  years
              
              
              3
                  years
              
              
              3
                  years
              
              
              3
                  yearsShares
                  issuable upon conversion
              
              
              5,172,414
              
              
              5,928,854
              
              
              1,678,322
              
              
              624,664Warrants
                  issued
              
              
              1,100,000
              
              
              550,000
              
              
              220,000
              
              
              330,000Exercise
                  price of warrants
              
              $
              1.25
              
              $
              1.25
              
              $
              1.25
              
              $
              1.25Term
                  of warrants at issuance
              
              
              5
                  years
              
              
              5
                  years
              
              
              5
                  years
              
              
              5
                  yearsMarket
                  Price on issue dates
              
              $
              0.51
              
              $
              0.15
              
              $
              0.22
              
              $
              0.18Risk
                  free interest rate on issuance date
              
              
              4.00
              %
              
              5.17
              %
              
              4.77
              %
              
              4.79
              %Volatility
                  on date of issuance
              
              
              261.79
              %
              
              242.90
              %
              
              239.80
              %
              
              237.66
              %Fair
                  value per share of conversion shares
              
              
              0.5026
              
              
              0.1464
              
              
              0.2143
              
              
              0.1756Beneficial
                  conversion feature fair value
              
              $
              2,599,655
              
              $
              867,984
              
              $
              359,664
              
              $
              624,664Note
                  discount amount
              
              $
              1,000,000
              
              $
              500,000
              
              $
              200,000
              
              $
              300,000Warrant
                  fair value per share at issuance
              
              $
              0.4929
              
              $
              0.1476
              
              $
              0.2167
              
              $
              0.1768Fair
                  values of warrants at issuance dates
              
              $
              542,190
              
              $
              81,180
              
              $
              47,674
              
              $
              58,344Value
                  of warrants allocable to loan costs
              
              $
              49,290
              
              $
              7,380
              
              $
              4,334
              
              $
              5,304Fair
                  value of derivative related to warrants
              
              $
              492,900
              
              $
              73,800
              
              $
              43,340
              
              $
              53,040Fair
                  value of derivative allocated tobeneficial
                  conversion feature
              
              $
              1,599,655
              
              $
              367,984
              
              $
              159,664
              
              $
              324,664Aggregate
                  fair value allocated toderivative
                  instruments
              
              $
              2,141,845
              
              $
              449,164
              
              $
              207,338
              
              $
              383,008




Note
      Conversions




On
      June
      6, 2006 AJW converted an aggregate of $114,487 related to the 8% Callable
      Secured Convertible Notes issued April 1, 2005 at $0.1879 per share.
      Accordingly, the Company issued an aggregate of 609,300 shares of its Class
      A
      common stock to AJW. On September 19, 2006 AJW converted an aggregate of $63,324
      related to the 8% Callable Secured Convertible Notes issued April 1, 2005 at
      $0.104 per share. Accordingly, the Company issued an aggregate of 609,846 shares
      of its Class A common stock to AJW. The conversion prices for the April 1,
      2005
      note represent the note's stated conversion price of 60% of the average of
      the
      lowest three intra-day trading prices for the Company's common stock during
      the
      20 trading days immediately preceding the conversion date.




F-18




An
      analysis of the fiscal 2006 conversions of the AJW Notes and the significant
      assumptions used to value the beneficial conversion feature recognized upon
      conversion are contained in the following table:




Conversion
                  date
              
              6/6/2006
              
              9/19/2006Original
                  proceeds from note
              
              $
              1,500,000
              
              $
              1,500,000Note
                  amount converted
              
              $
              114,487
              
              $
              63,424Principal
                  remaining after conversion
              
              $
              802,996
              
              $
              739,572Conversion
                  price
              
              $
              0.188
              
              $
              0.104Term
                  of notes at conversion
              
              
              1.80
                  years
              
              
              1.53
                  yearsShares
                  issued on conversion
              
              
              609,300
              
              
              609,846Potential
                  remaining conversion shares
              
              
              4,273,528
              
              
              7,111,269Common
                  Stock Price on conversion date
              
              $
              0.40
              
              $
              0.25Risk
                  free interest rate at conversion date
              
              
              4.99
              %
              
              4.72
              %Volatility
                  on conversion dates
              
              
              241.68
              %
              
              240.74
              %Fair
                  value per share of conversion shares
              
              
              0.3736
              
              
              0.2291Fair
                  value of derivative
              
              $
              1,596,590
              
              $
              1,629,192Derivative
                  liability reclassified to additional paid-incapital
                  upon conversion
              
              $
              227,634
              
              $
              139,716Derivative
                  valuation loss recognizedon
                  conversion
              
              $
              (13,184
              )
              $
              (45,305
              )




On
      August
      10, 2005, AJW converted $500,000 of the Notes for 500,000 Shares of Class A
      common stock of the Company and through September 30, 2005 an additional $62,300
      was converted into 700,000 shares of class A common stock. On October 4, 2005
      an
      additional $6,867 was converted into 58,000 shares of Class A common stock
      and
      on October 20, 2005 an additional $13,350 was converted into 150,000 shares
      of
      Class A Common Stock. Such conversions were made at a 40% discount to market
      pursuant to the terms of the Secured Convertible Note agreements. As a result
      of
      the conversions, $1,229,053 of the derivative liability was reclassified to
      additional paid-in capital.





An
      analysis of the individual conversions of the AJW Notes during fiscal 2005
      and
      the significant assumptions used to value the beneficial conversion feature
      recognized upon conversion are contained in the following table:




Conversion
                  date
              
              8/10/2005
              
              9/16/2005
              
              9/22/2005
              
              10/4/2005
              
              10/20/2005
              
              TotalOriginal
                  proceeds from note
              
              $
              1,500,000
              
              $
              1,500,000
              
              $
              1,500,000
              
              $
              1,500,000
              
              $
              1,500,000Note
                  amount converted
              
              $
              500,000
              
              $
              31,150
              
              $
              31,150
              
              $
              13,350
              
              $
              6,659
              
              $
              582,517Principal
                  remaining after conversion
              
              $
              1,000,000
              
              $
              968,850
              
              $
              937,700
              
              $
              924,350
              
              $
              917,691Conversion
                  price
              
              $
              1.00
              
              $
              0.09
              
              $
              0.09
              
              
              0.089
              
              
              0.1184Remaining
                  term of notes
              
              
              2.64
                  years
              
              
              2.54
                  years
              
              
              2.52
                  years
              
              
              2.49
                  years
              
              
              2.45
                  yearsShares
                  issued on conversion
              
              
              500,000
              
              
              350,000
              
              
              350,000
              
              
              150,000
              
              
              58,000Potential
                  remaining conversion shares
              
              
              1,000,000
              
              
              10,885,955
              
              
              10,535,955
              
              
              10,385,955
              
              
              7,749,015Common
                  stock price on conversion date
              
              $
              2.00
              
              $
              0.40
              
              $
              0.23
              
              $
              0.27
              
              $
              0.25Risk
                  free interest rate
              
              
              4.18
              %
              
              4.00
              %
              
              3.96
              %
              
              4.22
              %
              
              4.29
              %Volatility
                  on conversion dates
              
              
              232.59
              %
              
              251.54
              %
              
              254.69
              %
              
              254.89
              %
              
              253.00
              %Fair
                  value per share of conversion shares
              
              $
              1.9227
              
              $
              0.3923
              
              $
              0.2190
              
              $
              0.2637
              
              $
              0.2423Fair
                  value of derivative
              
              $
              1,922,700
              
              $
              4,270,560
              
              $
              2,311,589
              
              $
              2,738,776
              
              $
              1,877,586Derivative
                  liability reclassified to AdditionalPaid
                  in Capital upon conversion
              
              $
              961,350
              
              $
              137,305
              
              $
              76,790
              
              $
              39,555
              
              $
              14,053
              
              $
              1,229,053Derivative
                  valuation gain (loss)recognized
                  on conversion
              
              
              ($77,975
              )
              
              ($82,271
              )
              
              ($21,756
              )
              $
              8,910
              
              $
              10,875
              
              
              ($162,217
              )




On
      April
      11, 2007, AJW converted $156,438 of the Notes for 3,563,483 Shares of Class
      A
      common stock of the Company The conversion was made at a 40% discount to market
      pursuant to the terms of the Secured Convertible Note agreements. As a result
      of
      the conversion, $149,666 of the derivative liability was reclassified to
      additional paid-in capital.




