**U.S. SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

**FORM 10-KSB/A**

**Amendment No. 2**

**AnnualReport Pursuant to Section 13 or 15(d)of the Securities Exchange Act of 1934For the Fiscal Year Ended December 31, 2005**

**Commission File Number 1-13463**

**BIO-KEY INTERNATIONAL, INC.**

(Name of small businessissuer in its charter)
| **DELAWARE**                                                     | **41-1741861**                        |
|------------------------------------------------------------------|---------------------------------------|
| (State or other  jurisdiction of  Incorporation or organization) | (IRS Employer  Identification Number) |

 

**3349 HIGHWAY 138,BUILDING D, SUITE B, WALL, NJ 07719**

(Address of PrincipalExecutive Offices) (Zip Code)

**(732) 359-1100**

Issuer’s telephonenumber, including area code.

Securities registeredpursuant to Section 12(b) of the Act:

| Title of Each Class                        | ** ** | **Name of Exchange on which Registered** |
|--------------------------------------------|------------|------------------------------------------|
| Common Stock,  $0.0001 par value per share |       | None                                     |

 

Securities registered under Section 12(g) ofthe Exchange Act

**None**

Check whether the issuer is not required to filereports pursuant to Section 13 or 15(d) of the Exchange Act. o

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

Check if there is no disclosure of delinquent filersin response to Item 405 of Regulation S-B contained in this form, and nodisclosure will be contained, to the best of registrants knowledge, indefinitive proxy or information statements incorporated by reference in Part IIIof this Form 10-KSB or any amendment to this form 10-KSB. x

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o   No x

State issuer’s revenues for its most recent fiscalyear: $14,226,095

The aggregate market value of the voting andnon-voting common equity held by non-affiliates of the registrant based on theclosing sale price of the registrant’ common stock as reported on the OTCBulletin Board on March 15, 2006 was $23,132,637. The information providedshall in no way be construed as an admission that any person whose holdings areexcluded from the figure is an affiliate or that any person whose holdings areincluded in the figure is not an affiliate, and any such admission is herebydisclaimed. The information provided is solely for the record keeping purposesof the Securities and Exchange Commission.

As of March 15, 2006, 48,036,983 shares of theregistrant’s common stock were outstanding.

Transitional Small Business Disclosure Formats (checkone):

Yes o   No x

 

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**EXPLANATORY NOTE**

This Amendment on Form 10-KSB/A constitutesAmendment No. 2 to the registrant’s Annual Report on Form 10-KSBfor the period ended December 31, 2005, which was originally filed withthe Securities and Exchange Commission on March 30, 2006 (as amended, the “OriginalReport”). The purpose of this Amendment No. 2 is to amend the registrant’sfinancial statements and management’s discussion and analysis for restatements ofthe registrant’s December 31, 2004 and 2005 annual financial statements asamended, and to provide further clarification under Item 8A (Controls andProcedures). The restatements are further explained in note B of the financialstatements. Except as amended hereby, this Form 10-KSB/A does notamend, update or change any other information contained in the Original Report.

**DOCUMENTSINCORPORATED BY REFERENCE**

None.

**TABLE OF CONTENTS**
|          |   | PART I                                                                                                                  |   |   |   |
|----------|--------|------------------------------------------------------------------------------------------------------------------------------|--------|--------|--------|
|     |   |                                                                                                                         |   |   |   |
| Item 1.  |   | Description of Business                                                                                                      |   | 1      |   |
| Item 2   |   | Description of Property                                                                                                      |   | 16     |   |
| Item  3  |   | Legal  Proceedings                                                                                                           |   | 16     |   |
| Item 4   |   | Submission of Matters to a Vote of Security Holders                                                                          |   | 16     |   |
|     |   |                                                                                                                         |   |   |   |
|     |   | PART II                                                                                                                 |   |   |   |
|     |   |                                                                                                                         |   |   |   |
| Item 5   |   | Market for Common Equity and Related Stockholder  Matters                                                                    |   | 17     |   |
| Item 6   |   | Management’s Discussion and Analysis or Plan of  Operation                                                              |   | 21     |   |
| Item  7  |   | Financial  Statements                                                                                                        |   | 41     |   |
| Item 8   |   | Changes in and Disagreements with Accountants on  Accounting and Financial Disclosure                                        |   | 42     |   |
| Item 8A  |   | Controls and Procedures                                                                                                      |   | 42     |   |
| Item  8B |   | Other  Information                                                                                                           |   | 42     |   |
|     |   |                                                                                                                         |   |   |   |
|     |   | PART III                                                                                                                |   |   |   |
|     |   |                                                                                                                         |   |   |   |
| Item 9   |   | Directors, Executive Officers, Promoters and Control  Persons;   Compliance with Section 16(a) of the Exchange Act |   | 43     |   |
| Item 10  |   | Executive Compensation                                                                                                       |   | 45     |   |
| Item 11  |   | Security Ownership of Certain Beneficial Owners and  Management and Related Stockholder Matters                              |   | 48     |   |
| Item 12  |   | Certain Relationships and Related Transactions                                                                               |   | 50     |   |
| Item 13  |   | Exhibits                                                                                                                     |   | 51     |   |
| Item 14  |   | Principal Accountant Fees and Services                                                                                       |   | 51     |   |
|     |   | Signatures                                                                                                                   |   | 148    |   |

 

**PRIVATE SECURITIES LITIGATION REFORM ACT**

All statements other than statements of historicalfacts contained in this Annual Report on Form 10-KSB, includingstatements regarding our future financial position, business strategy and plansand objectives of management for future operations, are forward-lookingstatements. The words “anticipate,” “believe,” “estimate,” “will,” “may,” “future,”“plan,” “intend” and “expect” and similar expressions generally identifyforward-looking statements. Although we believe our plans, intentions andexpectations reflected in the forward-looking statements are reasonable, we cannotbe sure they will be achieved. Actual results may differ materially fromthe forward-looking statements contained herein due to a number of factors.Many of these factors are set forth under the caption “Risk Factors”****in Item I of this Annual Report and other filings with theSecurities and Exchange Commission. These factors are not intended to representa complete list of the general or specific factors that may affect us. Itshould be recognized that other factors, including general economic factors andbusiness strategies, may be significant, presently or in the future.Except as required by law, we undertake no obligation to update anyforward-looking statement, whether as a result of new information, futureevents or otherwise.

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**PART I**

**ITEM 1.**                    DESCRIPTION OFBUSINESS

BIO-key International, Inc.,a Delaware corporation (“the Company,” “BIO-key,” “we,” or “us”), was foundedin 1993 to develop and market proprietary biometric technology and softwaresolutions. Biometric technology is the science of analyzing specific humancharacteristics which are unique to each individual in order to identify aspecific person from a broader population.

 On March 30,2004, BIO-key acquired Public Safety Group, Inc. (PSG), a privately heldcompany that is a leader in wireless solutions for law enforcement and publicsafety markets. PSG’s primary technology is PocketCopTM, a handheld solutionthat provides mobile officers, such as detectives who are not typically intheir vehicles, a hand-held mobile information software solution.

On September 30,2004, BIO-key completed a transaction with Aether Systems, Inc. topurchase its Mobile Government Division(“Mobile Government” or “AMG”), aleading provider of wireless data solutions for use by public safety organizations,primarily state, local police, fire and rescue and emergency medical servicesorganizations. The PacketCluster mobile information software is integrated with50 separate State/NCIC databases, as well as other state, local and federaldatabases. Its open architecture and its published Application ProgrammingInterface (API) make it easy to interface with a wide range of informationsources. PacketCluster products deliver real-time information in seconds,freeing dispatchers to handle more pressing emergencies.

Effective January 1,2005, BIO-key International, Inc., a Minnesota corporation (“Old BIO-key”),reincorporated in the State of Delware. The reincorporation was effectedpursuant to an Agreement and Plan of Merger (the “Merger Agreement”) wherebyOld BIO-key was merged with and into the Company, its wholly owned subsidiary,in order to reincorporate in the State of Delaware (the “Reincorporation”). Asa result of the Reincorporation, the legal domicile of the Company is nowDelaware.

Pursuant to the MergerAgreement, at the effective time of the Reincorporation: (i) eachoutstanding share of Common Stock of Old BIO-key, $0.01 par value per share,was automatically converted into one share of Common Stock, $0.0001 par valueper share, of the Company; (ii) each outstanding share of Series C 7%Convertible Preferred Stock of Old BIO-key, $0.01 par value per share, wasautomatically converted into one share of Series A 7% ConvertiblePreferred Stock, $0.0001 par value per share, of the Company, with such Series A7% Convertible Preferred Stock containing substantially identical terms andconditions as the Series C 7% Convertible Preferred Stock of Old BIO-key; (iii) eachoption to purchase shares of Old BIO-key’s Common Stock granted by Old BIO-keyunder any warrant, stock option plan or similar plan of Old BIO-key outstandingimmediately before the Reincorporation was, by virtue of the Merger Agreementand without any action on the part of the holder thereof, converted intoand become an option to purchase, upon the same terms and conditions, the samenumber of shares of the Company’s Common Stock at an exercise price per shareequal to the exercise price per share thereunder immediately before theReincorporation; and (iv) each warrant, option or stock option plan of OldBIO-key was assumed by, and continues to be, a warrant, option or plan of theCompany. Accordingly, as a result of the Reincorporation, the shareholders ofOld BIO-key became shareholders of the Company, and Old BIO-key has been mergedout of existence by operation of law. Each certificate representing shares ofcapital stock of Old BIO-key outstanding immediately before theReincorporation, is deemed from and after the Reincorporation for all corporatepurposes to represent the same number of shares of capital stock of theCompany.

As a result of the recentmergers, and as discussed in Note M to the Consolidated FinancialStatements, we have organized BIO-key International, Inc. into threereporting segments: Law Enforcement, Fire Safety and Biometrics. During 2005,the Company continued to integrate the products, operations and technologiesacquired from Public Safety Group, Inc. and Aether Systems, Inc.

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**Products**

BIO-key® operatesin three major segments—biometrics, law enforcement and fire safety. Thesesegments are described below and a list of products in each line is noted.

*Biometrics*

BIO-key’s fingeridentification algorithm—Vector Segment Technology (VSTTM) is the coreintellectual property behind its full suite of biometric products thatinclude:

·                  **Vector Segment Technology SDK (VST)**—BIO-key’sbiometric development kit that provides developers the ability to takeadvantage of a highly accurate, device interoperable algorithm. VST isavailable as a low level SDK for incorporation into many complex applicationsystems. VST runs in Windows, Linux or Solaris systems.

·                  **True User Identification**®—BIO-key’sbiometric identification solution that offers large scale one to many userlookup with nothing but a single fingerprint. This solution leverages the powerof Oracle for large scale solutions in the millions of users, or uses smallerdatabases for more modest applications to 100,000 users.

·                  **WEB-key**®—BIO-key’s biometricplatform that offers an enhanced level of security by securing the user’sauthentication with trusted communications and simple use. WEB-key runs onWindows or Linux systems.

·                  **Biometric Service ProviderTM**—BIO-keyprovides support for the BioAPI (a standards based solution meeting worldwideneeds, see *www.bioapi.org*fordetails) for a compliant interface to applications using biometrics forverification and identification. BIO-key enhances the traditional use of theBioAPI by adding support for CE devices, supporting identification calls andalso providing a single user interface for multiple fingerprint readers.

·                  **ID Director**TM—BIO-key’s solution for singlesign on integration with Computer Associates SiteMinder, Oracle’s FusionMiddleware SSO, and other solutions, utilizing the power and security ofWEB-key. This solution provides a simple to implement, custom authenticationscheme for companies looking to enhance authentication and add a level ofsecurity and audit through re-authentication of a user at the transactionlevel.

The Company’s biometric identification technologyimproves both the accuracy and speed of finger-based biometrics. The Company’sproprietary biometric technology scans a fingerprint and identifies a person,typically within a few seconds or less, in databases of a million people ormore. BIO-key can accomplish this without using any other identifying data—akey differentiator for BIO-key since other biometric solutions may alsorequire traditional token/card identification. BIO-key’s core technologysupports user enrollment on over 40 different commercially available readersand in turn can offer compatibility among those readers through a singlefingerprint template. We have also added INCITS 378-2004 support to oursoftware development kits which makes our products compatible with all of theRegistered Traveler projects, PIV initiatives, and FIXS consortium solutions.We believe our fingerprint identification technology has a broad range ofpossible information security and access control applications, including:

·                  SecuringInternet sites and electronic transactions

·                  Securing accessto logical networks and applications

·                  Securing accessto buildings and restricted areas

·                  Providing fast,accurate member identification services

·                  Securing mobiledevices such as cell phones and PDA’s

·                  Preventingidentity theft with positive identification and false alias validation

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*LawEnforcement*

·                  **MobileCopTM**— A complete wireless query andmessaging application that puts the power of mobile and wireless technology towork for agencies of every size, MobileCopTM sets the standard for mobile lawenforcement. Providing real-time retrieval of motor vehicle, warrant andcriminal history information, powerful mobile integration capabilities, and anintuitive user interface, MobileCop delivers the most in performance and it’seasy to see why over 1,200 law enforcement agencies around the country havedeployed MobileCop for fast and secure access to critical information in thefield.