F-19




The
      transaction will be recorded in the second quarter of fiscal 2007. An analysis
      of the 2007 conversion of the AJW Notes and the significant assumptions used
      to
      value the beneficial conversion feature recognized upon conversion are contained
      in the following table:


Conversion
                  date
              
              April
                  11, 2007Original
                  proceeds from note
              
              $
              1,500,000Note
                  amount converted
              
              $
              156,438Principal
                  remaining after conversion
              
              $
              583,165Conversion
                  price
              
              $
              0.044Term
                  of notes at conversion
              
              
              1
                  yearShares
                  issued on conversion
              
              
              3,563,483Potential
                  remaining conversion shares
              
              
              12,148,637Common
                  Stock Price on conversion date
              
              $
              0.055Risk
                  free interest rate at conversion date
              
              
              4.97
              %Volatility
                  on conversion dates
              
              
              228.21
              %Fair
                  value per share of conversion shares
              
              
              0.0420Fair
                  value of derivative
              
              $
              510,243Derivative
                  liability reclassified to additional paid-incapital
                  upon conversion
              
              $
              149,666Derivative
                  valuation gain recognizedon
                  conversion
              
              $
              115,381




The
      carrying value of these Notes as of December 31, 2006 was $2,079,398 net of
      discount. The carrying value will be increased each quarter over the three
      year
      life of the loan as the accretion of the discount related to the embedded
      derivatives is recorded until the carrying value equals the face value of
      $6,000,000 less any amounts converted. As of December 31, 2006, the derivative
      instruments had a fair value of $11,147,056. An analysis of the valuation of
      the
      individual tranches as of December 31, 2006 and the significant assumptions
      used
      to value the warrants and the beneficial conversion feature are contained in
      the
      following table:


April
                  1, 2005 Agreement
              
              
              March
                  14, 2006 AgreementTranche
                  1
              
              Tranche
                  2
              
              Tranche
                  3
              
              Tranche
                  1
              
              Tranche
                  2
              
              Tranche
                  3
              
              Tranche
                  4
              
              TotalValuation
                  date
              
              
              12/31/2006
              
              
              12/31/2006
              
              
              12/31/2006
              
              
              12/31/2006
              
              
              12/31/2006
              
              
              12/31/2006
              
              
              12/31/2006Aggregate
                  note amounts
              
              $
              739,780
              
              $
              1,300,000
              
              $
              1,200,000
              
              $
              1,000,000
              
              $
              500,000
              
              $
              200,000
              
              $
              300,000
              
              $
              5,239,780Conversion
                  price at December 31, 2006
              
              $
              0.0800
              
              $
              0.0800
              
              $
              0.0800
              
              $
              0.0733
              
              $
              0.0733
              
              $
              0.0733
              
              $
              0.0733Term
                  of notes at December 31, 2006
              
              
              1.25
                  years
              
              
              1.40
                  years
              
              
              1.60
                  years
              
              
              2.2
                  years
              
              
              2.50
                  years
              
              
              2.70
                  years
              
              
              2.80
                  yearsShares
                  issuable upon conversion
              
              
              9,987,192
              
              
              17,475,562
              
              
              15,893,151
              
              
              14,290,909
              
              
              7,017,684
              
              
              2,777,036
              
              
              4,140,000Warrants
                  outstanding
              
              
              1,650,000
              
              
              1,430,000
              
              
              1,320,000
              
              
              1,100,000
              
              
              550,000
              
              
              220,000
              
              
              330,000
              
              
              6,600,000Exercise
                  price of warrants
              
              $
              0.45
              
              $
              0.45
              
              $
              0.45
              
              $
              1.25
              
              $
              1.25
              
              $
              1.25
              
              $
              1.25Term
                  of warrants at December 31, 2006
              
              
              5.25
                  years
              
              
              5.4
                  years
              
              
              5.6
                  years
              
              
              4.2
                  years
              
              
              4.5
                  years
              
              
              4.7
                  years
              
              
              4.5
                  yearsMarket
                  Price on December 31, 2006
              
              $
              0.155
              
              $
              0.155
              
              $
              0.155
              
              $
              0.155
              
              $
              0.155
              
              $
              0.155
              
              $
              0.155Risk
                  free interest rate at December 31, 2006
              
              
              4.80
              %
              
              4.80
              %
              
              4.80
              %
              
              4.80
              %
              
              4.80
              %
              
              4.80
              %
              
              4.80
              %Volatility
                  at year end
              
              
              233.53
              %
              
              233.53
              %
              
              233.53
              %
              
              233.53
              %
              
              233.53
              %
              
              233.53
              %
              
              233.53
              %Fair
                  value per share of conversion shares
              
              $
              0.1347
              
              $
              0.1373
              
              $
              0.1401
              
              $
              0.1463
              
              $
              0.1487
              
              $
              0.1496
              
              $
              0.1501Beneficial
                  conversion feature fair value
              
              $
              1,345,275
              
              $
              2,399,395
              
              $
              2,226,630
              
              $
              2,090,760
              
              $
              1,043,530
              
              $
              415,445
              
              $
              621,414
              
              $
              10,142,448Warrant
                  fair value per share at year end
              
              $
              0.1533
              
              $
              0.1535
              
              $
              0.1537
              
              $
              0.1488
              
              $
              0.1501
              
              $
              0.1508
              
              $
              0.1511Fair
                  value of derivative related to warrants
              
              $
              252,945
              
              $
              219,505
              
              $
              202,884
              
              $
              163,680
              
              $
              82,555
              
              $
              33,176
              
              $
              49,863
              
              $
              1,004,608Fair
                  value of derivative related tobeneficial
                  conversion feature
              
              $
              1,345,275
              
              $
              2,399,395
              
              $
              2,226,630
              
              $
              2,090,760
              
              $
              1,043,530
              
              $
              415,445
              
              $
              621,414
              
              $
              10,142,448Aggregate
                  fair value of derivative instruments
              
              $
              1,598,220
              
              $
              2,618,900
              
              $
              2,429,514
              
              $
              2,254,440
              
              $
              1,126,085
              
              $
              448,621
              
              $
              671,277
              
              $
              11,147,056







The
      carrying value of the AJW Notes outstanding as of December 31, 2005 was $655,358
      net of discount. The carrying value will be increased each quarter over the
      three year loan period as the accretion of the discount related to the embedded
      derivatives is recorded until the carrying value equals the face value of
      $4,000,000 less any amounts converted. As of December 31, 2005, the derivative
      instruments had a fair value of $10,057,733.




F-20




An
      analysis of the valuation of the individual tranches as of December 31, 2005
      and
      the significant assumptions used to value the warrants and the beneficial
      conversion feature are contained in the following table:




Tranche
                  1
              
              Tranche
                  2
              
              Tranche
                  3
              
              TotalValuation
                  date
              
              
              12/31/2005
              
              
              12/31/2005
              
              
              12/31/2005Aggregate
                  note amounts
              
              $
              917,691
              
              $
              1,300,000
              
              $
              1,200,000
              
              $
              3,417,691Conversion
                  price at December 31, 2005
              
              $
              0.156
              
              $
              0.156
              
              $
              0.156Term
                  of notes at December 31, 2005
              
              
              2.25
                  years
              
              
              2.4
                  years
              
              
              2.6
                  yearsShares
                  issuable upon conversion
              
              
              5,957,684
              
              
              8,333,333
              
              
              7,692,308Warrants
                  outstanding
              
              
              1,650,000
              
              
              1,430,000
              
              
              1,320,000
              
              
              4,400,000Exercise
                  price of warrants
              
              $
              4.25
              
              $
              4.25
              
              $
              4.25Term
                  of warrants at December 31, 2005
              
              
              4.25
                  years
              
              
              4.4
                  years
              
              
              4.6
                  yearsMarket
                  Price on December 31, 2005
              
              $
              0.40
              
              $
              0.40
              
              $
              0.40Risk
                  free interest rate at December 31, 2005
              
              
              4.37
              %
              
              4.37
              %
              
              4.37
              %Volatility
                  at year end
              
              
              252.54
              %
              
              252.54
              %
              
              252.54
              %Fair
                  value per share of conversion shares
              
              $
              0.3867
              
              $
              0.3883
              
              $
              0.3903Beneficial
                  conversion feature fair value
              
              $
              2,303,836
              
              $
              3,235,833
              
              $
              3,002,308
              
              $
              8,541,977Warrant
                  fair value per share at year end
              
              $
              0.3367
              
              $
              0.3447
              
              $
              0.3540Fair
                  value of derivative related to warrants
              
              $
              555,555
              
              $
              492,921
              
              $
              467,280
              
              $
              1,515,756Fair
                  value of derivative related tobeneficial
                  conversion feature
              
              $
              2,303,836
              
              $
              3,235,833
              
              $
              3,002,308
              
              $
              8,541,977Aggregate
                  fair value of derivative instruments
              
              $
              2,859,391
              
              $
              3,728,754
              
              $
              3,469,588
              
              $
              10,057,733




The
      derivative liability is comprised of the following as of December 31, 2006
      and
      2005:


December
                  31, 2006
              
              December
                  31, 2005AJW
                  Notes
              
              $
              10,142,448
              
              $
              1,515,756AJW
                  Warrants
              
              
              1,004,608
              
              
              8,541,977William
                  Robinson Note
              
              
              127,641
              
              
              -Total
                  derivative liability
              
              $
              11,274,697
              
              $
              10,057,733




The
      derivative valuation loss reported in the accompanying condensed consolidated
      statements of operations results from the revaluation to fair value of the
      beneficial conversion feature and attached warrants associated with the above
      notes. As the fair value of the derivative changes, a gain or a loss is
      recognized.