·                  **PocketCop®**— PocketCop® is a software solution that provides police officers and othersecurity personnel instantaneous access to important criminal, civil, andprivate database information in a wireless environment. PocketCop® is ahandheld application that allows law enforcement officers to access state andfederal databases over the wireless network for Palm OS, Windows CE, and PocketPC. Using a portable wireless handheld device and the PocketCop® applicationsoftware, an authorized user can access suspect information such as wantedstatus, warrant status, vehicle registration and driver license status.PocketCop® technology has been deployed in numerous police departments in theUnited States, including the deployment for the Massachusetts State Police.

·                  **IdentityMatchTM -**a web-based system that allows lawenforcement agencies to capture and store fingerprints online and to identifysubjects by matching their fingerprint against those stored in the database,securely and in real time. Fingerprints can be captured using a live scandevice from existing 10-print cards or through a wide variety ofinexpensive commercially available fingerprint readers. This is an AFIScompanion, not a replacement, product designed to maximize the value offingerprint data and also to provide a new level of safety for the lawenforcement personnel.

BIO-key also provides anumber of optional features designed to augment the core Law Enforcementproducts. These include:

·                  **Field Interview TrackerTM -**enables personnel to capturefield contact information. The data is stored in a searchable database where itcan be located quickly. Police agencies can create online contact forms thatmeet their specific needs and multiple agencies can share information whileusing their own forms and procedures.

·                  **TStopTM -**was developed to enable law enforcement agencies tocomply with state mandated and voluntary traffic stop reporting. Lawenforcement personnel can capture the required information on their mobilecomputer and transmit it to the server where it is stored and can generatereports.

·                  **State Crash Report** - enables personnel to use their mobilecomputer to collect data needed for their state’s crash report. This data canbe wirelessly transmitted to a server so a supervisor can review and approveit. Once complete the report can be printed in the state’s format. Onlyselected states are supported.

·                  **Multiple Application Programming Interface**(API)- allows an agency to have multiple ports to the server to accommodatedisparate interfaces. These multiple API ports are in addition to the one portthat is inherent in the server as well as the State/NCIC interface.

·                  **Incident Command -**using FieldSoft’sPDonScene, this solution is used by both patrol and tactical teams, such as aSWAT, to manage people and resources at the scene of an incident or at acentral location such as an emergency operations center. It can also be usedfor general event management.

·                  **InfoServerTM  -**BIO-key’ssolution for an agency’s central messaging switch for application softwareservice, State/NCIC interfaces, Computer Aided Dispatch (CAD) and RecordsManagement Software (RMS) interfaces, data sharing and other applications.

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*Fire Safety*

In addition to lawenforcement/fire service mobile data solutions, BIO-key offers its Sunpro fireservice/EMS records management software, FireRMSTM, that helps large and smallagencies manage operations, track incidents and support fire prevention initiatives.FireRMS Mobile provides wireless query and messaging solutions that extendcomputer aided dispatch, fire records, and other in-house data sources to amobile environment and provide mission-critical information to emergencyresponse personnel where and when they need it.

·                  **PacketCluster® RescueTM**—BIO-key’s mobileinformation solution for fire and EMS, runs off the same server as MobileCopTM.It provides much of MobileCopTM****functionalitywithout the State/NCIC interface not required by fire service andEMS. Rescue provides mission-critical data such as HAZMAT information andbuilding plans that fire service officers need to know while at a fire scene.

·                  **FireRMS Records Management Software**— thisNFIRS 5.0-compliant fire records system helps manage operations, trackincidents and support fire prevention initiatives. It is designed to speed dataentry and reduce completion time for front-line personnel.

·                  **CAD Interfaces**—CAD interfaces provide aconnection between BIO-key records and all major CAD systems with the mostcomprehensive real time integration. Incident reports are opened as soon as CADdispatches a call. Incidents are current and ready to complete when the crewreturns to the station, streamlining and improving the accuracy of incidentreporting.

·                  **RMS Interfaces**—RMS interfaces provide amechanism to integrate patient care reports collected in the field with theNIBRS report. Patient data is populated in the appropriate fields, eliminatingredundant data entry.

·                  **Other Interfaces**—BIO-key providesinterfaces to other third party solutions including EMS billing, EMScounty/state interfaces, professional staffing solutions and others.

BIO-key also offers thefollowing Fire/EMS Partner solutions:

·                  **EMS Field Data Collection**—Regist*r Expressfrom MedDataSolutions enables EMS field data collection for efficientcollection of patent data where it is generated.

·                  **Geographic Data Analysis**—FireViewTM fromthe Omega Group allows Fire and EMS agencies to analyze their deploymentstrategies.

·                  **Personnel Staffing**—TelestaffTM from PDSIautomates and manages complex Fire/RMS agency staffing needs and is integratedwith FireRMS’s Personnel and Roster modules.

·                  **Incident Command Module**—FDonSceneTM byFieldSoft provides incident management, responder accountability, and tacticalsurvey or preplan browser software solutions. FDonScene interfaces withPacketCluster Rescue to support incident management-en route or on scene.

**CurrentBusiness Plan**

BIO-key’s currentbusiness plan is to:

·                  **License its core technology “VST” and True UserIdentification®**tooriginal equipment manufacturers, systems integrators, and applicationdevelopers who develop products and applications that utilize its biometricfinger matching solutions.

·                  **License WEB-key®,** the Company’ssecurity centric web-based biometric authentication solution.

·                  **Provide for “device independent” finger identificationmatching**for virtually any application by using the latest advancesin scanning technology.

·                  **License its wireless software solutions for the publicsafety market**directly to counties, cities and towns across NorthAmerica as well as through systems integrators and resellers.

·                  **Leverage its FireRMS suite of products**forthe growing Emergency Medical Service data collection and reporting market.

·                  **Integrate its core technology competencies**toleverage new business opportunities and develop new markets for its innovativeproducts.

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**Markets**

*Law Enforcement*

BIO-key’s InfoServerTM, MobileCopTM and PocketCop® Law Enforcement products are the leadingwireless mobile data communications client/server solution, implemented in morethan 1,200 agencies nationwide. Providing immediate access to mission-criticaldata and enabling in-field reporting, BIO-key software keeps officers on thestreet, improving their productivity and enhances officer safety. BIO-keysolutions are able to run across any and all wireless infrastructures andintegrate with virtually all computer-aided dispatch (CAD) and recordsmanagement systems. This makes us a proven leader in multi-agency cooperationand interoperability, which are absolutely critical in times of large-scalenatural and terrorist threats.

·         *Growth potential*—BIO-key’slarge base of more than 1,200 law enforcement agencies continues to be astrength that helps leverage additional sales from both existing customers andnew customers. A key opportunity is the growing awareness of the need formulti-agency interoperability. In these situations, BIO-key offers:

·                  BIO-key’s LE products can run on any and allwireless infrastructures. BIO-key also has proven success implementing seamlessroaming across multiple infrastructures for multi-agency consortiums.

·                  BIO-key’s open architecture.

·                  BIO-key has experience in large, complex andmulti-agency implementations such as Hamilton County, Ohio, Sheriff’s Officeand Pennsylvania State Police.

Thesecapabilities position BIO-key well to work with leading CAD vendors, even with vendorsthat have mobile data solutions but do not have the depth of interoperabilitycapability that BIO-key offers.

Anadditional growth area is the introduction of BIO-key’s finger-based biometricidentification to law enforcement. In addition to now offering biometric loginto our traditional InfoServerTM product, we have introduced the IdentityMatchTM fingerprint identification solution, whichlets law enforcement personnel capture fingerprints in the field and,using BIO-key’s patented Vector Segment Technology®, then analyzes andcategorizes fingerprints the same way a fingerprint expert would—only faster.IdentityMatchTM also enables multiple law enforcement agencies to sharefingerprint data with other agencies. This powerful tool, built on BIO-key’s understandingof law enforcement requirements and its fingerprint technology, presentopportunities for the law enforcement business segment in the coming year.

*FireSafety*

BIO-key’sFireRMS fire records management software is a flexible solution available for Fire Service andEMS**agencies. It is a comprehensivecollection of modules that manage a range of activities from daily schedulingto vehicle maintenance. FireRMS streamlines data collection across all areas ofdepartment operations, and integrates with other department systems to providea seamless solution for data access, whether in the station or on the scene ofan incident. In addition to helping first responders efficiently delivertraditional fire safety and services and respond to massive emergencysituations, it enables adherence to NFIRS, NEMSIS, HIPAA, and ISO requirements.The solutions also bring the station into the field with mobile datacommunications solutions, and most recently, FireRMS Mobile, which brings thecapabilities of FireRMS to first responders where and when they most need toreport and access critical information.

·        *Growth potential*—a growth opportunity for the fire businesssegment is in the mobile market with the RMS mobile products. BIO-key’s FireRMSMobile solutions extend the power of our FireRMS product to the field.Inspectors, for example, can now perform occupancy inspections over awireless or synched connection using a pen tablet. This approach eliminatesredundant data entry, and provides immediate updates of critical informationand notification of violations. Likewise, EMS workers can collect criticalpatient data and relay the data to medical personnel. This new mobile approachto fire and EMS data collection and access offers great potential among bothnew and existing FireRMS customers.

*Finger-based BiometricIdentification*

Finally,BIO-key is a leader in finger-based biometric identification. In partnerships with OEMs,integrators, and solution providers, we provide biometric software solutions toprivate and public sector customers. BIO-key’s patented vector segmenttechnology is the foundation for these solutions.

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BIO-key’sWEB-key ® is a cost-effective,easy-to-deploy, fingerprint-based strong authentication system. This uniquesolution allows users to positively identify themselves to any application withthe simple scan of their finger. This capability is a significant improvementin both convenience and security over other alternatives and provides companieswith a cost-effective solution to thwart phishing attacks and comply withgovernment regulations and legislation such as FFIEC compliance, HIPAA,Sarbanes-Oxley, and the Electronic Signatures Act. BIO-key couples thesecapabilities with device interoperability and system flexibility and scalability.BIO-key enables the use of about 40 different fingerprint sensor technologiesto enroll and identify employees, customers or business partners. Mostrecently, BIO-key integrated its biometric capabilities with its public safetymission with the introduction of IdentityMatchTM, a real-time, in-stationsolution that allows law enforcement professionals to capture fingerprints froma suspect or captured from a crime scene and compare them to fingerprints.BIO-key has also formed relationships with providers of biometric logonsoftware like IdentiPHI, Softex, and Computer Associates to provideenterprise-ready SingleSignOn systems to many large companies in the US andabroad. Also, BIO-key has integrated to a pure physical access solution inNextGenID, which has been deployed at BIO-key facilities.

·                  *Growth potential*—As the provider of the core technology,BIO-key’s greatest growth potential for this market is as a partner withcompanies that offer cutting-edge applications that address growing concernsparticularly about identity theft and terrorism.

Forexample, BIO-key has implemented programs that will enable biometric access.These include a national pilot with a large fitness center chain to providefinger-based membership and access to its locations around the country; withIdentiPHI to provide strong network based authentication on BIO-key technology;and with the Pegasus Program to authenticate users accessing anationwide information-sharing system designed by and for the nation’ssheriffs. These represent the kind of partnership-based opportunities BIO-keymay see in the finger-based biometric market.

Inparallel, BIO-key is both strengthening security and improving user and systemadministrator convenience by integrating biometric log-in, as well as two-factorauthentication, with its law enforcement and fire safety products. This is atrue differentiator to potential new customers, and creates add-onopportunities with existing customers.

**Competition**

The markets forBIO-key products and technologies are developing and are characterized byintense competition and rapid technological change. No assurance can be giventhat our competitors will not develop new or enhanced technologies that willoffer superior price, performance, or features, or render BIO-key products ortechnologies obsolete.