F-21




The
      components of the derivative valuation loss for the years ended December 31,
      2006 and 2005 consisted of the following:


Year
                  ended December 31,2006
              
              2005Derivative
                  valuation (loss) on issuance of notes - AJW
              
              
              ($2,451,967
              )
              
              ($3,313,576
              )Derivative
                  valuation (loss) on issuance of warrants -AJW
              
              
              (663,080
              )
              
              (11,046,172
              )Derivative
                  valuation (loss) on conversion -AJW
              
              
              (58,489
              )
              
              (162,217
              )Derivative
                  valuation gain on conversion -Robinson
              
              
              20,010
              
              
              -Derivative
                  valuation gain on conversion -Lively
              
              
              4,193
              
              
              -Derivative
                  valuation gain on conversion -Gardiner
              
              
              840
              
              
              -Derivative
                  valuation (loss) on issuance of note - Gardiner
              
              
              (37,050
              )
              
              -Derivative
                  valuation (loss) on issuance of note- Robinson
              
              
              (368,608
              )
              
              -Derivative
                  valuation (loss) - beneficial conversion revaluation -
                  Robinson
              
              
              757,019
              
              
              -Derivative
                  valuation (loss) on issuance of notes - Lively
              
              
              (58,306
              )
              
              -Derivative
                  valuation (loss) - beneficial conversion revaluation -
                  Lively
              
              
              106,799
              
              
              -Derivative
                  valuation (loss) - beneficial conversion revaluation -
                  Gardiner
              
              
              (20,520
              )
              
              -Derivative
                  valuation gain (loss) - warrant revaluation AJW
              
              
              1,240,536
              
              
              10,634,976Derivative
                  valuation gain (loss)- beneficial conversion revaluation -
                  AJW
              
              
              2,563,741
              
              
              (2,295,177
              )$
              1,035,118
              
              
              ($6,182,166
              )




The
      following table reflects amounts credited to additional paid-in capital upon
      the
      conversion of notes payable with beneficial conversion features to common
      stock:




**December
                  31****2006**
              
              **2005**Beneficial
                  conversion feature associated with notes payable issued
                  to:James
                  Gardiner
              
              $
              146,731
              
              $
              -William
                  Robinson
              
              
              183,570
              
              
              -Frank
                  Lively
              
              
              38,465
              
              
              -Beneficial
                  conversion feature associated with convertible notespayable
                  to AJW Partners, et al reclassified as additional paid-incapital
                  upon conversion of notes payable
              
              
              364,353
              
              
              1,229,053Bedlington
                  Securities
              
              
              -
              
              
              250,000Guy
                  Stewart
              
              
              -
              
              
              150,000Joe
                  Theisman (Note 7)
              
              
              -
              
              
              117,000Total
                  beneficial conversion of derivative securities
              
              $
              733,119
              
              $
              1,746,053




On
      May 8,
      2007, the Company received $335,000 pursuant to a Securities Purchase Agreement
      dated May 8, 2007 with AJW in exchange for 6% Callable Secured Convertible
      Notes
      and issued five year warrants to purchase 20,033,500 shares of common stock
      priced at $0.07 valued at $1,788,992 on the date of issuance which was recorded
      as a derivative liability. An aggregate of $2,992 was recognized as loan costs
      and $1,786,000 was recognized as a derivative valuation loss on issuance of
      the
      warrants. The beneficial conversion feature was valued at $687,873 and was
      recorded as a derivative liability. An aggregate of $335,000 was allocated
      to
      discounts on the individual notes, representing 100% of the face value of the
      notes which will accrete over the three year life of the notes, with the
      remaining $387,873 recognized as a derivative valuation loss. The Company
      incurred loan costs totaling $71,492 which consists of fees of $68,500 paid
      in
      cash, and a five year warrant to purchase 33,500 shares of common stock priced
      at $0.07 valued at $2,992 using the Black Scholes method on the date of issuance
      which will be amortized over the three year term of the notes.




F-22




An
      analysis of the issuance under the May 8, 2007 Securities Purchase Agreement
      with AJW and the significant assumptions used to value the warrants and
      beneficial conversion feature are contained in the following table:


Issue
                  date
              
              5/8/2007Aggregate
                  note amounts
              
              $
              335,000Conversion
                  price on issue dates
              
              $
              0.02Term
                  of notes at issuance
              
              
              3
                  yearsShares
                  issuable upon conversion
              
              
              15,320,122Warrants
                  issued
              
              
              20,033,500Exercise
                  price of warrants
              
              $
              0.07Term
                  of warrants at issuance
              
              
              5
                  yearsMarket
                  Price on issue dates
              
              $
              0.047Risk
                  free interest rate on issuance date
              
              
              4.54
              %Volatility
                  on date of issuance
              
              
              231.77
              %Fair
                  value per share of conversion shares
              
              
              0.0449Beneficial
                  conversion feature fair value
              
              $
              687,873Note
                  discount amount
              
              $
              335,000Warrant
                  fair value per share at issuance
              
              $
              0.0893Fair
                  values of warrants at issuance dates
              
              $
              1,788,992Value
                  of warrants allocable to loan costs
              
              $
              2,992Fair
                  value of derivative related to warrants
              
              $
              1,786,000Fair
                  value of derivative allocated to benficialconversion
                  fearure
              
              $
              352,873Aggregate
                  fair value allocated to derivative instruments
              
              $
              2,141,865




On
      January 15, 2006 the Company issued an unsecured note to James Gardiner in
      the
      amount of $90,000 in exchange for cash of $82,000 and fees of $8,000. The note
      is due December 31, 2007, is unsecured and bears interest at the rate of 12%
      and
      is convertible into Class A common stock at $0.30 per share at any time. The
      note contains a beneficial conversion feature due to the conversion price of
      $0.30 being lower than the market price of $0.53 on the date of issuance. The
      beneficial conversion feature was valued at $127,050 using the Black Scholes
      method on the date of issuance, and was recorded as a derivative liability
      on
      the date of issuance. The Company allocated $90,000 of the beneficial conversion
      feature as a discount on the note, which will accrete over the life of the
      note.
      As of March 31, 2006, the derivative liability was valued at $147,570, which
      resulted in an additional $20,520 of derivative valuation loss recorded in
      the
      three month period ended March 31, 2006. On April 20, 2006 the holder converted
      the note into 300,000 shares of the Company's Class A common stock. The
      derivative on the date of conversion was valued at $146,730. As a result of
      the
      conversion, the Company will recognize a derivative valuation gain of $840
      representing the change of the value from the March 31, 2006 valuation date
      to
      the date of conversion and as a result, reclassified $146,730 to additional
      paid
      in capital and expensed the remaining discount on the note in the amount of
      $85,000 to interest expense.




F-23




An
      analysis of the valuation of the beneficial conversion feature and the
      significant assumptions used are contained in the following table:




Valuation
                    date
                
                
                Issuance
                    date
                  January
                    15, 2006
                
                
                Report
                    date
                  March
                    31, 2006
                
                
                Conversion
                    date
                  April
                    20, 2006Aggregate
                    note amount
                
                $
                90,000
                
                $
                90,000
                
                $
                90,000Conversion
                    price
                
                $
                0.30
                
                $
                0.30
                
                $
                0.30Term
                    of note
                
                
                1.95
                    years
                
                
                1.75
                    years
                
                
                1.70
                    yearsShares
                    issuable upon conversion
                
                
                300,000
                
                
                300,000
                
                
                300,000Market
                    Price
                
                $
                0.45
                
                $
                0.53
                
                $
                0.53Risk
                    free interest rate
                
                
                4.39
                %
                
                4.80
                %
                
                4.89
                %Volatility
                    on issue date
                
                
                253.76
                %
                
                247.96
                %
                
                246.20
                %Fair
                    value per share of conversion shares
                
                $
                0.4235
                
                $
                0.4919
                
                $
                0.4891Beneficial
                    conversion feature fair value
                
                $
                127,050
                
                $
                147,570
                
                $
                146,730Note
                    discount amount
                
                $
                90,000
                
                $
                90,000
                
                $
                90,000Fair
                    value of derivative related tobeneficial
                    conversion feature
                
                $
                37,050
                
                $
                57,570
                
                $
                56,730Derivative
                    valuation gain (loss) recognized
                
                
                
                
                $
                (20,520
                )
                $
                840




On
      January 17, 2006 the Company issued an unsecured note in the amount of $88,637
      bearing interest at the rate of 5.0% to a vendor in exchange for services
      previously rendered. The note was originally due in full on April 19, 2006.
      The
      note was personally guaranteed by Mr. Robinson who had pledged certain of his
      personal assets as collateral. During the year ended December 31, 2006, Mr.
      Robinson paid the note and all accrued interest in full on behalf of the
      Company.




On
      March
      20, 2006 the Company issued an unsecured note in the amount of $57,052 to a
      vendor in exchange for services previously rendered. The note was originally
      due
      in three equal monthly installments of $19,024 beginning March 25, 2006. No
      interest is due if payments are paid by the due dates. If any monthly
      installment is past due, the note bears interest at the rate of 10% per annum.
      The Company renegotiated the terms of the note due to its default and, on
      September 29, 2006 the vendor converted the note and all accrued interest
      totaling $60,019 at a conversion rate of $0.20 into 300,097 shares of Class
      A
      common stock.