*Biometrics*

In addition tocompanies that provide existing commonplace methods of restricting access tofacilities and logical access points such as pass cards, PIN numbers,passwords, locks and keys, there are numerous companies involved in thedevelopment, manufacturing and marketing of fingerprint biometrics products tocommercial, government, law enforcement and prison markets. These companiesinclude, but are not limited to, Cogent, NEC, IDENTIX, Sagem-Morpho, and Bioscrypt.

The most recentautomated fingerprint identification product sales in the market have beendeployed for government and law enforcement applications, typically at morecost than BIO-key’s products and licensing arrangements. Although mostcompanies that target consumer application markets have completed developmentof their biometric products, such technologies have not been widely accepted inthe commercial markets to date. Most companies competing for commercialopportunities are in the business of selling scanning devices and tie theiralgorithm to a specific device. BIO-key has created a “device independent”algorithm that provides flexibility in choosing the correct device and opticalor tactile sense to fit the application served.

BIO-key has found thatcommercial markets have been slow to widely purchase biometrics as a viablealternative to their current security methods. As a result, the primarycompetition for biometric technology consists of traditional security methodssuch as passwords, PINs, cards, and tokens.

With respect tocompeting biometrics technologies, each has its strength and weaknesses andnone has emerged as a market leader:

·                  *Fingerprint identification*is generallyviewed as inexpensive and non-intrusive.

·                  *Iris scanning*is viewed as accurate, butcan be expensive and inconvenient to use.

·                  *Facial recognition*has recently receivedsubstantial attention; however, it can have accuracy limitations and be highlydependent on ambient lighting conditions, angle of view and other factors.

The market forbiometric technology is evolving. Computer breaches, identity theft, phishingand other events in the recent past are driving a large-scale shift tobiometric deployments. In addition, companies such as IBM, Dell, Gateway, MPC,Samsung and HP have all introduced computers with integrated finger scanningdevices to complement the conventional username/password technique since it ishighly susceptible to hackers and security breaches. BIO-key supports theseintegrated devices for broader enterprise level security solutions.

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## *LawEnforcement*

The public safetymarket comprises agencies at all government levels, with a range of users, froma few to many hundreds. BIO-key competitors in the mobile data market includeComputer Aided Dispatch/Records Management companies such as Printrak, InfoCopand Motorola. Each has comprehensive CAD and/or RMS offerings and has augmentedthose with their own mobile data and field reporting solutions. While thesesolutions may not be as functionally rich as the BIO-key suite ofproducts, they are sometimes less expensive. They also provide a completesolution from one vendor.

*FireSafety*

The fire recordsmanagement market includes a large number of RMS vendors including Firehouse,FDM and ETI. These and other competing companies represent a wide range oforganizations, from large integration companies, to small garage companies, andoffer products similar in scope to BIO-key’s FireRMS. The functionalityand price of these products also encompass wide ranges of features and costs.

**Marketingand Distribution**

BIO-key’smarketing and distribution efforts comprise the following major initiatives:

·                  During the pastyear, BIO-key has strengthened its alliance with Oracle and has been recognizedas a Certified Partner in the Oracle Partner Network. BIO-key supports theOracle e-business suite of applications and provides the biometric enablerfor the Oracle Single Sign on product. As an Oracle development partner,BIO-key provides the underlying database used for true user identification andon demand alias checking. As a development partner, BIO-key participates inOracle Trade Shows such as Oracle Open World and Oracle Apps World.

·                  BIO-key hasstrategic alliances with technology leaders including Oracle, Netegrity,Hewlett Packard, Dell, Verizon, Sprint/Nextel, Cingular and others.

·                  BIO-key is alsopromoting biometric technology and its offerings through industry trade shows,public speaking engagements, press activities and partner marketing programs

·                  BIO-key isdirecting licensing efforts to original equipment manufacturers, applicationdevelopers and system integrators.

·                  BIO-key isbuilding a reseller, integrator and partner network as well as a direct salesteam.

Following are thespecific marketing/sales programs in place:

·                  *Direct Selling Efforts*— BIO-key now has abase of area sales directors who are responsible for both the law enforcementand fire safety markets. This team of sales professionals brings extensiveexperience in technical solution and relationship-based selling. They aresupported by a pre-sales team that includes system engineering and proposalmanagement and a post-sales program management, implementation and trainingprofessionals. Included in this team are individuals who are themselves formerpolice officers and firefighters.

BIO-key’s direct sales force also includes area sales directors for theOEM and Federal Government markets, each of whom brings not only extensivesales experience but also expertise in emerging biometric technologies. TheBIO-key sales force is rounded out by Inside Sales, which is responsible formaintaining and supporting our existing install base, acting as a front-linesupport for any inquiries on our product line, and facilitating activities thatmake the field team more productive.

·                  *Conferences and Trade Shows*— BIO-keyattends and actively participates in various product-related conferences andtrade shows in the technology and security industries to generate marketawareness of biometric and wireless mobile data technology generally and ourofferings specifically. BIO-key’s public safety software often is featured atour business partners’ booths at these events, showcasing the interoperabilityof the two products.

·                  *Strategic Alliance*— BIO-key’s strategicalliances and reseller agreements with other vendors play a significant role inour overall sales efforts. In the past year, BIO-key has initiated andbolstered numerous important and promising long-term relationships. Just a fewexamples include:

·         BIO-keyis partnering with Cingular, the largest wireless carrier in the country, tofirst responders in a seven-county Tennessee consortium of fire, police and EMSagencies in access to mission critical information using MobileCOP solution inconjunction with Cingular’s nationwide* EDGE wireless data network

·         TheOmega Group continues to provide FireView software mapping tools that helpreview existing deployment policies and develop new strategies, to complementBIO-key’s range of solutions for Fire/EMS agencies.

·         BIO-keynow resells solutions from ThreatScreen that provide anexposure-diagnostic/identification, data collection, and reporting tool tofirst responders so they can quickly assess victims to determine chemical,biological, or nuclear agent exposure.

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·         SilexTechnology America, Inc., which develops fingerprint reader productsdesigned to support a variety of secure computing options, utilizes BIO-key’sVST and WEB-key technology.

·                  *Strategic Marketing Alliance—*BIO-key hasestablished a strategic marketing alliance with Hewlett Packard to provideBIO-key handheld technology for the Massachusetts State Police.

·                  *Reseller Relationships*—BIO-key hasestablished reseller relationships with companies that resell BIO-key publicsafety software.

**Licensing**

BIO-key targetsboth Internet infrastructure companies and large portal providers as possiblelicensees for its WEB-key ®solution. On the Internet infrastructure side, BIO-key seeks to partner withInternet server manufacturers, providers of database and data warehouse enginesoftware, horizontally positioned application engines, firewall solutionproviders and peripheral equipment manufacturers. On the portal side, BIO-keyis targeting financial service providers such as credit and debit cardauthorization and issuing institutions, Internet retailers,business-to-business application service providers (ASPs) and corporateintranets. In the past three years, BIO-key has undertaken a WEB-key ® and VST direct sellingeffort, and entered into license agreements with OEMs and systemintegrators to develop applications for distribution to their respectivecustomers.

BIO-key is alsoaddressing the security needs of application providers in the followingvertical markets:

·                  *Government*—Using BIO-key’s technology,Northup Grumman deployed an application within the Department of Defense tocross-credential visitors and contractors to certain military bases.

·                  *Education*—Educational BiometricTechnologies, Lunch Byte Systems and Identimetrics have incorporated BIO-keytechnology to enable school children to pay for school lunch programs andcheckout library books using their fingerprints. VST technology enables schoolsto enroll these children and reduces the administrative costs of managingpasswords and collecting payments.

·                  *Commerce:*ChoicePoint has implemented acheck cashing solution using BIO-key’s VST technology to reduce fraud andidentity theft.

·                  *Patient Records and Information Management:*HBOC,one of the largest healthcare patient records and information managementcompanies, has integrated BIO-key technology into their portal and has deployedtheir solution in a pilot for the Baptist Hospital System.

·                  *Financial:*BIO-key is working with severalcompanies focusing on financial applications such as point of sale systems andemployee trusted identification cards, as well as customer facing applicationsover the Internet. BIO-key has also begun work with several financialinstitutions to incorporate its technology for secure access to money transfersfor institutional customers.

**IntellectualProperty Rights**

We believe thatour intellectual property is important to our biometric, law enforcement andfire information management segments:

Patents—ourbiometrics segment uses patented technology and trade secrets developed oracquired by us. In May 2005, the U.S. Patent Office issued us a patent forour Vector Segment fingerprint technology (VST), BIO-key’s core biometricanalysis and identification technology. Additionally, we have a number of U.S.and foreign patent applications in process related to this intellectualproperty.

Trademarks— Wehave registered our trademarks (“BIO-key”, “SACman”, “SACcat”, “SACremote”, “TrueUser Identification”, “WEB-key”, “PacketCluster”, “PacketCluster Patrol”, “PacketWriter”,“PacketBlue”, “SunPro” and the design mark for “Ceurulean” with the U.S. Patentand Trademark Office. We have also applied for trademarks for “PocketCop” and “Cerulean”.

Copyrights andtrade secrets—We take measures to ensure copyright and license protection forour software releases prior to distribution. When possible, the software islicensed in an attempt to ensure that only licensed and activated softwarefunctions to its full potential. We also take measures to protect theconfidentiality of our trade secrets.

**Researchand Development**

Our research anddevelopment efforts are concentrated on enhancing the functionality,reliability and integration of our current products as well as developing newand innovative products for the biometrics, law enforcement and fire markets.Although BIO-key believes that its identification technology is one of the mostadvanced and discriminating fingerprint technologies available today, themarkets in which BIO-key compete are characterized by rapid technologicalchange and evolving standards. In order to maintain its position in the market,BIO-key will continue to upgrade and refine its existing technologies.

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In 2005, BIO-keyannounced the launch of IdentityMatch, our fingerprint identification system.IdentityMatch offers a tool for agencies to store and search fingerprints andthe associated demographic data, the ability to compare new prints with thosepreviously captured as a low-cost AFIS alternative or to be used for a widevariety of routine identification transactions not supported by AFIS.IdentityMatchTM is currently being tested by a number of customers.

During fiscalyears ended December 31, 2004 and 2005, BIO-key spent approximately$2,980,000 and $6,846,000 respectively, on research and development. BIO-key’slimited customer base during that time did not directly bear these costs, whichwere principally funded through outside sources of equity and debt financing.

**GovernmentRegulations**

BIO-key is notcurrently subject to direct regulation by any government agency, other thanregulations generally applicable to businesses or related to specific projectrequirements. In the event of any international sales, the company would besubject to various domestic and foreign laws regulating such exports and exportactivities.

**EnvironmentalRegulations**

As of the date ofthis report, BIO-key has not incurred any material expenses relating to ourcompliance with federal, state, or local environmental laws and does not expectto incur any material expenses in the foreseeable future.

**Employeesand Consultants**

BIO-key currentlyemploys one-hundred (100) individuals on a full-time basis: fifty-one(51) in engineering, customer support, research and development; Thirteen(13) in finance and administration; and twenty-six (26) in sales andmarketing. BIO-key also uses the services of ten (10) consultants whoprovide engineering and technical services.

**RISK FACTORS**

 *Thefollowing material risk factors, among others, may affect the Company’sfinancial condition and results of operations.*

**Business and Financial Risks**

**Based on our lack of significant revenue sinceinception and recurring losses from operations, our auditors have included anexplanatory paragraph in their opinion as to the substantial doubt about ourability to continue as a going concern.**

Due to, amongother factors, our history of losses (excluding gains from valuation changes inembedded derivatives) and limited revenue, our independent auditors haveincluded an explanatory paragraph in their opinion for the year ended December 31,2005 as to the substantial doubt about our ability to continue as a goingconcern. Our financial statements have been prepared in accordance withaccounting principals generally accepted in the United States, whichcontemplate that we will continue to operate as a going concern. Our financialstatements do not contain any adjustments that might result if we are unable tocontinue as a going concern.

**Sinceour formation, we have historically generated minimal revenue and havesustained substantial operating losses.**

As of December 31,2005, we had negative working capital of approximately $10,400,000 and anaccumulated deficit of approximately $42,762,000. Since our inception, we havefocused almost exclusively on developing our core technologies and, until thefourth quarter of 2004 have not generated any significant revenue. In order toincrease revenue, we have developed a direct sales force and anticipate theneed to retain additional sales, marketing and technical support personnel andmay need to incur substantial expenses. We cannot assure you that we willbe able to secure these necessary resources, that a significant market for ourtechnologies will develop or that we will be able to achieve our targetedrevenue.

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**Wehave identified material weaknesses in our internal control over financialreporting and have failed to maintain an effective system of disclosurecontrols and procedures. If we are unable to successfully address such materialweaknesses or if we continue to maintain an ineffective system of disclosurecontrols and procedures, we may not be able to accurately report ourfinancial results or prevent fraud. As a result, current and potentialstockholders could lose confidence in our financial reporting; this would harmour business and the trading price of our common stock.**

After a review ofour March 31, 2005, June 30, 2005 and September 30, 2005quarterly operating results, as well as our 2005 annual operating results,conducted pursuant to Rule 13a-15 under the Securities Exchange Actof 1934, as amended (the “Exchange Act”), our Co-Chief Executive Officers andour Chief Financial Officer have determined that, as of each such date, ourdisclosure controls and procedures were not effective to provide reasonableassurance that information that we are required to disclose in reports that wefile or submit under the Exchange Act is recorded, processed, summarized andreported within the time periods specified by the Securities and ExchangeCommission rules and forms. Our management reached this conclusion afteridentifying our system to capture disclosure items, our internal process ofreview for account reconciliations, our documentation of internal controls andour internal process for preparing our annual report on Form 10-KSBfor the fiscal year ended December 31, 2005 as being inadequate to providesuch assistance.

In addition, ourindependent auditors, DS&B, Ltd., notified the Audit Committee of our Boardof Directors on April 18, 2005 that they believed there were reportableconditions during 2004 and 2005 which constituted a material weakness in ourinternal controls. These weaknesses concerned deficiencies in the design andimplementation of our internal controls and the fact that, due to two recentacquisitions, we were not staffed properly in our accounting and reporting departmentand may not have had appropriate accounting and reporting software. Forthese reasons, we were not able to meet our schedule for preparing ouraudit and for filing our annual report on Form 10-KSB for the fiscalyear ended December 31, 2004 in a timely manner.

Effective internalcontrol over financial reporting and disclosure controls and procedures arenecessary for us to provide reliable financial reports and effectively preventfraud and to operate successfully as a public company. We have in the pastdiscovered, as described above, and may in the future discover, areas ofour disclosure and internal controls that need improvement. We are in theprocess of addressing these issues to ensure that our internal control overfinancial reporting and disclosure controls and procedures are improved so asto provide reasonable assurance that the information we are required todisclose in reports that we file or submit under the Exchange Act is recorded,processed, summarized and reported within the time periods specified in theSecurities and Exchange rules and forms. If, however, we cannot providereliable financial reports or prevent fraud, our reputation and operatingresults would be harmed.

We cannot be certain that our efforts to improve thematerial weaknesses in our internal control over financial reporting and theineffectiveness of our disclosure controls and procedures will be successful orthat we will be able to maintain adequate controls over our financial processesand reporting in the future. We will need to commit substantial resources,including substantial time from our management team’s accounting personnel andfrom external consultants, to implement and integrate into our organizationimproved disclosure controls and additional procedures generally and to improvesystems to report financial information on a timely basis. Any failure or delayto develop or maintain effective controls, or difficulties encountered in theirimplementation or in other effective improvement of our internal and disclosurecontrols could materially harm our operating results or cause us to fail tomeet our reporting obligations. If we are unable to adequately establish orimprove our internal controls over financial reporting, our external auditorsmay not be able to issue an unqualified opinion on the effectiveness ofour internal controls. Ineffective internal and disclosure controls could alsocause investors to lose confidence in our reported financial information, whichwould likely have a significant negative effect on the trading price of oursecurities.

**Our****biometric technology has yet to gain widespread marketacceptance and we do not know how large of a market will develop for ourtechnology.**

Biometrictechnology has received only limited market acceptance, particularly in theprivate sector. Our technology represents a novel security solution and we havenot yet generated significant sales. Although recent security concerns relatingto identification of individuals has increased interest in biometrics generally,it remains an undeveloped, evolving market. Biometric based solutions competewith more traditional security methods including keys, cards, personalidentification numbers and security personnel. Acceptance of biometrics as analternative to such traditional methods depends upon a number of factorsincluding:

·      the reliability of biometric solutions

·      public perception regarding privacyconcerns

·      costs involved in adopting and integratingbiometric solutions

For these reasons, we areuncertain whether our biometric technology will gain widespread acceptance inany commercial markets or that demand will be sufficient to create a marketlarge enough to produce significant revenue or earnings. Our future successdepends, in part, upon business customers adopting biometrics generally, andour solution specifically.

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**Biometrictechnology is a new approach to Internet security****which must be acceptedin order for our WEB-key**® **solutionto generate significant revenue.**

Our WEB-key ® authentication initiativerepresents a new approach to Internet security which has been adopted on alimited basis by companies which distribute goods, content or softwareapplications over the Internet. The implementation of our WEB-key ® solution requires thedistribution and use of a finger scanning device and integration of databaseand server side software. Although we believe our solutions provides a higherlevel of security for information transmitted over the Internet than existingtraditional methods, unless business and consumer markets embrace the use of ascanning device and believe the benefits of increased accuracy outweighimplementation costs, our solution will not gain market acceptance.

**Oursoftware products may contain defects which will make it more difficultfor us to establish and maintain customers.**

Although we havecompleted the development of our core biometric technology, it has only beenused by a limited number of business customers. Despite extensive testingduring development, our software may contain undetected design faults andsoftware errors, or “bugs” that are discovered only after it has been installedand used by a greater number of customers. Any such default or error in new orexisting software or applications could cause delays in delivering our technologyor require design modifications. These could adversely affect our competitiveposition and cause us to lose potential customers or opportunities. Since ourtechnologies are intended to be utilized to secure physical and electronicaccess, the effect of any such bugs or delays will likely have a detrimentalimpact on us. In addition, given that biometric technology generally, and ourbiometric technology specifically, has yet to gain widespread acceptance in themarket, any delays would likely have a more detrimental impact on our businessthan if we were a more established company.

While we havecommenced a significant sales and marketing effort, we have only begun todevelop a significant distribution channel and may not have the resourcesor ability to sustain these efforts or generate any meaningful sales.

**Inorder to generate revenue from our biometric products, we are dependent uponindependent original equipment manufacturers, system integrators andapplication developers, which we do not control. As a result, it may bemore difficult to generate sales.**

We market ourtechnology through licensing arrangements with:

·                  Originalequipment manufacturers, system integrators and application developers whichdevelop and market products and applications which can then be sold to endusers

·                  Companies whichdistribute goods, services or software applications over the Internet

As a technologylicensing company, our success will depend upon the ability of thesemanufacturers and developers to effectively integrate our technology intoproducts and services which they market and sell. We have no control over theselicensees and can not assure you that they have the financial, marketing ortechnical resources to successfully develop and distribute products or applicationsacceptable to end users or generate any meaningful revenue for us. These thirdparties may also offer the products of our competitors to end users.

**Wederive nearly all of our revenue from government contracts, which are oftennon-standard, involve competitive bidding, may be subject to cancellationwith or without penalty and may produce volatility in earnings andrevenue.**

Most of ourbusiness involves providing products and services under contracts with U.S.federal, state and local government agencies. Obtaining contracts fromgovernment agencies is challenging, and government contracts often includeprovisions that are not standard in private commercial transactions. Forexample, government contracts may:

·                  includeprovisions that allow the government agency to terminate the contract withoutpenalty under some circumstances;

·                  be subject topurchasing decisions of agencies that are subject to political influence;

·                  contain onerousprocurement procedures; and

·                  be subject tocancellation if government funding becomes unavailable.

Securinggovernment contracts can be a protracted process involving competitive bidding.In many cases, unsuccessful bidders may challenge contract awards, whichcan lead to increased costs, delays and possible loss of the contract for thewinning bidder.

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**Weface intense competition and may not have the financial and humanresources necessary to keep up with rapid technological changes, whichmay result in our technology becoming obsolete.**

The Internet,facility access control and information security markets are subject to rapidtechnological change and intense competition. We compete with both establishedbiometric companies and a significant number of startup enterprises as well asproviders of more traditional methods of access control. Most of our competitorshave substantially greater financial and marketing resources than we do andmay independently develop superior technologies, which may result inour technology becoming less competitive or obsolete. We may not be ableto keep pace with this change. If we are unable to develop new applications orenhance our existing technology in a timely manner in response to technologicalchanges, we will be unable to compete in our chosen markets. In addition, ifone or more other biometric technologies such as voice, face, iris, handgeometry or blood vessel recognition are widely adopted, it would significantlyreduce the potential market for our fingerprint identification technology.

**Wedepend on key employees and members of our management team, including our Chairmanof the Board and Co-Chief Executive Officer, in order to achieve our goals. Wecannot assure you that we will be able to retain or attract such persons.**

A loss of ourcurrent Chairman of the Board of Directors or Co-Chief Executive Officer couldseverely and negatively impact our operations. We have had an employmentcontract with Michael W. DePasquale, our Co-Chief Executive Officer through March 28,2008. Although the contract does not prevent him from resigning, it doescontain confidentiality and non-compete clauses which are intended to preventhim from working for a competitor within one year after leaving our Company.Our success depends on our ability to attract, train and retain employees withexpertise in developing, marketing and selling software solutions. In order tosuccessfully market our technology, we will need to retain additionalengineering, technical support and marketing personnel. The market for suchpersons remains highly competitive and our limited financial resources will makeit more difficult for us to recruit and retain qualified persons.

**Wecan not assure you that the limited intellectual property protection for ourcore technology provides a meaningful competitive advantage or barrier to entryagainst our competitors.**

Our success andability to compete is dependent in part upon proprietary rights to ourtechnology. We rely primarily on a combination of patent, copyright andtrademark laws, trade secrets and technical measures to protect our proprietyrights. We have filed a patent application relating to both the optictechnology and biometrics solution components of our technology wherein severalclaims have been allowed. In May 2005, the U.S. Patent Office issued us apatent for our Vector Segment fingerprint technology (VST), BIO-key’s corebiometric analysis and identification technology. We cannot assure you that anyadditional patents will be issued that we will have the resources to protectany patent from infringement. Although we believe our technology does not currentlyinfringe upon patents held by others, we can not assure you that suchinfringements do not exist or will not exist in the future, particularly as thenumber of products and competitors in the biometric industry segment grows.

**Wemay need to obtain additional financing to execute our business plan,which may not be available. If we are unable to raise additional capitalor generate significant revenue, we may not be able to continueoperations.**

Since ourinception, we have not generated any significant revenue (other than revenuefrom acquired businesses) and have experienced substantial losses, includingapproximately $10,221,000 during 2005, excluding the impact related to embeddedderivative fair value adjustments. In March 2004, we completed a privateplacement equity offering that resulted in approximately $12,000,000 in grossproceeds to the Company and a private placement convertible debt offering in September 2004that resulted in approximately $10,000,000 in gross proceeds to the Company (aportion of which was used to finance the acquisition of Aether MobileGovernment). In June 2005, we raised approximately $5,000,000 in grossproceeds through a private placement convertible debt offering and in January 2006we received approximately $1,000,000 in another a private placement convertibledebt offering. To the extent that we will require additional capital to supportour operations, expand our marketing and sales efforts and to execute ourbusiness plan to substantially increase revenue, we may need to obtainadditional financing through the issuance of debt or equity securities. Ourlong-term viability and growth will depend upon the successfulcommercialization of our technologies and our ability to obtain adequatefinancing. We have not and cannot assure you that we will ever be able tosecure any such financing on terms acceptable to us. If we cannot obtain suchfinancing or generate such revenues, we may not be able to execute ourbusiness plan or continue operations.

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**Wemay not be able to successfully complete the integration of PSG and AMGinto our operations.**

The integration ofPSG and AMG into our operations involves a number of risks, including:

·                  difficultyintegrating operations and personnel;

·                  diversion ofmanagement attention;

·                  potentialdisruption of ongoing business;

·                  inability toretain key personnel;

·                  inability tosuccessfully incorporate the acquired products and services into our productand service offerings and to develop new products and services; and

·                  impairment ofrelationships with employees, customers or vendors.

Failure toovercome these risks or any other problems encountered in connection with theacquisitions of PSG and AMG could slow our growth or lower the quality of ourservices, which could reduce customer demand. The result could be a materialadverse effect on our financial position and results of operations.

**Wemay not achieve profitability with respect to the law enforcement andpublic safety components of our business if we are unable to maintain, improveand develop the wireless data services we offer.**

We believe thatour future business prospects depend in part on our ability to maintainand improve our current services and to develop new ones on a timely basis. Ourservices will have to achieve market acceptance, maintain technologicalcompetitiveness and meet an expanding range of customer requirements. As aresult of the complexities inherent in our service offerings, major newwireless data services and service enhancements require long development and testingperiods. We may experience difficulties that could delay or prevent thesuccessful development, introduction or marketing of new services and serviceenhancements. Additionally, our new services and service enhancementsmay not achieve market acceptance. If we cannot effectively develop andimprove services we may not be able to recover our fixed costs orotherwise become profitable.