On
      April
      20, 2006 Mayo Hadden converted $200,000 of his outstanding Convertible Note
      into
      666,667 shares of common stock at the conversion price of $0.30 per share.
      On
      June 28, 2006, he converted the remaining balance of $131,250 plus $11,563
      of
      accrued interest at the conversion price of $0.30 into 476,043 shares of Class
      A
      Common Stock. On September 28, 2006 the Company issued an additional 317,362
      shares of Class A common stock to Mr. Hadden relative to an agreement lowering
      the conversion price from $0.30 to $0.18. The additional shares issued were
      valued at $0.18, the market price as of the date of issuance. The value of
      $57,125 was recorded as additional interest on the note in the accompanying
      statements of operations for the year ended December 31, 2006.





On
      April
      25, 2006 the Company issued a note to Sierra Nevada Corporation pursuant to
      an
      agreement as more fully described in Note 9 dated April 25, 2006 due August
      25,
      2006 under certain conditions in the amount of $500,000. The note is
      non-interest bearing until August 25, 2006, at which time it will bear interest
      at the rate of 8.5% and is secured by certain inventory of the Company. The
      Company recorded the initial net present value of $486,192 related to the note
      using an 8.5% interest rate. The note is being accreted to the face value at
      8.5% using the effective interest method and accordingly, recognized accretion
      of the note of $13,808 as interest expense, bringing the face value to $500,000
      as of September 30, 2006. (See Note 9).




On
      July
      21, 2006 Equipment Depot converted their $25,000 note and $1,500 of accrued
      interest into 106,000 shares of Company Class A common stock at a conversion
      price of $0.25 per share. The conversion price exceeded the market price on
      the
      conversion date of July 21, 2006 of $0.18 thus no beneficial conversion was
      recognized.




F-24




The
      Company is currently in discussions with Charles McClure to amend his note
      agreement which continues to be in default.


**December
                  31,**
                **2006**
              
              **December
                  31,**
                **2005****Current
                  - Unrelated parties**Convertible
                  Notes payable C.M.G. Tech., interest accrues at 10% perannum
                  due February 25, 2007 currently in default
              
              
              822,094
              
              
              822,094Note
                  payable Charles McClure, secured by an airship, interest
                  accruesat
                  25.0% per annum and is due December 31, 2005, currently in
                  default
              
              
              250,000
              
              
              250,000Demand
                  Notes to Vendors - unsecured, interest accrues at 12% perannum
                  currently in default
              
              
              781
              
              
              154,887Note
                  payable - Sierra Nevada Corporation - non interest bearing secured
                  bycertain
                  inventory due August 25, 2006
              
              
              500,000
              
              
              -Note
                  payable - 21st Century Airship, Inc. - interest accrues at
                  12%
              
              
              -
              
              
              144,844Convertible
                  Note payable - Mayo Hadden, unsecured, interest accruesat
                  10.0% per annum due February 25, 2007
              
              
              -
              
              
              331,250Commercial
                  Promissory Note, - Equipment Depot, Inc., interest at 9.0%per
                  annum, secured, due June 19, 2006
              
              
              -
              
              
              25,000$
              1,572,875
              
              $
              501,094**Long-term
                  - unrelated parties**Notes
                  payable - AJW Partners, LLP and affiliates, callable
                  securedconvertible
                  notes bearing interest at 8% per annum, $739,573due
                  April 4, 2008; $1,300,000 due May 25, 2008 and$1,200,000
                  due August 4, 2008 less total discount of$1,549,058
                  and $2,762,333, respectively
              
              
              1,690,721
              
              
              655,358Notes
                  payable - AJW Partners, LLP and affiliates, callable
                  securedconvertible
                  notes bearing interest at 6% per annum, $1,000,000due
                  April 14, 2009; $500,000 due July 5, 2009, 200,000 due$200,000
                  due September 11, 2009 and $300,000 due October19,
                  2006 less total discount of $1,611,323
              
              
              388,677
              
              
              -Total
                  long term notes payable
              
              $
              2,079,398
              
              $
              655,358





**NOTE
      7 - NOTES PAYABLE - RELATED PARTIES**




During
      the year ended December 31, 2005, Billy Robinson loaned the Company funds to
      be
      used for working capital purposes which were payable on demand. On August 12,
      2005 Mr. Robinson agreed to extend their note and, as additional consideration
      for extending the due date of the loans, the Company issued 20,465 shares of
      its
      Class A common stock valued at $28,631 to Mr. Robinson based on the bid price
      as
      of that date. The Company recorded the value of the shares as additional
      interest expense related to the note. The Company issued Mr. Robinson a
      Convertible Promissory Note in the amount of $460,851 on December 31, 2005.
      The
      note bears interest at the rate of 12%, is unsecured and convertible into the
      Company's Class A common stock at a price of $0.30 per share. The conversion
      price approximated the market price on the date of the note. The note is due
      on
      December 31, 2007.




F-25





On
      April
      19th, 2006, the Board approved a $1,000,000 line of credit with Mr. Robinson.
      On
      April 19, 2006 pursuant to the line of Credit, the Company entered into a
      convertible variable promissory note in the principal amount as of March 31,
      2006 of $565,188 including all related accrued interest. The note bears interest
      at the rate of 12% per annum, is unsecured and is convertible into Class A
      common stock at $0.30 per share. The note is due on December 31, 2007. The
      note
      contains a beneficial conversion due to the conversion price of $0.30 being
      lower than the market price of $0.53 on the date of issuance. The beneficial
      conversion feature was valued at $926,720 on the date of issuance and recorded
      as a derivative liability. The Company has allocated $565,188 of the beneficial
      conversion feature as a discount on the note, which represents 100% of the
      face
      value of the note, which will accrete over the life of the note. In addition,
      the Company recognized a derivative valuation loss on the issuance of the note
      in the amount of $361,533.




Mr.
      Robinson advanced certain amounts from time to time to the Company under the
      line of credit during the year ended December 31, 2006 resulting in the
      recognition of additional discounts and derivative valuation losses upon
      issuance. The derivative analysis of the valuation upon issuance and the
      revaluation as of December 31, 2006 of the beneficial conversion feature related
      to Mr. Robinson's note and the significant assumptions used are contained in
      the
      following table:


Issuance
                  date
                March
                  31, 2006
              
              from
                  April 1 to
                June
                  30, 2006
              
              from
                  July 1 to
                September
                  30, 2006
              
              from
                  October 1 to
                December
                  31, 2006
              
              Report
                  date
                December
                  31, 2006Aggregate
                  note amounts
              
              $
              565,188
              
              $
              127,395
              
              $
              94,884
              
              $
              76,538
              
              $
              362,412Conversion
                  price
              
              $
              0.30
              
              $
              0.30
              
              $
              0.30
              
              $
              0.30
              
              $
              0.30Term
                  of notes
              
              
              1.75
                  years
              
              
              1.55
                  - 1.7 years
              
              
              1.30
                  - 1.47 years
              
              
              1.13
                  - 1.04 years
              
              
              1.0
                  yearShares
                  issuable upon conversion
              
              
              1,883,960
              
              
              424,649
              
              
              316,279
              
              
              255,127
              
              
              1,375,974Market
                  Price
              
              $
              0.53
              
              $
              0.29
                  - $0.50
              
              $
              0.16
                  - $0.24
              
              $
              0.14
                  - $0.18
              
              $
              0.16Risk
                  free interest rate
              
              
              4.80
              %
              
              4.96%
                  - 5.14
              %
              
              5.03%
                  - 5.20
              %
              
              4.96%
                  - 5.04
              %
              
              5.00
              %Volatility
              
              
              247.96
              %
              
              240.51%
                  - 246.75
              %
              
              239.40%
                  - 241.84
              %
              
              234.58%
                  - 236.18
              %
              
              233.53
              %Fair
                  value per share of conversion shares
              
              $
              0.4919
              
              $
              0.25
                  - $0.46
              
              $
              0.13
                  - $0.20
              
              $
              0.09
                  - $0.13
              
              $
              0.1051Beneficial
                  conversion feature fair value
              
              $
              926,720
              
              $
              116,620
              
              $
              55,453
              
              $
              27,527
              
              $
              144,615Note
                  discount amount
              
              $
              565,188
              
              $
              109,545
              
              $
              55,453
              
              $
              27,527Fair
                  value of derivative related tobeneficial
                  conversion feature
              
              $
              361,532
              
              $
              7,075
              
              $
              -
              
              $
              -
              
              $
              144,615





On
      April
      20, 2006, Mr. Robinson converted $50,000 of the balance at the stated conversion
      rate into 166,667 shares of Class A common stock. On September 29, 2006, Mr.
      Robinson On September 28, 2006 Mr. Robinson utilized the $350,000 of the balance
      owed to him under the note to exercise 1,750,000 vested options priced at $0.20
      and $85,000 of the balance owed to him under the note to exercise 500,000 vested
      options priced at $0.17 under the 2005 Stock Option Plan. An aggregate of
      2,250,000 shares were issued. Total accretion the discount of $576,362 was
      recorded as interest expense during the year ended December 31, 2006. The
      carrying value of the note is $181,061, net of discount of $181,351 and is
      recorded in Notes Payable - related parties in the accompanying balance sheet
      as
      of December 31, 2006. As a result of the conversions, the Company recognized
      a
      derivative valuation loss of $20,010 representing the change of the value from
      the previous valuation date to the date of conversion and as a result,
      reclassified an aggregate of $265,087 to additional paid in capital and recorded
      interest expense for the associated discount on the line of credit in the amount
      of $385,804 during the year ended December 31, 2006.