**Ourlaw enforcement and public safety division depends upon wireless networks ownedand controlled by others.**

If we do not havecontinued access to sufficient capacity on reliable networks, we may beunable to deliver services and our sales could decrease. Our ability to growand achieve profitability partly depends on our ability to buy sufficientcapacity on the networks of wireless carriers such as Verizon Wireless, BellSouth Corporation, Metrocall, Motient and AT&T Wireless and on thereliability and security of their systems. All of our services are deliveredusing airtime purchased from third parties. We depend on these companies toprovide uninterrupted and bug free service and would not be able to satisfy ourcustomers’ needs if they failed to provide the required capacity or neededlevel of service. In addition, our expenses would increase and ourprofitability could be materially adversely affected if wireless carriers wereto increase the prices of their services. Our existing agreements with thewireless carriers generally have one-year terms. Some of these wirelesscarriers are, or could become, our competitors and if they compete with us theymay refuse to provide us with their services.

**Newlaws and regulations that impact our law enforcement and public safety divisioncould increase our costs or reduce our opportunities to earn revenue.**

We are notcurrently subject to direct regulation by the Federal Communications Commissionor any other governmental agency, other than regulations applicable tobusinesses in general. However, in the future, we may become subject toregulation by the FCC or another regulatory agency. In addition, the wirelesscarriers who supply us airtime and certain of our hardware suppliers aresubject to regulation by the FCC and regulations that affect them couldincrease our costs or reduce our ability to continue selling and supporting ourservices.

**Ifwe fail to adequately manage our resources, it could have a severe negativeimpact on our financial results or stock price.**

We could besubject to fluctuations in technology spending by existing and potentialcustomers. Accordingly, we will have to actively manage expenses in a rapidlychanging economic environment. This could require reducing costs duringeconomic downturns and selectively growing in periods of economic expansion. Ifwe do not properly manage our resources in response to these conditions, ourresults of operations could be negatively impacted.

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**Wegranted a blanket security interest in all of our assets to the holders of oursecured debt. If we are unable to make our required monthly payments on suchdebt, or any other event of default occurs, it could have a material adverseeffect on our business and operations, and the debt holders may forecloseon our assets.**

As part ofour secured convertible debt financing transactions, we granted to LaurusMaster Fund, Ltd. and another holder of such secured debt a blanketsecurity interest in all of our assets, including assets of our subsidiary. Seethe “Management’s Discussion and Analysis or Plan of Operation” section ofthis report. In the event we default in payment on such debt, or any otherevent of default occurs under the relevant financing documents, and the defaultis not cured, 120% of the outstanding principal amount of the secured notes,plus accrued interest and fees will accelerate and be due and payable in full.See the “Long Term Obligations” footnote to this report for a list of suchpotential events of default.

The cash requiredto pay such accelerated amounts on the secured notes following an event ofdefault would most likely come out of our working capital. As we rely on ourworking capital for our day to day operations, such a default could have amaterial adverse effect on our business, operating results, or financialcondition to such extent that we are forced to restructure, file forbankruptcy, sell assets or cease operations. In addition, upon an event ofdefault, the holder of the secured debt could foreclose on our assets orexercise any other remedies available to them. If our assets were foreclosedupon, we were forced to file for bankruptcy or cease operations; stockholdersmay not receive any proceeds from disposition of our assets andmay lose their entire investment in our stock.

**Ourobligations under our debt securities may adversely affect our ability toenter into potential significant transactions with other parties.**

As a result of ourdebt financing transactions with Laurus Master Fund, Ltd., the ShaarFund, Ltd. and other institutional and accredited investors, we incurredsignificant repayment obligations, and we agreed to certain restrictive covenants.In particular, for so long as 25% of the aggregate principal amount of theconvertible term notes remains outstanding, we will need the consent of theholders of such notes before we can take certain actions, including thefollowing:

·                  pay any dividends;

·                  merge, effect amaterial reorganization, liquidate or dissolve;

·                  materiallychange the scope of our business; or

·                  create, incur orassume any debt (other than certain trade debt, equipment financings and debtfor the purchase of assets in the ordinary course of business).

Accordingly,unless we obtain the noteholders’ consent, we may not be able to enterinto certain transactions. In addition, in connection with any potentialsignificant transaction (such as a merger, sale of substantially all our assets,joint venture, or similar transaction), it is likely that we would have to payoff such debt obligations and have the applicable security interests released.Although we have the right at any time to prepay our debt obligations, we canonly do so upon payment of either 110% or 120% of the then principal balance,plus all other amounts owing under the notes. See the “Long Term Obligations”footnote of this report. Based on an aggregate principal balance of$11.3 million at December 31, 2005, a complete prepayment wouldrequire a cash payment of approximately $12.7 million. These provisionscould have the practical effect of increasing the costs of any potentialsignificant transaction, and restrict our ability to enter into any suchtransaction.

**Ourobligations to the holders of our outstanding preferred stock may furtheraffect our ability to enter into potential significant transactions with otherparties.**

We will need toobtain the consent of the holders of a majority of the then outstanding sharesof our convertible preferred stock before we can take certain actions,including the following:

·                  a sale or otherdisposition of any material assets;

·                  an acquisitionof a material amount of assets;

·                  engaging in amerger, reorganization or consolidation; or

·                  incur orguaranty any indebtedness in excess of $50,000.

Accordingly, unless weobtain such consent, we may not be able to enter into certaintransactions.

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**Risks Related To Our Common Stock**

**Wehave issued a substantial number of securities that are convertible into sharesof our common stock which will result in substantial dilution to the ownershipinterests of our existing shareholders.**

As of March 15th, 2006, approximately45,764,000 shares of our common stock were reserved for issuance upon exerciseor conversion of the following securities:

·                  15,273,000shares upon conversion of outstanding convertible term notes;

·                  20,729,000shares upon exercise of outstanding stock options and warrants;

·                  1,878,000 sharesupon exercise of options available for future grant under our existing optionplans; and

·                  7,884,000 sharesor more upon conversion of our outstanding shares of convertible preferredstock and cumulative dividends in arrears.

The exercise orconversion of these securities will result in a significant increase in thenumber of outstanding shares and substantially dilute the ownership interestsof our existing shareholders.

**Asubstantial number of our convertible securities are convertible into shares ofcommon stock at a conversion price of $.70 per share. Most of these shares areeligible for public resale. The trading price of our common stock and ourability to raise additional financing may be adversely affected by theinflux into the market of such a substantial number of shares.**

Our outstanding Series A Convertible PreferredStock and cumulative dividends in arrears are convertible into 7,287,987 sharesof common stock as of December 31, 2005 at a per share conversion price of$.70. Although many of the shares issuable upon conversion of our Series AConvertible Preferred Stock are eligible for public resale under SecuritiesExchange Commission Rule 144, we have agreed to file a registrationstatement to cover the public resale of all of these shares. This significantincrease in the number of shares available for public sale may have anegative impact on the trading price of our shares and substantially dilute theownership interests of our existing shareholders. In the event that our stocktrades below $.70 per share, in order to raise additional financing we wouldlikely be required to issue additional shares of common stock or securitiesconvertible into common stock at a purchase or conversion price, as applicable,of less than $.70 per share. Any issuance of shares at a purchase price of lessthan $.70 per share would reduce the conversion price of our Series AConvertible Preferred Shares to such lower price. This would require us toissue additional shares upon conversion of our Series A Shares and furtherdilute the ownership interests of our existing shareholders. To the extentthese factors are viewed negatively by the market, it may provide anincentive for persons to execute short sales of our common stock that couldadversely affect the trading price of our common stock.

In January 2006, the Company issued ConvertibleTerm Notes in the aggregate principal amount of $1,000,000 to certaininvestors. The Convertible Notes are convertible into 1,000,000 shares of Series BConvertible Preferred Stock of the Company, which shares are convertible intoshares of the Common Stock of the Company at an initial fixed conversion of$0.70 per share for an aggregate amount of 1,428,571 shares. Although many ofthe shares issuable upon conversion of our Series B Convertible PreferredStock are eligible for public resale under Securities Exchange Commission Rule 144,we have agreed to file a registration statement to cover the public resaleof all of these shares. This significant increase in the number of sharesavailable for public sale may have a negative impact on the trading priceof our shares and substantially dilute the ownership interests of our existingshareholders. In the event that our stock trades below $.70 per share, in orderto raise additional financing we would likely be required to issue additionalshares of common stock or securities convertible into common stock at apurchase or conversion price, as applicable, of less than $.70 per share. Anyissuance of shares at a purchase price of less than $.70 per share would reducethe conversion price of our Series B Convertible Preferred Shares to suchlower price. This would require us to issue additional shares upon conversionof our Series B Shares and further dilute the ownership interests of ourexisting shareholders. To the extent these factors are viewed negatively by themarket, it may provide an incentive for persons to execute short sales ofour common stock that could adversely affect the trading price of our commonstock.

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**ApplicableSEC Rules governing the trading of “penny stocks” limits the trading andliquidity of our common stock, which may affect the trading price of our commonstock.**

Our common stockcurrently trades on the OTC Bulletin Board. Since our common stock continues totrade below $5.00 per share, our common stock is considered a “penny stock” andis subject to SEC rules and regulations, which impose limitations upon themanner in which our shares can be publicly traded. These regulations requirethe delivery, prior to any transaction involving a penny stock, of a disclosureschedule explaining the penny stock market and the associated risks. Underthese regulations, certain brokers who recommend such securities to personsother than established customers or certain accredited investors must make aspecial written suitability determination regarding such a purchaser andreceive such purchaser’s written agreement to a transaction prior to sale.These regulations have the effect of limiting the trading activity of ourcommon stock and reducing the liquidity of an investment in our common stock.

**Wedo not intend to pay dividends in the foreseeable future.**

We have neverdeclared or paid a dividend on our common stock. In addition, the terms of ouroutstanding Convertible Preferred Shares preclude us from declaring or paying adividend on our common stock unless a dividend is also declared or paid, asapplicable, on our Convertible Preferred Shares. We intend to retain earnings,if any, for use in the operation and expansion of our business and, therefore,do not anticipate paying any dividends on our common stock in the foreseeablefuture.

**Thetrading price of our common stock may be volatile.**

The trading priceof our shares has from time to time fluctuated widely and in the futuremay be subject to similar fluctuations. The trading price may beaffected by a number of factors including the risk factors set forth in thisReport as well as our operating results, financial condition, announcements ofinnovations or new products by us or our competitors, general conditions in thebiometrics and access control industries, and other events or factors. Althoughwe believe that approximately 15 registered broker dealers currently make amarket in our common stock, we can not assure you that any of these firms willcontinue to serve as market makers or have the financial capability tostabilize or support our common stock. A reduction in the number of marketmakers or the financial capability of any of these market makers could alsoresult in a decrease in the trading volume of and price of our shares. Inrecent years broad stock market indices, in general, and the securities oftechnology companies, in particular, have experienced substantial pricefluctuations. Such broad market fluctuations may adversely affect thefuture-trading price of our common stock.

**ITEM 2.**                    DESCRIPTION OFPROPERTY

We do not own anyreal estate. We conduct operations from leased premises in Marlborough,Massachusetts (38,000 square feet), Eagan, Minnesota (6,800 square feet), Wall,New Jersey (2,180 square feet) and Winter Park, Florida (900 square feet). Webelieve that our current facilities are adequate for the foreseeable future.

**ITEM 3.**                    LEGALPROCEEDINGS

Prior to ouracquisition of PSG in March 2004, PSG had been named as a defendant in acivil action initiated in the Superior Court Department in Hampden County,Commonwealth of Massachusetts by The Vince Group, Inc. (“TVG”). The casehas since been removed to the United States District Court for the District ofMassachusetts at the request of the Parties. The complaint claims that PSG isobligated to pay a percentage of certain of its revenues to TVG inconsideration for a strategic business introduction allegedly made by an agentof TVG. PSG has denied the allegations and filed an answer in the litigation,and as of the date of this report the outcome of the litigation is pending. Theclaim is for an unspecified amount including actual damages, interest, andattorney’s fees. Management believes the claim is without merit and will settleout of court for an amount, which will not have a material adverse affect onour business, financial condition or operating results.

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

No matters weresubmitted to a vote of security holders in the fourth quarter of 2005.

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**PART II**

**ITEM 5.**                    MARKET FORCOMMON EQUITY AND RELATED STOCKHOLDER MATTERS

Our common stockcurrently trades on the OTC Bulletin Board under the symbol “BKYI”. Thefollowing table sets forth the range of high and low bid prices per share ofour common stock for each of the calendar quarters identified below as reportedby the OTC Bulletin Board. These quotations represent inter-dealer prices, without retail mark-up, markdown orcommission, and may not represent actual transactions.

| 2005:                                  | ** ** | **High**   | ** ** | **Low**    | ** ** |
|----------------------------------------|------------|------------|------------|------------|------------|
| ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Quarter ended  December 31, 2005  |       | $          | 0.81       |       | $          | 0.50 |   |
| Quarter ended  September 30, 2005 |       | 1.21       |       | 0.74       |       |
| Quarter ended  June 30, 2005      |       | 1.39       |       | 0.99       |       |
| Quarter ended  March 31, 2005     |       | 1.63       |       | 1.13       |       |
|                                        |            |            |            |            |            |  |  |

 

| 2004:                                  | ** ** | **High**   | ** ** | **Low**    | ** ** |
|----------------------------------------|------------|------------|------------|------------|------------|
| ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Quarter ended  December 31, 2004  |       | $          | 1.61       |       | $          | 0.74 |   |
| Quarter ended  September 30, 2004 |       | 1.43       |       | 0.60       |       |
| Quarter ended  June 30, 2004      |       | 3.00       |       | 1.26       |       |
| Quarter ended  March 31, 2004     |       | 1.85       |       | 1.03       |       |
|                                        |            |            |            |            |            |  |  |

 

| 2003:                                  | ** ** | **High**   | ** ** | **Low**    | ** ** |
|----------------------------------------|------------|------------|------------|------------|------------|
| ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Quarter ended  December 31, 2003  |       | $          | 1.40       |       | $          | 0.53 |   |
| Quarter ended  September 30, 2003 |       | .59        |       | 0.38       |       |
| Quarter ended  June 30, 2003      |       | .64        |       | 0.30       |       |
| Quarter ended  March 31, 2003     |       | .73        |       | 0.35       |       |
|                                        |            |            |            |            |            |  |  |

 

The last price of ourcommon stock as reported on the OTC Bulletin Board on March 15, 2006 was$0.62 per share.

**Holders**

As of March 15,2006, the number of stockholders of record of our common stock was 192. Basedon broker inquiry conducted in connection with the distribution of proxysolicitation materials in connection with the Company’s special meeting ofshareholders in February 2006, we believe that there are approximately4,816 beneficial owners of our common stock.

**Dividends**

We have not paidany cash dividends to date, and have no intention of paying any cash dividendson our common stock in the foreseeable future. The terms of our outstandingConvertible Preferred Stock preclude us from declaring or paying a dividend onour common stock unless a dividend is also declared or paid, as applicable, onour Convertible Preferred Stock. The declaration and payment of dividends isalso subject to the discretion of our Board of Directors and certainlimitations imposed under the Delaware General Corporation Law. The timing,amount and form of dividends, if any, will depend on, among other things,our results of operations, financial condition, cash requirements and otherfactors deemed relevant by our Board of Directors.

**RecentSales Of Unregistered Securities.**

(a)           Between December 11,2003 and March 2, 2004, the Company issued an aggregate of 4,120,345shares of common stock upon conversion of $2,538,938 principal amount and$551,321 of accrued interest due under our Secured Convertible Note dated November 26,2001. The shares were issued in a private placement transaction exempt from theregistration requirements of the Securities Act pursuant to Section 4(2) thereunderwithout payment of underwriting discounts or commission to any person.

(b)          On March 3, 2004,the Company issued 65,000 shares of Series C convertible preferred stockto The Shaar Fund Ltd. in exchange for the cancellation of $5,736,232principal amount of outstanding convertible promissory notes and $763,768 ofaccrued interest due thereunder. The Series C convertible preferred isconvertible at the option of the holder into common stock at a conversion priceof $.75 per share, subject to certain anti-dilution adjustments. The securitieswere issued to one accredited investor in a private placement transactionexempt from the registration requirements of the Securities Act pursuant to Section 4(2) thereunder,without payment of underwriting discounts or commissions to any person.

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(c)           On March 30, 2004,the Company issued 5,257 shares of Series C convertible preferred stock toThe Shaar Fund Ltd. in exchange for the cancellation of all of our issuedand outstanding shares of Series B preferred stock. The Series Cconvertible preferred are convertible at the option of the holder into commonstock at a conversion price of $.75 per share, subject to certain anti-dilutionadjustments. The securities were issued to one accredited investor in a privateplacement transaction exempt from the registration requirements of theSecurities Act pursuant to Section 4(2) thereunder, without paymentof underwriting discounts or commissions to any person.

(d)           On March 30,2004, the Company issued 18,275 shares of Series C convertible preferredstock to The Shaar Fund Ltd. in exchange for the cancellation of$1,777,500 principal amount of outstanding convertible promissory notes and$49,963 of accrued interest due thereunder. The Series C convertiblepreferred are convertible at the option of the holder into common stock at aconversion price of $.75 per share, subject to certain anti-dilutionadjustments. The securities were issued to one accredited investor in a privateplacement transaction exempt from the registration requirements of theSecurities Act pursuant to Section 4(2) thereunder, without paymentof underwriting discounts or commissions to any person.

(e)           On March 30, 2004,the Company issued an aggregate of 2,422,108 shares of common stock to ten (10) individualsand Harward Investments, Inc. in connection with the Company’s acquisitionof Public Safety Group, Inc. These securities were issued in a privateplacement transaction exempt from the registration requirements of theSecurities Act pursuant to Section 4(2) thereof directly by theCompany without engaging in any advertising or general solicitation of any kindand without payment of underwriting discounts or commissions to any person.

(f)             On March 31,2004, the Company issued an aggregate of 8,888,928 shares of common stock andwarrants to purchase 4,444,464 shares of common stock to forty-nine(49) accredited investors for aggregate gross proceeds of approximately$12,000,000 in cash. These securities were issued in a private placementtransaction exempt from the registration requirements of the Securities Actpursuant to Section 4(2) thereof directly by the Company withoutengaging in any advertising or general solicitation of any kind and withoutpayment of underwriting discounts or commissions to any person.

(g)          On April 29, 2004,the Company issued 3,750 shares of Series C convertible preferred stock toThomas J. Colatosti in exchange for the cancellation of $375,000 principal amountof outstanding convertible promissory notes. The Series C convertiblepreferred are convertible at the option of the holder into common stock at aconversion price of $.75 per share, subject to certain anti-dilutionadjustments. The securities were issued to one accredited investor in a privateplacement transaction exempt from the registration requirements of theSecurities Act pursuant to Section 4(2) thereunder, without paymentof underwriting discounts or commissions to any person.

(h)          On September 29,2004, the Company issued secured convertible term notes in the aggregateprincipal amount of $5,050,000 and warrants to purchase 1,122,222 shares ofcommon stock at an exercise price of $1.35 per share to Laurus MasterFund, Ltd. and other institutional and accredited investors. Thesesecurities were issued in a private placement transaction exempt from theregistration requirements of the Securities Act pursuant to Section 4(2) thereofdirectly by the Company without engaging in any advertising or generalsolicitation of any kind and without payment of underwriting discounts orcommissions to any person.

(i)              On September 29,2004, the Company issued secured convertible term notes in the aggregateprincipal amount of $4,950,000 and warrants to purchase 1,099,997 shares ofcommon stock at an exercise price of $1.35 per share to The ShaarFund Ltd. and other institutional and accredited investors. Thesesecurities were issued in a private placement transaction exempt from theregistration requirements of the Securities Act pursuant to Section 4(2) thereofdirectly by the Company without engaging in any advertising or generalsolicitation of any kind and without payment of underwriting discounts orcommissions to any person.

(j)              In September 2004,the Company issued consultants warrants to purchase 620,667 shares of theCompany’s common stock at an exercise price of $1.55 per share. The warrantshave a term of five (5) years and vest immediately. These securities wereissued in a private placement transaction exempt from the registrationrequirements of the Securities Act pursuant to Section 4(2) thereofdirectly by the Company without engaging in any advertising or generalsolicitation of any kind and without payment of underwriting discounts orcommissions to any person.

(k)           On May 31, 2005,the Company issued secured convertible term notes in the aggregate principalamount of $2,794,723 and warrants to purchase 828,066 shares of common stock atan exercise price of $1.50 per share to The Shaar Fund Ltd. and otherinstitutional and accredited investors. These securities were issued in aprivate placement transaction exempt from the registration requirements of theSecurities Act pursuant to Section 4(2) thereof directly by theCompany without engaging in any advertising or general solicitation of any kindand without payment of underwriting discounts or commissions to any person.

(l)              On June 8,2005, the Company issued secured convertible term notes in the aggregateprincipal amount of $2,000,000 and warrants to purchase 444,444 shares ofcommon stock at an exercise price of $1.55 per share to Laurus MasterFund, Ltd. These securities were issued in a private placement transactionexempt from the registration requirements of the Securities Act pursuant to Section 4(2) thereofdirectly by the Company without engaging in any advertising or generalsolicitation of any kind and without payment of underwriting discounts orcommissions to any person.

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(m)            On August 31,2005, the Company entered into an Amendment and Waiver with Laurus Master Fund,Ltd.(“Laurus “) pursuant to which Laurus allowed the Company to defer certainpayments of monthly principal due under the Secured Convertible Term Note datedSeptember 29, 2004. The Company issued 612,166 shares of its Common Stockto Laurus as consideration for this principal payment deferral. Thesesecurities were issued in a private placement transaction exempt from theregistration requirements of the Securities Act pursuant to Section 4(2) thereofdirectly by the Company without engaging in any advertising or generalsolicitation of any kind and without payment of underwriting discounts orcommissions to any person.

(n)              On August 31,2005, the Company entered into an Amendment and Waiver with The ShaarFund Ltd. and other institutional and accredited investors pursuant towhich these investors allowed the Company to defer certain payments of monthlyprincipal due under the Secured Convertible Term Note dated September 29,2004. The Company issued 263,706 shares of its Common Stock to these investorsas consideration for this principal payment deferral. These securities wereissued in a private placement transaction exempt from the registrationrequirements of the Securities Act pursuant to Section 4(2) thereofdirectly by the Company without engaging in any advertising or generalsolicitation of any kind and without payment of underwriting discounts orcommissions to any person.

(o)              On January 23,2006, BIO-key International, Inc. entered into an Amendment and Waiverwith Laurus pursuant to which Laurus allowed the Company to extend the maturityof the Secured Convertible Term Notes dated September 29, 2004 and June 7,2005. The fixed conversion price under each of the Secured Notes was reset from$1.35 to $0.85 per share. In addition, the exercise price of all warrants topurchase Common Stock of the Company held by Laurus was reset to $1.00 pershare. The Company issued 150,000 shares of the Company’s Common Stock toLaurus as consideration for this payment deferral. These securities were issuedin a private placement transaction exempt from the registration requirements ofthe Securities Act pursuant to Section 4(2) thereof directly by theCompany without engaging in any advertising or general solicitation of any kindand without payment of underwriting discounts or commissions to any person.

(p)              On January 23,2006, the Company entered into an Amendment and Waiver with The Shaar Fund Ltd.and other institutional and accredited investors pursuant to which theseinvestors allowed the Company to extend the maturity of the Subordinated Notesissued by the Company on September 29, 2004 and on May 31, 2005.Additionally, the interest rate was fixed at fifteen percent (15%) and allprincipal amounts are due at the maturity date and shall be paid in shares ofCommon Stock priced at $0.70 per share if the average closing price of theCommon Stock for the thirty (30) trading days immediately preceding thematurity date is greater than $1.10. Interest shall be paid, at the Company’selection, in cash or shares of Common Stock, with the Common Stock priced atthe average closing price of the Common Stock for the ten (10) tradingdays immediately preceding the repayment date. The currently applicable fixedconversion price was amended to $0.70 per share. In addition, the exerciseprice of all warrants to purchase Common Stock held by the Subordinated NoteHolders that currently have an exercise price greater than $1.00 per share wasreset to$1.00 per share. In connection with this financing, we also reduced theconversion price of the Series A Convertible Preferred shares held by theShaar Fund Ltd. to $0.70 per share.