F-26





An
      analysis of the valuation of the beneficial conversion feature related to Mr.
      Robinson's note and the significant assumptions used are contained in the
      following table:


Conversion
                  date
              
              April
                  20, 2006
              
              September
                  29, 2006Original
                  proceeds from note
              
              $
              565,188
              
              $
              565,188Note
                  amount converted
              
              $
              50,000
              
              $
              435,000Principal
                  remaining after conversion
              
              $
              515,188
              
              $
              302,466Conversion
                  price
              
              $
              0.30
              
              $
              0.30Term
                  of notes at conversion
              
              
              1.70
                  years
              
              
              1.25
                  yearsShares
                  issued on conversion
              
              
              166,667
              
              
              1,450,000Potential
                  remaining conversion shares
              
              
              1,717,293
              
              
              1,008,220Common
                  Stock Price on conversion date
              
              $
              0.53
              
              $
              0.165Risk
                  free interest rate at December 31, 2005
              
              
              4.89
              %
              
              4.91
              %Volatility
                  on conversion dates
              
              
              246.20
              %
              
              239.76
              %Fair
                  value per share of conversion shares
              
              
              0.4891
              
              
              0.1266Fair
                  value of derivative
              
              $
              839,928
              
              $
              127,641Derivative
                  liability reclassified to additional paid-incapital
                  upon conversion
              
              $
              81,517
              
              $
              183,570Derivative
                  valuation loss recognizedon
                  conversion
              
              $
              -
              
              $
              (20,010
              )




At
      December 31, 2005 the Company issued Convertible Promissory Notes aggregating
      $124,343 to Frank Lively, a director of the Company in lieu of deferred salaries
      and for working capital advances made to the Company. The notes were subject
      to
      a 10% loan transaction fee and bear interest at the rate of 12%, are unsecured
      and convertible into the Company's Class A common stock at a price of $0.30
      per
      share. The conversion price approximated the market price on the date of the
      note. The notes are due on December 31, 2007.




On
      April
      19, 2006, the Board approved two convertible promissory notes for amounts as
      of
      April 17th, 2006, of $83,726 and $13,056, respectively with Frank Lively for
      cash advanced for working capital plus fees and interest. The notes bear
      interest at the rate of 12% per annum, are unsecured and are convertible into
      Class A common stock at $0.30 per share. The notes are due on December 31,
      2007.
      The notes contain a beneficial conversion feature due to the conversion price
      of
      $0.30 being lower than the market price of $0.53 on the date of issuance. The
      beneficial conversion feature was valued at $149,457 on the date of issuance
      and
      recorded as a derivative liability. The Company has allocated $91,151 of the
      beneficial conversion feature as a discount on the balance of the notes as
      of
      March 31, 2006 which will accrete over the life of the notes. In addition,
      the
      Company recognized a derivative valuation loss on the issuance of the note
      in
      the amount of $58,306. Total accretion of $12,986 was recorded during the three
      months ended June 30, 2006. The Company paid $15,000 of principal and accrued
      interest in July 2006 to Mr. Lively.




On
      September 29, 2006 Mr. Lively utilized the balance owed to him under the notes,
      including principal and all related interest of $92,973 to exercise vested
      options at an exercise price of $0.20 per share under the 2005 Stock Option
      Plan. An aggregate of 464,465 shares were issued to him and the Notes were
      cancelled. The Company recorded the remaining discount of $78,165 to interest
      expense during the year ended December 31, 2006. In addition, the Company
      reclassified $38,466 to additional paid in capital and recognized a derivative
      valuation loss of $4,193 upon the conversion of the notes.




F-27




An
      analysis of the valuation upon issuance, upon revaluation as of June 30, 2006
      and upon conversion as of September 29, 2006 of the beneficial conversion
      feature related to Mr. Lively's note and the significant assumptions used are
      contained in the following table:





Issuance
                    date
                  March
                    31, 2006
                
                Report
                    date
                  June
                    30, 2006
                
                Conversion
                    Date
                  September
                    29, 2006Aggregate
                    note amounts
                
                $
                91,151
                
                $
                91,151
                
                $
                91,151Conversion
                    price
                
                $
                0.30
                
                $
                0.30
                
                $
                0.30Term
                    of notes
                
                
                1.75
                    years
                
                
                1.50
                    years
                
                
                1.25
                    yearsShares
                    issuable upon conversion
                
                
                303,837
                
                
                303,836
                
                
                303,836Market
                    Price
                
                $
                0.53
                
                $
                0.17
                
                $
                0.165Risk
                    free interest rate
                
                
                4.80
                %
                
                5.16
                %
                
                4.91
                %Volatility
                    on issue date
                
                
                247.96
                %
                
                242.54
                %
                
                239.76
                %Fair
                    value per share of conversion shares
                
                
                0.4919
                
                
                0.1404
                
                
                0.1266Beneficial
                    conversion feature fair value
                
                $
                149,457
                
                $
                42,659
                
                $
                38,466Note
                    discount amount
                
                $
                91,151
                
                $
                78,165
                
                $
                -Fair
                    value of derivative related tobeneficial
                    conversion feature
                
                $
                58,306
                
                $
                (35,506
                )
                $
                38,466Derivative
                    valuation loss recognizedon
                    conversion
                
                
                
                
                
                
                
                $
                (4,193
                )




During
      the year ended December 31, 2005, Cherokee converted a $600,000 portion of
      their
      debt to Class A common shares at the rate of $0.20 per share into 3,000,000
      Class A common shares. The conversion rate was determined based on the fair
      value of the common stock on the date of the note of September 16, 2005 of
      $0.18
      per share. On August 12, 2005 Cherokee agreed to extend their note and, as
      additional consideration for extending the due date of the loans, the Company
      issued 73,553 shares of its Class A common stock valued at $102,974 to Cherokee
      based on the bid price as of that date. The Company recorded the value of the
      shares as additional interest expense related to the note. In addition, on
      December 31, 2005 the Company issued a Convertible Promissory Note in the amount
      of $312,255 to Cherokee which replaced the two notes outstanding at December
      31,
      2004. The new note bears interest at the rate of 12%, is unsecured and
      convertible into the Company's Class A common stock at a price of $0.30 per
      share. The conversion price approximated the market price on the date of the
      note. The notes are due on December 31, 2007.




On
      April
      19, 2006, the Board approved a convertible promissory note for an aggregate
      amount as of April 17th, 2006 in the amount of $312,255 plus accrued interest
      with Cherokee Raiders, LP, by way of cash advanced for working capital plus
      fees
      and interest. The note bears interest at the rate of 12% per annum, is unsecured
      and is convertible into Class A common stock at $0.30 per share. The note is
      due
      on December 31, 2007. This note replaces the note dated December 31, 2005 on
      identical terms.




The
      three
      notes discussed above provide for acceleration of payment from amounts in excess
      of a minimum of $7,000,000 that are raised in any type of financing. Such
      prepayments would be made on a pro rata basis among certain note holders. As
      a
      result of this acceleration provision, the notes have all been treated as
      current liabilities.




On
      April
      20, 2006 the Company issued an aggregate of 937,776 shares upon exercise of
      the
      conversion rights to Class A common stock at a conversion price of $0.30 per
      share associated with Convertible Notes in the aggregate amount of $281,333.
      The
      four executive employees converted an aggregate of $131,419, Frank Lively
      converted one of his notes representing deferred salary in the amount of
      $41,914, and Mr. Robinson and Cherokee each converted $50,000.




During
      the year ended December 31, 2005, Jim Alman converted $50,000 of the balance
      of
      his loan at December 31, 2004 to Class A common shares at the rate of $0.20
      per
      share and received 250,000 Class A common shares. The conversion rate was
      determined based on the fair value of the common stock on the date of the note
      of September 16, 2005 of $0.18 per share. In addition, the Company issued a
      Convertible Promissory Note to Mr. Alman in the amount of $50,000.The note
      bears
      interest at the rate of 12%, is unsecured and convertible into the Company's
      Class A common stock at a price of $0.30 per share. The conversion price
      approximated the market price on the date of the note. The note is due on
      December 31, 2007. On September 29, 2006 James Alman utilized the balance owed
      to him under his note, including principal and all related interest of $68,286
      to exercise 341,432 vested options under the 2005 Stock Option Plan. An
      aggregate of 341,432 shares were issued to him and the Note was cancelled.
      There
      was no beneficial conversion feature recognized on this note.




F-28




During
      the year ended December 31, 2005, Proxity loaned the Company funds to be used
      for working capital purposes which were payable on demand. On August 12, 2005
      Proxity agreed to extend their note and, as additional consideration for
      extending the due date of the loans, the Company issued 25,000 shares of its
      Class A common stock valued at $35,000 to Cherokee based on the bid price as
      of
      that date. The Company recorded the value of the shares as additional interest
      expense related to the note. The Company issued Proxity a Convertible Promissory
      Note in the amount of $351,600 on December 31, 2005. The note bears interest
      at
      the rate of 12%, is unsecured and convertible into the Company's Class A common
      stock at a price of $0.30 per share. The conversion price approximated the
      market price on the date of the note. The note is due on December 31, 2007.
      During the year ended December 31, 2006 the Company paid an aggregate of $50,000
      of the principal balance of the Convertible Note payable to Proxity,
      Inc.