(q)              OnJanuary 23, 2006, the Company issued Convertible Term Notes in theaggregate principal amount of $1,000,000 to certain investors. The ConvertibleNotes are convertible into 1,000,000 shares of Shares of Series BConvertible Preferred Stock of the Company at an initial fixed conversion of$0.70 per share for an aggregate amount of 1,428,571 shares. These securitieswere issued in a private placement transaction exempt from the registrationrequirements of the Securities Act pursuant to Section 4(2) thereofdirectly by the Company without engaging in any advertising or generalsolicitation of any kind and without payment of underwriting discounts orcommissions to any person.

**ConvertiblePreferred Stock**

In March 2004,we designated 100,000 shares of preferred stock as Series C ConvertiblePreferred Stock (the “Series A Convertible Preferred Shares”). When theCompany reincorporated in Delaware, the Series A Convertible PreferredShares were re-named as Series A Convertible Preferred Stock of which44,557 are issued and outstanding as of December 31, 2005. The followingdescribes the material provisions of the Series A Convertible PreferredShares which are more fully set forth in the Certificate of Designation on filewith the Delaware Secretary of State.

The Series AConvertible Preferred Shares accrue a cumulative annual dividend of 7% on the$100 face amount of such shares payable June 15 and December 15 eachyear in shares of common stock. In the event of a liquidation, dissolution orwinding up of the Company, the Series A Convertible Preferred Shares havea liquidation preference of $100 per share (plus all accrued and unpaiddividends thereon) prior to any payment or distribution to holders of ourcommon stock. The Series A Convertible Preferred Shares are convertibleinto common stock at a conversion price of $.70 per share. The conversion priceis subject to proportional adjustment in the event of stock splits, stockdividends or reclassifications. Subject to certain exceptions, in the event weissue additional shares of common stock at a purchase price less than theconversion price of the Series A Convertible Preferred Shares, theconversion price shall be lowered to such lesser price. In the event that theaverage closing bid price of our common stock is less than $1.00 per share forthirty (30) consecutive trading days at any time after March 3, 2007,we will be required to redeem the Series A Convertible Preferred Shares bypayment of $100 per share plus all accrued and unpaid dividends due thereon.

We are required toobtain the consent of the holders of a majority of the Series AConvertible Preferred Shares in order to, among other things, issue any sharesof preferred stock that are equal to or have a preference over the Series AConvertible Preferred Shares or issue any shares of preferred stock, rights,options, warrants, or any other securities convertible into common stock of theCompany, other than those issued to employees of the Company in the ordinarycourse of their employment or to consultants or other persons providingservices to the Company so long as such issuances do not exceed 500,000 sharesof common stock. We are also required to obtain such consent in order to, amongother things, complete a sale or other disposition of any material assets,complete an acquisition of a material amount of assets, engage in a merger,reorganization or consolidation, or incur or guaranty any indebtedness inexcess of $50,000.

In January 2006,the Company designated 1,000,000 shares of preferred stock as Series BConvertible Preferred Stock, all of which are issued and outstanding. Thefollowing describes the material provisions of the Series B ConvertiblePreferred Shares which are more fully set forth in the Certificate ofDesignation on file with the Delaware Secretary of State.

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The Series BConvertible Preferred Shares accrue a cumulative annual dividend of 15% on the $1face amount of such shares payable January 1, April 1, July 1and October 1 each year in shares of common stock. In the event of aliquidation, dissolution or winding up of the Company, the Series BConvertible Preferred Shares have a liquidation preference of $1 per share(plus all accrued and unpaid dividends thereon) prior to any payment ordistribution to holders of our common stock. The Series B ConvertiblePreferred Shares are convertible into common stock at a conversion price of$.70 per share. The conversion price is subject to proportional adjustment inthe event of stock splits, stock dividends or reclassifications. Subject tocertain exceptions, in the event we issue additional shares of common stock ata purchase price less than the conversion price of the Series BConvertible Preferred Shares, the conversion price shall be lowered to suchlesser price.

If during the thirty (30)consecutive trading day period occurring prior to January 1, 2009, theaverage closing bid price for one share of Common Stock, as reported byBloomberg, L.P. is at least $1.10, all outstanding Series B shares shallautomatically be converted into Common Stock, at the then effective conversionrate. Upon conversion, all accrued or declared but unpaid dividends on the Series Bshares shall be paid in shares of Common Stock. In the event that the averageclosing bid price of our common stock is less than $1.10 per share for thirty(30) consecutive trading days at any time after January 1, 2009, wewill be required to redeem the Series A Convertible Preferred Shares bypayment of $1 per share plus all accrued and unpaid dividends due thereon. Foras long as twenty-five percent (25%) of the Series B Convertible PreferredStock are outstanding, we are required to obtain the consent of the holders ofa majority of the Series B Convertible Preferred Shares in order to, amongother things, issue any shares of preferred stock that are equal to or have apreference over the Series B Convertible Preferred Shares or issue anyshares of preferred stock, rights, options, warrants, or any other securitiesconvertible into common stock of the Company, other than those issued toemployees of the Company in the ordinary course of their employment or toconsultants or other persons providing services to the Company. We are alsorequired to obtain such consent in order to, among other things, complete asale or other disposition of any material assets, complete an acquisition of amaterial amount of assets, engage in a merger, reorganization or consolidation,or incur or guaranty any indebtedness in excess of $50,000

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**ITEM 6. MANAGEMENT’SDISCUSSION AND ANALYSIS OR PLAN OF OPERATION**

This Management’sDiscussion and Analysis or Plan of Operation and other parts of this Reportcontain forward-looking statements that involve risks and uncertainties. Allforward-looking statements included in this Report are based on informationavailable to us on the date hereof, and we assume no obligation to update anysuch forward-looking statements. Our actual results could differ materiallyfrom those anticipated in these forward-looking statements as a result of anumber of factors, including those set forth in the section captioned “**RISK FACTORS**” in Item 1 and elsewhere inthis Report. The following should be read in conjunction with our auditedfinancial statements included elsewhere herein.

The following Management’sDiscussion and Analysis or Plan of Operation (“MD&A”) is intended to helpyou understand BIO-key International (the “Company”, “we”, “us” or “our”).MD&A is provided as a supplement to and should be read in conjunction withour financial statements and the accompanying notes. The results included inthis MD&A have been restated. Our MD&A includes the following sections:

OVERVIEW provides adescription of our business, the major items that affected our business, andhow we analyze our business. It then provides an analysis of our overall 2005performance and a description of the significant events impacting 2005 andthereafter.

RESULTS OF OPERATIONSprovides an analysis of the consolidated and segment results of operations for2005 compared to 2004 and 2004 compared to 2003.

LIQUIDITY AND CAPITALRESOURCES provides an overview of our cash flows, financing, contractualobligations and embedded derivatives activities.

RESTATEMENT provides adescription and reconciliation of the restatement. For additional information,see Item 8, Financial Statements and Supplementary Data, Note B,Restatement of Previously Issued Financial Statements.

CRITICAL ACCOUNTINGPOLICIES provides a discussion of our accounting policies that require criticaljudgment, assumptions and estimates.

OTHER MATTERS provides adiscussion of our significant non-operational items which impact our financialstatements, such as the SEC comment letter.

RECENT ACCOUNTINGSTANDARDS by reference to Note 1 to the Consolidated Financial Statementsprovides a description of accounting standards which we have not yet beenrequired to implement and may be applicable to our operations, as well as thosesignificant accounting standards which were adopted during 2005.

**OVERVIEW**

Our Business

We develop and marketproprietary fingerprint identification biometric technology and softwaresolutions. We also deliver advanced identification solutions and informationservices to law enforcement departments, public safety agencies and othergovernment and private sector customers. Our mobile wireless technologyprovides first responders with critical, reliable, real-time data and imagesfrom local, state and national databases.

We pioneered thedevelopment of automated, finger identification technology that can be usedwithout the aid of non-automated methods of identification such as a personalidentification, password, token, smart card, ID card, credit card, passport,driver’s license or other form of possession or knowledge based identification.This advanced BIO-keyTM identification technology improves both the accuracy andspeed of finger-based biometrics and is the only finger identificationalgorithm that has been certified by the International Computer SecurityAssociation (ICSA).

Since our inception in1993, we have spent substantial time and effort in completing the developmentof what we believe is the most discriminating and effective finger biometrictechnology available. During the past two years, our focus has shifted to marketingand selling this technology and completing strategic acquisitions that can helpus leverage our capability to deliver identification solutions. We have built adirect sale force of professionals with substantial experience in sellingtechnology solutions to government and corporate customers. We expect tocontinue to add additional qualified personnel beyond 2005.

On March 30, 2004,we acquired all of the outstanding capital stock of Public Safety Group, Inc.,a privately-held provider of wireless solutions for law enforcement and publicsafety markets based in Winter Park, Florida, in exchange for an aggregate of2,422,108 shares of our common stock, $500,000 in cash, and our assumption of$600,000 in aggregate net liabilities of PSG. The acquisition was completedpursuant to the terms of an agreement and plan of merger by and among theCompany, BIO-key Acquisition Corp., a wholly-owned subsidiary of the Company,PSG and all of the shareholders of PSG. As a result of this transaction, PSGbecame a wholly-owned subsidiary of the Company.

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On September 30,2004, we completed our acquisition of the Mobile Government Division fromAether Systems Inc. Pursuant to the Asset Purchase Agreement dated as of August 16,2004 by and among the Company, Aether, Cerulean Technology, Inc. andSunPro, Inc., the Company paid Aether a purchase price of $10,000,000 incash, subject to post-closing adjustments to reflect changes in Aether MobileGovernment’s working capital and cash flows since June 30, 2004.Post-closing working capital adjustments resulted in an additional payment bythe Company of $341,878 in December 2004. In connection with thisacquisition, the Company issued a subordinated secured promissory note toAether in the face amount of $6,884,588 (the “Aether Note”). The Aether Noteevidences a contingent reimbursement obligation of the Company to Aether and asurety fee payable by the Company to Aether, in each case with respect to aletter of credit maintained by Aether for the Company’s benefit in connection withthe acquisition. The Company’s obligations under the Aether Note are secured bya security interest granted to Aether in all or substantially all of theCompany’s assets, subordinate to the security interest described in the “Long-TermObligations” footnote to this annual report.

Aether Mobile Governmentprovides wireless data solutions for use by public safety organizations,primarily state and local police, fire and rescue and emergency medicalservices organizations that enable such organizations to access law enforcementdatabases to validate identities and obtain suspect information. Its publicsafety solutions are integrated into fifty (50) different state databases,as well as local and federal databases, and its products deliver real-time informationin seconds, without the need for human dispatchers or other resources.

# INTRODUCTION

During2005, the Company continued to integrate the products, operations andtechnology of the Mobile Government business, acquired from Aether Systems in September 2004,in an effort to leverage new business opportunities. Our financial objective isto increase revenue, manage expenses and attain profitability. While totalexpenses have increased in dollars, they have declined as a percentage ofrevenue in 2005 and 2004. In the fourth quarter of 2005, the Companyrestructured its operations into three business segments: Biometrics, LawEnforcement and Fire Safety. Each segment will be headed by a General Managerand organized to quickly respond to market needs as well as to drive down coststo achieve profitability. Management believes that this initiative will lead toincreased opportunities in 2006 as the General Managers develop theirorganizations. A detailed analysis of each segment can be found below.

**RESULTSOF OPERATIONS**

**ConsolidatedResults of Operations **

**Three Year % trend**
| ** **                            | ** ** | **Years ended December 31,** | ** ** |
|---------------------------------------|------------|---------------------------------------------|------------|
| ** **                            | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                            | ** ** | **(Restated)**                              | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
| **Revenues**                          | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Services                              |       | 76                                          | %          | 59 | % | 5 | % |
| License fees and other                |       | 24                                          | %          | 41 | % | 95 | % |
|                                  |       | 100                                         | %          | 100 | % | 100 | % |
| **Costs  and other expenses**         | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Services                              |       | 20                                          | %          | 21 | % | 1 | % |
| Cost of license fees and other        |       | 7                                           | %          | 16 | % | 41 | % |
| Selling, general and administrative   |       | 83                                          | %          | 124 | % | 975 | % |
| Research, development and engineering |       | 48                                          | %          | 52 | % | 481 | % |
|                                  |       | 158                                         | %          | 213 | % | 1,498 | % |
| **Operating  loss**                   |       | (58                                         | )%         | (113 | )% | (1,398 | )% |
|                                  |       |                                        |       |   |   |   |   |
| **Other  income (deductions)**        | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total other income (deductions)       |       | (32                                         | )%         | (77 | )% | (486 | )% |
| **NET INCOME (LOSS)**                 |       | (26                                         | )%         | (190 | )% | (1,884 | )% |

 

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As discussed inNote M to the Consolidated Financial Statements, we have three reportingsegments: Law Enforcement, Fire Safety and Biometrics. The Law Enforcement andFire Safety segments were purchased during 2004. As noted earlier, in thefourth quarter of 2005 the Company restructured its operations into threebusiness segments, prior to this segmentation of the business managementevaluated the business as one consolidated operation. For presentation andcomparability purposes the allocation of costs between segments for priorperiods have been estimated.