At
      December 31, 2005 the Company issued Convertible Promissory Notes aggregating
      $263,266 to four executive employees of the Company in lieu of deferred
      salaries. The notes bear interest at the rate of 12%, are unsecured and
      convertible into the Company's Class A common stock at a price of $0.30 per
      share. The conversion price approximated the market price on the date of the
      note. The notes are due on December 31, 2007. On September 29, 2006 the
      remaining balance due to the executive employees, John Youngbeck and Keith
      Vierela utilized the balances owed to them under their notes including principal
      and all related interest of $55,096 and $80,062, respectively to exercise
      398,317 and 280,474 vested options, respectively under the 2005 Stock Option
      Plan. An aggregate of 678,791 shares were issued and the Notes were cancelled.
      No beneficial conversion features were present on these notes.


**December
                  31,**
                **2006**
              
              **December
                  31,**
                **2005****Current
                  - Related Parties**Convertible
                  Promissory Note - Cherokee Raiders, interest at 12%per
                  annum, due December 31, 2007, unsecured
              
              
              262,255
              
              
              312,255Convertible
                  Promissory Note - Proxity Inc., interest at 12% per annum,due
                  July 31, 2008, unsecured
              
              
              301,600
              
              
              351,600Convertible
                  Promissory Note - Billy Robinson, interest at 12%per
                  annum, due December 31, 2007, unsecured, net of discount
                  of
              
              
              181,061
              
              
              460,851181,350
                  and $0, respectivelyConvertible
                  Promissory Note - Jim Alman - interest at 12% perannum,
                  due December 31, 2007, unsecured
              
              
              -
              
              
              50,000Convertible
                  Promissory Notes - four executive employees - interest at12%
                  per annum, unsecured, due December 31, 2007
              
              
              -
              
              
              263,266Convertible
                  Promissory Notes - Frank Lively - interest at 12% perannum,
                  unsecured, due December 31, 2007
              
              
              -
              
              
              124,343$
              1,562,315
              
              $
              1,137,768





F-29





**NOTE
      8 - COMMITMENTS AND CONTINGENCIES**




Certain
      trade vendors in the ordinary course of business have not been paid. There
      is
      currently no litigation pending for said vendors and the amounts owed have
      been
      accrued in the accompanying financial statements as of December 31, 2006.




On
      January 1, 2006, the Company entered into a new employment agreement with Mr.
      Robinson. The new agreement supersedes the agreement discussed above. The term
      of this agreement is for a period of one year subject to renewal for successive
      one year periods, unless 14 days prior written notice is provided by either
      party. Mr. Robinson will receive an annual salary of not less than $250,000.
      The
      agreement provides for standard benefits, vacation and participation in the
      Company's bonus pool as defined in the agreement. In addition, the Company
      shall
      issue to Employee options to purchase shares of Company stock (Shares) in
      accordance with the Company's Stock Option Plan. The agreement may be terminated
      for due cause, upon death, upon disability, voluntary termination by him, or
      us,
      without due cause by providing 14 days prior written notice. Mr. Robinson is
      subject to a non-compete and non-solicitation provision during the employment
      term and during a specified Post-Employment Period (as defined in the employment
      agreement).





On
      January 1, 2006, the Company entered into an employment agreement with our
      Vice
      President, James D. Alman. The new agreement supersedes the agreement discussed
      above. The term of this agreement is for a period of one year, subject to
      renewal for successive one year periods, unless 14 days prior written notice
      is
      provided by either party. Mr. Alman will receive an annual salary of not less
      than $135,000. The agreement provides for standard benefits, vacation and
      participation in the Company's bonus pool as defined in the agreement. In
      addition, the Company shall issue to Employee options to purchase shares of
      Company stock (Shares) in accordance with the Company's Stock Option Plan.
      The
      Agreement may be terminated for due cause, upon death, upon disability,
      voluntary termination by him, or us without due cause by providing 14 days
      prior
      written notice. Mr. Alman is subject to a non-compete and non-solicitation
      provision during the employment term and during a specified Post-Employment
      Period.




On
      January 1, 2006, the Company entered into an employment agreement with Keith
      Vierela as Chief Operating Officer. The new agreement supersedes the agreement
      discussed above. The term of this agreement is one year, subject to renewal
      for
      successive one year periods, unless 14 days prior written notice is provided
      by
      either party. Mr. Vierela will receive an annual salary of not less than
      $150,000. The agreement provides for standard benefits, vacation and
      participation in the Company's bonus pool as defined in the agreement. In
      addition, the Company shall issue to Employee options to purchase shares of
      Company stock (Shares) in accordance with the Company's Stock Option Plan.
      The
      Agreement may be terminated for due cause, upon death, upon disability,
      voluntary termination by him, or us without due cause by providing 14 days
      prior
      written notice. Mr. Vierela is subject to a non-compete and non-solicitation
      provision during the employment term and during a specified Post-Employment
      Period. On November 15, 2006 Mr. Vierela and the Company terminated the contract
      under an agreement as of that date. Under the terms of the agreement, Mr.
      Vierela was released from all restrictive covenants of his employment agreement
      in exchange for the return and cancellation of 500,000 shares of Class A common
      stock held by Mr. Vierela. The transaction was recorded as of the date of the
      termination of the contract as a reduction of the outstanding shares of the
      Company.




On
      January 1, 2006, TSI entered into a new employment agreement with John Youngbeck
      as Executive Vice President. The term of this agreement is one year, subject
      to
      renewal for successive one year periods, unless 14 days prior written notice
      is
      provided by either party. Mr. Youngbeck will receive an annual salary of not
      less than $100,000. The agreement provides for standard benefits, vacation
      and
      participation in the Company's bonus pool as defined in the agreement. In
      addition, the Company shall issue to Employee options to purchase shares of
      Company stock (Shares) in accordance with the Company's Stock Option Plan.
      The
      Agreement may be terminated for due cause, upon death, upon disability,
      voluntary termination by him, or the Company without due cause by providing
      14
      days prior written notice. Mr. Youngbeck is subject to a non-compete and
      non-solicitation provision during the employment term and during a specified
      Post-Employment Period.




On
      January 1, 2006, TSI entered into a new employment agreement with Michael Lawson
      as Corporate Marketing Officer. The term of this agreement is one year, subject
      to renewal for successive one year periods, unless 14 days prior written notice
      is provided by either party. Mr. Lawson will receive an annual salary of not
      less than $100,000. The agreement provides for standard benefits, commissions
      of
      2% of all gross sales less costs registered by the employee, vacation and
      participation in the Company's bonus pool as defined in the agreement. In
      addition, the Company shall issue to Employee options to purchase shares of
      Company stock (Shares) in accordance with the Company's Stock Option Plan.
      The
      Agreement may be terminated for due cause, upon death, upon disability,
      voluntary termination by him, or the Company without due cause by providing
      14
      days prior written notice. Mr. Lawson is subject to a non-compete and
      non-solicitation provision during the employment term and during a specified
      Post-Employment Period.




F-30




On
      January 1, 2006, the Company entered into an hourly consulting agreement with
      Frank Lively. The consulting agreement provides for the cancellation of Mr.
      Lively's prior employment agreement. Fees due under the consulting agreement
      are
      convertible into Class A common shares of the Company by Mr. Lively at the
      lesser of $0.30 per share or the closing price on the date of conversion. This
      contract was terminated on July 15, 2006.




On
      January 1, 2006, the Company entered into an hourly consulting agreement with
      Steve Johnson. Fees due under the consulting agreement are convertible into
      Class A common shares of the Company by Mr. Johnson at the lesser of $0.30
      per
      share or the closing price on the date of conversion.




In
      January, 2006 the Company entered into a Strategic Consulting Agreement for
      finance consulting services. The agreement calls for a minimum term of 90 days
      and the payment of the equivalent of $120,000 of the Company's Class A common
      stock at a 30% discount to the closing price and 150,000 warrants at a price
      to
      be determined upon the close of a financing transaction as defined in the
      agreement. The agreement was cancelled effective April 19, 2006 and the Company
      issued an aggregate of 114,285 shares of Class A Common stock valued at $60,571
      pursuant to the terms of a cancellation agreement. The warrants potentially
      issuable in the agreement were not issued.




In
      February, 2006, the Company entered into an Investor Relations Agreement for
      a
      term of one year with Osprey Partners to provide investor and shareholder
      relations services to the Company. The agreement calls for a monthly retainer
      of
      $6,000 and the issuance of warrants to purchase 600,000 shares of the Company's
      Class A common stock at a strike price of $0.45 per share with a value of
      $419,760 on the date of grant using the Black Scholes method. The warrants
      expire 7 years after the anniversary date. The warrants vest monthly over one
      year, with 50,000 warrants vesting at the signing of the agreement, subject
      to
      immediate vesting of all remaining warrants should the retainer become 30 days
      past due. During June, 2006 the retainer became 30 days past due and
      accordingly, the Company recognized compensation expense of $419,760 within
      general and administrative expenses in the accompanying statement of operations
      for the year ended December 31, 2006.




In
      March,
      2006 the Company executed a Due Diligence Agreement with GreenHills Ventures,
      LLC. ("GreenHills"). Under the agreement, the Company paid GreenHills $10,750
      plus expenses for GreenHills to perform due diligence on behalf of potential
      investors as a due diligence fee. In addition, the Company agreed to compensate
      GreenHills for any financing transaction (debt, equity, hybrid security, merger
      and acquisition or other similar arrangement financing) with any qualified
      purchaser as defined in the agreement. The compensation consists of the payment
      of cash of 10% of the aggregate value of any equity or non-loan financing and
      7%
      of the value to be paid in Class A common stock of the Company. In the event
      of
      a non-equity financing, the compensation consists of payment of cash of 3%
      of
      the aggregate value of the transaction and 7% of the value to be paid in Class
      A
      common stock of the Company. The agreement calls for the payment of a breakup
      fee to be paid under certain conditions as defined in the agreement of 2.5%
      of
      the first $5,000,000 of a financing plus 1% of any amount greater than
      $5,000,000. There are no transactions proposed or pending at this time under
      this agreement.




On
      April
      27, 2006 the Company entered into an Agreement, (the "Agreement") dated as
      of
      April 25, 2006, by and among the Company, Sierra Nevada Corporation "Sierra"
      and
      TSI. The Agreement is intended to clarify the relationship and obligations
      of
      the parties, which arise from three prior agreements (the Exclusive Agreement
      to
      Provide Integration Services, dated June 30, 2004, the Memorandum of Agreement
      dated November 4, 2004 and the Subcontract Agreement dated May 11, 2005) which
      were entered into prior to Techsphere becoming a wholly-owned subsidiary of
      the
      Company. The Agreement provides that SNC will serve as the prime contractor
      to
      Government End-Users for all Techsphere Airships and provided that Sierra will
      give Techsphere the right of first refusal to lease or sell other non-Techsphere
      manufactured airships to Sierra on competitive terms. The Agreement also is
      intended to arrive at an understanding with respect to amounts claimed by Sierra
      as owed, which arose from certain expenditures made by Sierra for which they
      are
      seeking reimbursement. The Agreement provides that if all other conditions
      of
      the Agreement are fulfilled that (i) Sierra will reduce its claim from $780,000
      to $500,000; (ii) the Company will within 90 days deliver four MAA-90 airship
      pods to Techsphere free and clear of any liens and encumbrances and (iii) if
      a
      delivery order is awarded and Techsphere delivers the completed MAA-90 airship
      to Sierra, Sierra will set-off the $500,000 payment due from the Company. The
      Company has delivered the four MAA-90 airship pods and has received the delivery
      order from Sierra in February, 2007 in excess of $1,000,000 calling for the
      completion of the MAA-90 airship as well as certain additional operating
      features and accessories. Final terms include a $500,000 credit against the
      note
      provided that a completed airship is delivered upon a mutually agreed upon
      milestone schedule.




F-31




Pursuant
      to the Agreement, the Company issued a note to Sierra dated April 25, 2006
      in
      the amount of $500,000 which bears interest at the rate of 8.5% beginning August
      25, 2006 secured by the above referenced airship pods. The Company recognized
      the net present value of the note as Selling, General and Administrative
      expenses in the accompanying statements of operations. (See Note 6)





During
      the year ended December 31, 2006, the Company executed an Airship Advertising
      Agreement with a fortune 100 publicly traded company for the lease and operation
      of two of its SA-68A spherical airships. The Company received an aggregate
      of
      $2,760,000 under the terms of the contract as amended for the construction
      of
      the airship. The construction process was halted and the Airship Advertising
      Agreement was cancelled in the first quarter of 2007. The Company is in the
      process of negotiating a repayment schedule for the $2,760,000 which is
      categorized as “Refundable Deposits to Customer” in the accompanying balance
      sheet as of December 31, 2006.




On
      December 10, 2006, the Company entered into a Licensing and Technical Assistance
      Agreement with Global Skyship Industries, Inc. (“Global”) for the use of certain
      patented technology and know how in the manufacture of TSI’s airships. The
      license agreement called for a term of 6 years ending December 10, 2012 and
      minimum royalty payments under the agreement of $240,000 for 2007 and 2008,
      $300,000 for 2009 and 2010 and $360,000 for 2011 and 2012. A total of $60,000
      was paid at the signing of the agreement in December, 2006 and has been recorded
      in prepaid expenses in the accompanying balance sheet at December 31,
      2006.




On
      April
      13, 2005, Proxity, then our majority shareholder, announced its intention to
      declare a dividend of shares of our common stock, owned by Proxity, to its
      holders of record. For each 500 shares of Proxity common stock held by a Proxity
      shareholder on the record date, Proxity will grant a dividend of one share
      of
      common stock of Cyber Defense. Proxity intends to distribute a total of
      approximately 560,000 shares of Cyber Defense to its holders. We have agreed
      to
      register such shares under the Securities Act of 1933, as amended. Mr. Robinson
      owns approximately 33% of the outstanding shares of capital stock of
      Proxity.




The
      Company has various noncancelable operating leases for administrative office
      and
      warehouse facilities. The leases provide for minimum future rentals. Future
      minimum lease payments under non-cancelable operating leases as of December
      31,
      2006 are $60,580 for the year ending December 31, 2007.




**NOTE
      9 - STOCKHOLDERS' DEFICIT**




COMMON
      STOCK




At
      December 31, 2006 and December 31, 2005, the Company had 66,867,316 and
      56,912,893 shares of Class A Common Stock outstanding, respectively, 545,455
      shares of Class B Common Stock, and 2 shares of Class C Common Stock issued
      and
      outstanding with 200,000,000 shares of Class A and Class B Common Stock
      authorized, par value $.001, and 200,000,000 shares of Class C Common Stock
      authorized, par value $.001. In addition, the Company had 100,000,000 shares
      of
      Class A Preferred Stock authorized, par value $.001, with no shares issued
      and
      outstanding. Class B Common Stock allows for 1,000 votes per share. Class C
      Common Stock allows for one vote per share and entitles the holder to receive
      the net assets of the Company upon dissolution. Additional paid in capital
      at
      December 31, 2006 and 2005 was $20,372,513 and $14,644,966, respectively. The
      accumulated deficit as at December 31, 2006 and 2005 was $38,516,199 and
      $16,476,382, respectively.




During
      2005, the Company discontinued banking activity in Canada, which resulted in
      the
      recognition of $7,064 of income for the year ended December 31, 2005 related
      to
      prior year currency translation adjustments.




F-32




STOCK
      ISSUANCES




The
      Company issued the following shares of Class A Common Stock during the year
      ended December 31, 2006.




On
      April
      20, 2006, the Company issued an aggregate of 337,618 shares of its Class A
      common stock at a price of $0.53 valued at $178,938 to vendors in exchange
      for
      services and to settle existing obligations of the Company.




On
      April
      20, 2006 the Company issued 55,000 shares of its Class A common stock upon
      the
      conversion of $11,000 of accounts payable by David Barnes, its Chief Financial
      Officer at the price of $0.20 per share.




On
      April
      20, 2006 the Company issued an aggregate of 937,776 shares of its Class A common
      stock upon the conversion of related party convertible notes at a conversion
      price of $0.30 for a total amount of $281,333.




On
      April
      20, 2006 the Company issued an aggregate of 966,667 shares of its Class A common
      stock upon the conversion of unrelated convertible notes at a conversion price
      of $0.30 for a total amount of $290,000.




On
      June
      6, 2006 the Company issued 609,300 shares of its Class A common stock to AJW
      upon conversion of $114,487 of their convertible notes at a conversion price
      of
      $0.1879.




On
      June
      28, 2006 the Company issued 476,043 shares of its Class A common stock upon
      conversion of $142,813 of unrelated convertible notes at a conversion price
      of
      $0.30. On September 28, 2006 the Company issued an additional 317,362 shares
      of
      Class A common stock to relative to an agreement lowering the conversion price
      from $0.30 to $0.18.




On
      July
      21, 2006 the Company issued 46,666 shares of its Class A common stock upon
      the
      conversion of $7,000 of accounts payable by its Chief Financial Officer, David
      M. Barnes at a price of $0.15 per share.




On
      July
      21, 2006 the Company issued 616,000 shares of its Class A common stock at a
      price of $0.18 per share valued at $110,880 to vendors for services
      rendered.




On
      July
      21, 2006 the Company issued 106,000 shares of its Class A common stock to
      Equipment Depot in conversion of their Note and all related accrued interest
      of
      $26,500 at a conversion price of $0.25 per share.




On
      September 18, 2006 the Company issued 609,846 shares to AJW upon conversion
      of
      $63,424 of their Notes at a conversion price of $0.104 per share.




On
      September 28, 2006 the Company issued 300,097 shares of its Class A common
      stock
      upon conversion of $60,019 of unrelated convertible notes and related interest
      at a conversion price of $0.20.




On
      September 28, 2006 an aggregate of 4,496,162 shares were issued pursuant to
      the
      exercise of options as discussed above.




On
      September 28, 2006 the Company issued an additional 317,362 shares of Class
      A
      common stock valued at $57,125 to Mayo Hadden valued at $0.18 per share
      representing the market price as June 28, 2006, the date of the conversion
      of
      the remaining balance of his note.




On
      September 30, 2006, the Company issued 579,886 shares of its Class A common
      stock to two vendors at a price of $0.20 with a total value of $115,977 for
      services rendered.




The
      Company issued the following shares of Class A Common Stock during the year
      ended December 31, 2005.




The
      Board
      of Directors also approved the issuance of 390,000 shares of Class A common
      stock as Employee Restricted Stock Awards to five employees. Such shares were
      valued at $0.20 per share and a compensation charge in the aggregate amount
      of
      $78,000 has been recorded. In addition, 200,000 shares of Class A common stock
      valued at $0.20 per share were issued to the directors of the Company and a
      compensation charge in the aggregate amount of $40,000 has been
      recorded.




F-33




The
      Company also granted an aggregate of 30,461 shares of Class A common stock
      valued at $94,125 recorded in 2005 as compensation to two
      consultants.




The
      Company also granted an aggregate of 300,000 shares of Class A common stock
      valued at $90,000 recorded in 2005 as compensation to Equipment Depot,
      Inc.




**NOTE
      10 - INCOME TAXES**




The
      Company has paid no federal or state income taxes since its incorporation.
      As of
      December 31, 2006 and December 31, 2005, the Company had net operating loss
      carry forwards for federal income tax reporting purposes of $15,019,484 and
      $6,154,864 respectively, which if unused, will begin to expire in 2025 and
      2024,
      respectively. Deferred tax assets are reduced by a valuation allowance to the
      extent that uncertainty exists as to whether the deferred tax assets will
      ultimately be realized.





The
      net
      deferred tax asset consists of the following:


December
                  31
              
              December
                  312006
              
              2005Deferred
                  tax assetsOperating
                  loss carryforwards
              
              $
              5,651,952
              
              $
              2,316,196Amortization
              
              
              306,479
              
              
              110,450Depreciation
              
              
              10,739
              
              
              10,739Goodwill
              
              
              1,521,698
              
              
              1,636,234Valuation
                  allowance
              
              
              (7,490,868
              )
              
              --
              
              
              
              
              
              4,073,619Deferred
                  tax liabilities21st
                  Century License
              
              
              -
              
              
              (4,290,944
              )Net
                  Deferred Tax Asset (Liability)
              
              $
              -
              
              $
              (217,325
              )




The
      following is a reconciliation of the income tax computed using the federal
      statutory rate to the provision for income taxes:




December
                  31
              
              December
                  312006
              
              2005Tax
                  at federal statutory rate
              
              $
              (7,567,428
              )
              $
              (6,129,060
              )Non-deductible
                  expenses
              
              
              5,039,606
              
              
              2,986,630Benefit
                  of NOL carryforward
              
              
              3,335,757
              
              
              1,989,480Change
                  in valuation allowance
              
              
              168,818
              
              
              (334,584
              )State
                  taxes, net of federal benefit
              
              
              (807,934
              )
              
              (654,367
              )Other
              
              
              (386,144
              )
              
              (305,863
              )Income
                  tax benefit
              
              $
              (217,325
              )
              $
              (2,447,764
              )


F-34





**NOTE
      11 - STOCK OPTIONS**





On
      September 19, 2005, the Board of Directors approved and adopted the Cyber
      Defense Systems, Inc. 2005 Stock Option Plan and in 2006 it was approved by
      the
      shareholders.




Effective
      January 1, 2006, the Company adopted SFAS No. 123 (revised), "Share-Based
      Payment" (SFAS 123(R)) utilizing the modified prospective approach. Prior to
      the
      adoption of SFAS 123(R), stock option grants to employees and directors were
      accounted for in accordance with APB Opinion No. 25, "Accounting for Stock
      Issued to Employees" (the intrinsic value method) and the disclosure-only
      provisions of SFAS 123, "Accounting for Stock-Based Compensation". Accordingly,
      employee compensation expense was recognized only to the extent that the fair
      value of our common stock on the date of grant exceeded the stock option
      exercise price.




Under
      the
      modified prospective approach, SFAS 123(R) applies to new grants and to grants
      that were outstanding on January 1, 2006 that are subsequently modified,
      repurchased or cancelled. Under the modified prospective approach, compensation
      cost recognized in fiscal 2006 includes compensation cost for all share-based
      payments granted prior to, but not yet vested as of January 1, 2006, based
      on
      the grant-date fair value estimated in accordance with the original provisions
      of SFAS 123, and compensation cost for all share-based payments granted
      subsequent to January 1, 2006, based on the grant-date fair value estimated
      in
      accordance with the provisions of SFAS 123(R). Prior periods were not restated
      to reflect the impact of adopting the new standard.




The
      fair
      value of the options granted in fiscal year 2006 and 2005 was estimated at
      the
      date of grant using the Black-Scholes option-pricing model with the following
      assumptions for the years ending December 31,


**2006**
              
              **2005**Expected
                  volatility
              
              
              236.5%
                  - 239.8%
              
              
              250%Risk-free
                  interest rate
              
              
              4.6%-5.0%
              
              
              4.25%Expected
                  life of options (years)
              
              
              10
                  years
              
              
              10
                  yearsExpected
                  dividends
              
              
              -0-
              
              
              -0-




The
      following table represents stock option activity under the 2005 Stock Option
      Plan for the years ended December 31, 2006 and 2005.


**Number**
                **of**
                **Shares**
              
              **Weighted-**
                **Average**
                **Exercise**
                **Price**
              
              **Weighted-**
                **Average**
                **Remaining**
                **Contract**
                **Life
                  (years)**Outstanding
                  options at 1/1/05
              
              
              -Granted
              
              
              11,379,900
              
              $
              0.20
              
              
              9.72Outstanding
                  options at 12/31/05
              
              
              11,379,900
              
              $
              0.20Granted
              
              
              3,625,000
              
              $
              0.17Forfeited
              
              
              (1,296,900
              )
              $
              0.20Exercised
              
              
              (4,551,162
              )
              $
              0.20Outstanding
                  options at 12/31/06
              
              
              9,156,838
              
              $
              0.19
              
              
              8.42Outstanding
                  exercisable at 12/31/06
              
              
              9,131,838
              
              $
              0.19
              
              
              8.42
  F-35




At
      December 31, 2006, shares available for future stock option grants to employees
      and others under our 2005 Stock Option Plan were 1,292,000.




On
      September 28, 2007, the Company accelerated the vesting on all options
      outstanding as of that date, resulting in the immediate expensing of all
      remaining compensation expense relative to those options. On September 28,
      2006
      an aggregate of 4,496,162 options issued pursuant to the 2005 Stock Option
      Plan
      were exercised at a weighted average exercise price of $0.20. There were no
      cash
      proceeds realized by the Company in the exercise. As discussed in Note 7,
      Messrs. Robinson, Lively, Youngbeck, Vierela and Alman utilized the balances
      owed to them under their respective notes, including principal and all related
      interest of $732,718 to exercise 3,735,088 vested options under the 2005 Stock
      Option Plan. In addition on September 28, 2006, an aggregate of 761,064 options
      were exercised by employees and Board members. No proceeds were received by
      the
      Company on the exercise. Rather, the employees utilized amounts due to them
      by
      the Company for commissions, consulting fees and board fees as consideration
      for
      the options.




In
      connection with their purchase of 88,000 shares of Class A common stock prior
      to
      the merger of On Alert into Cyber Defense, All Stars Marketing, Inc. was granted
      an option to acquire up to an additional 88,000 shares for the same purchase
      price of $0.0593 per share through August 8, 2005. This option was exercised
      in
      2005. Registration rights were also granted for such shares.




**NOTE
      12 - SUBSEQUENT EVENTS**





In
      2005,
      TSI formed TSI Holdings Co, LLC ("TSI, LLC") a Georgia limited liability
      company. On January 30, 2007, TSI reactivated TSI, LLC, in order to raise
      funds in order deploy two (2) SA-60 Airships. The Company’s intent is to sell an
      aggregate of twenty-five (25%) percent membership interest in TSI, LLC. On
      February 5 , 2007, the Company raised $400,000 toward such funding for an
      aggregate of 4.5% membership interest in the TSI, LLC, leaving Cyber Defense
      Systems, Inc with an aggregate interest membership of 95.5% in TSI,
      LLC.




Subsequent
      to year end, Mr. Robinson advanced cash of an additional $427,045 through May
      17, 2007 under his line of credit.




On
      February 12, 2007 the Company issued 360,000 shares of Class A Common Stock
      to a
      vendor for services valued at $0.12 per share based on the closing market price
      as of that date. The Company will record an expense of $43,200 relative to
      this
      stock issuance in the first quarter of 2007. On April 17, 2007 the Company
      issued 100,000 shares of Class A Common Stock to a vendor for services valued
      at
      $0.065 per share based on the closing market price as of that date. The Company
      will record an expense of $6,500 relative to this stock issuance in the second
      quarter of 2007.





F-36