The Companyevaluates performance and allocates resources based on revenues and operatingincome (loss). Operating income (loss) for each segment includes selling,general and administrative expenses directly attributable to the segment inaddition to those allocated as a percentage based on the segments revenues. Thesegmentation of operating income as noted above and detailed below reflects howmanagement now evaluates its business.  Assets for the company arecommingled and are related to all operating segments. Management does not evaluateor identify the operating assets of the segments separately.
| ** **               | ** ** | ** ** | ** ** | ** **   | ** ** | ** **   | ** ** | **2005 - 2004** | ** ** | **2004 - 2003** | ** ** |
|--------------------------|------------|------------|------------|--------------|------------|--------------|------------|---------------------------|------------|---------------------------|------------|
| ** **               | ** ** | **2005**   | ** ** | **2004**     | ** ** | **2003**     | ** ** | **$ Chg**            | ** ** | **%  Chg**      | ** ** | **$ Chg** | ** ** | **%  Chg** | ** ** |
| ** **               | ** ** | ** ** | ** ** | **Restated** | ** ** | **Restated** | ** ** | ** **                | ** ** | ** **                | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Revenues*               | * *   | * *   | * *   | * *     | * *   | * *     | * *   | * *                  | * *   | * *                  | * *   | * * | * * | * * | * * |
| **Law  Enforcement**     | ** ** | ** ** | ** ** | ** **   | ** ** | ** **   | ** ** | ** **                | ** ** | ** **                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Service                  |       | $          | 7,886,000  |         | $          | 2,562,136    |       | $                         | —     |                      | $          | 5,323,864 |   | 208 | % | $ | 2,562,136 |   | n/a |   |
| License & other |       | 2,638,938  |       | 1,920,642    |       | —       |       | 718,296                   |       | 37                        | %          | 1,920,642 |   | n/a |   |
|                     |       | 10,524,938 |       | 4,482,778    |       | —       |       | 6,042,160                 |       | 135                       | %          | 4,482,778 |   | n/a |   |
| **Fire  Safety**         | ** ** | ** ** | ** ** | ** **   | ** ** | ** **   | ** ** | ** **                | ** ** | ** **                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Service                  |       | 2,814,616  |       | 693,967      |       | —       |       | 2,120,649                 |       | 306                       | %          | 693,967 |   | n/a |   |
| License & other |       | 406,470    |       | 187,229      |       | —       |       | 219,241                   |       | 117                       | %          | 187,229 |   | n/a |   |
|                     |       | 3,221,086  |       | 881,196      |       | —       |       | 2,339,890                 |       | 266                       | %          | 881,196 |   | n/a |   |
|                     |       |       |       |         |       |         |       |                      |       |                      |       |   |   |   |   |
| **Biometrics**           | ** ** | ** ** | ** ** | ** **   | ** ** | ** **   | ** ** | ** **                | ** ** | ** **                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Service                  |       | 161,033    |       | 95,303       |       | 10,694       |       | 65,730                    |       | 69                        | %          | 84,609 |   | 791 | % |
| License & other |       | 319,038    |       | 261,674      |       | 204,787      |       | 57,364                    |       | 22                        | %          | 56,887 |   | 28 | % |
|                     |       | 480,071    |       | 356,977      |       | 215,481      |       | 123,094                   |       | 34                        | %          | 141,496 |   | 66 | % |
|                     |       |       |       |         |       |         |       |                      |       |                      |       |   |   |   |   |
| *Total Revenue*          |       | $          | 14,226,095 |         | $          | 5,720,951    |       | $                         | 215,481    |                      | $          | 8,505,144 |   | 149 | % | $ | 5,505,470 |   | 2,555 | % |
|                     |       |       |       |         |       |         |       |                      |       |                      |       |   |   |   |   |
| *Cost of  goods sold*    | * *   | * *   | * *   | * *     | * *   | * *     | * *   | * *                  | * *   | * *                  | * *   | * * | * * | * * | * * |
| **Law  Enforcement**     | ** ** | ** ** | ** ** | ** **   | ** ** | ** **   | ** ** | ** **                | ** ** | ** **                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Service                  |       | $          | 2,260,845  |         | $          | 902,794      |       | $                         | —     |                      | $          | 1,358,051 |   | 150 | % | $ | 902,794 |   | n/a |   |
| License & other |       | 679,170    |       | 686,806      |       | —       |       | (7,636                    | )          | (1)                       | %          | 686,806 |   | n/a |   |
|                     |       | 2,940,015  |       | 1,589,600    |       | —       |       | 1,350,415                 |       | 85                        | %          | 1,589,600 |   | n/a |   |
| **Fire  Safety**         | ** ** | ** ** | ** ** | ** **   | ** ** | ** **   | ** ** | ** **                | ** ** | ** **                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Service                  |       | 602,317    |       | 253,913      |       | —       |       | 348,404                   |       | 137                       | %          | 253,913 |   | n/a |   |
| License & other |       | 165,074    |       | 96,081       |       | —       |       | 68,993                    |       | 72                        | %          | 96,081 |   | n/a |   |
|                     |       | 767,391    |       | 349,994      |       | —       |       | 417,397                   |       | 119                       | %          | 349,994 |   | n/a |   |
| **Biometrics**           | ** ** | ** ** | ** ** | ** **   | ** ** | ** **   | ** ** | ** **                | ** ** | ** **                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Service                  |       | 42,980     |       | 17,617       |       | 1,694        |       | 25,363                    |       | 144                       | %          | 15,923 |   | 940 | % |
| License & other |       | 93,247     |       | 107,009      |       | 87,387       |       | (13,762                   | )          | 13                        | %          | 19,622 |   | 22 | % |
|                     |       | 136,227    |       | 124,626      |       | 89,081       |       | 11,601                    |       | 9                         | %          | 35,545 |   | 40 | % |
|                     |       |       |       |         |       |         |       |                      |       |                      |       |   |   |   |   |
| *Total  COGS*            |       | $          | 3,843,633  |         | $          | 2,064,220    |       | $                         | 89,081     |                      | $          | 1,779,413 |   | 86 | % | $ | 1,975,139 |   | 2,217 | % |

 

23

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*Revenues*

*LawEnforcement*

The increase inthese revenue components from 2004 is primarily attributable to the fact thatthe business was acquired in the third quarter of 2004. Therefore 2004represents only one quarter of revenue, whereas 2005 reflects four quarters ofrevenue. The increase was partially offset with a reduction of revenues relatedto long-term project work, which during 2005 has diminished as a result of theCompany focusing the business to more of a licensing model.

*FireSafety*

The increase inthese revenue components from 2004 is primarily attributable to the fact thatthe business was acquired in the third quarter of 2004. Therefore 2004represents only one quarter of revenue, whereas 2005 reflects four quarters ofrevenue. This was compounded by a general increase in overall revenue that canbe attributed to a strengthened market presence through concerted effortstoward penetrating new markets by actively pursuing and marketing our FireSafety products. Additionally revenue growth can be also attributable tofunctionality that was added across the entire Fire Safety product suite aswell as the release of new FireRMS mobile product which was released in themiddle of 2005.

*Biometrics*

During 2004 and2005 Biometric segment continues to show strong revenue growth year over year.This is reflective of continued market acceptance of the product and strategicchannel relationships that have been developed. Additionally, the product hasbeen a proven solution in the educational industry as well has shown continuedcommercial integration and acceptance of the product.

***Costsof goods sold***

*LawEnforcement*

License and othercosts are attributable primarily to revenues derived from product sales forwhich we are required to pay a royalty. The slight decrease in cost isprimarily driven by the sales mix and is solely dependent specifically on whatproducts were sold.

Service costsincreased primarily because of personnel related costs that have increased overthe prior year primarily from the inclusion of a full year of costs as comparedto only one quarter in 2004. This was offset by reductions related to a reducedconcentration of project related revenues which are heavily burdened with laborcosts, both employees and contracted labor. As significant project revenuesdeclined after the first two quarters of 2005, this reduction offset theincrease that would have occurred related to maintaining a full twelve monthsof expense.

*FireSafety*

License and othercosts are attributable primarily to revenues derived from product sales forwhich we are required to pay a royalty. The slight increase in cost isprimarily driven by the sales volume in addition to product mix. These costsare solely dependent specifically on what products were sold.

Services costshave increased over the prior year primarily from the inclusion of a full yearof costs as compared to only one quarter as well as contractors and relatedcosts that have been incurred related to project and service related revenues.There was a significant growth in service revenues for which additional outsidecontractors were used in providing some of those services.

*Biometrics*

License and othercosts are primarily related to the hardware costs related to sales of biometricfingerprint readers. The change in cost of goods sold is directly attributableto the product mix between types of readers sold and the volume of readerssold. During 2004 and 2003 the volume attributable to readers remained fairly constantwhereas in 2005 volume decreased resulting in a reduction of related productcost.

Service cost hasincreased during 2005 related primarily to a higher percentage of revenuerequiring software customization and integration costs as compared to 2004 and2003.

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***Selling, general and administrative***
| ** **           | ** ** | ** ** | ** ** | ** **   | ** ** | ** **   | ** ** | **2005 - 2004** | ** ** | **2004 - 2003** | ** ** |
|----------------------|------------|------------|------------|--------------|------------|--------------|------------|---------------------------|------------|---------------------------|------------|
| ** **           | ** ** | **2005**   | ** ** | **2004**     | ** ** | **2003**     | ** ** | **$ Chg**            | ** ** | **% Chg**            | ** ** | **$ Chg** | ** ** | **% Chg** | ** ** |
| ** **           | ** ** | ** ** | ** ** | **Restated** | ** ** | **Restated** | ** ** | ** **                | ** ** | ** **                | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Law  Enforcement** |       | $          | 7,471,524  |         | $          | 3,047,247    |       | $                         | —     |                      | $          | 4,424,277 |   | 145 | % | $ | 3,047,247 |   | n/a |   |
| **Fire Safety**      |       | 2,802,220  |       | 783,948      |       | —       |       | 2,018,272                 |       | 257                       | %          | 783,948 |   | n/a |   |
| **Biometrics**       |       | 1,550,865  |       | 3,283,093    |       | 2,099,922    |       | (1,732,228                | )          | (53)                      | %          | 1,183,171 |   | 56 | % |
|                 |       |       |       |         |       |         |       |                      |       |                      |       |   |   |   |   |
| **Total**            |       | $          | 11,824,609 |         | $          | 7,114,288    |       | $                         | 2,099,922  |                      | $          | 4,710,321 |   | 66 | % | $ | 5,014,366 |   | 238 | % |

 

SG&A costsincreased during the year as a result of 2005 representing a full 12 monthsworth of expenses as compared to 2004 which included only 3 months of expensesof the Law and Fire segments. As noted above, these costs are allocated basedon the Segment’s percentage of revenue. Changes in SG&A costs betweenbusiness segments are the result of the change in their respective percentageof BIO-key’s total revenue.

During 2004 theincrease in SG&A was primarily attributable to the acquisition of MobileGovernment. The additional costs incurred were the result of legal and auditcosts surrounding both the acquisition of Mobile Government as well as PublicSafety Group. Additionally, theincrease was due to an increased workforce in sales and administration functionsas well as the associated overhead which results from fully loaded laborcharges associated with supporting larger operations. This increase was offsetslightly by the elimination of non essential functions done in order to alignthe business with its revised model of focusing sales through channel partnersand creating a model focused on licensing as oppose to integration projects.

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***Research, development and engineering***
| ** **           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **2005 - 2004** | ** ** | **2004 - 2003** | ** ** |
|----------------------|------------|------------|------------|------------|------------|------------|------------|---------------------------|------------|---------------------------|------------|
| ** **           | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** | **$ Chg**            | ** ** | **% Chg**            | ** ** | **$ Chg** | ** ** | **% Chg** | ** ** |
| **Law  Enforcement** |       | $          | 3,931,265  |       | $          | 1,309,026  |       | $                         | —     |                      | $          | 2,622,239 |   | 200 | % | $ | 1,309,026 |   | n/a |   |
| **Fire  Safety**     |       | 1,207,263  |       | 337,310    |       | —     |       | 869,953                   |       | 258                       | %          | 337,310 |   | n/a |   |
| **Biometrics**       |       | 1,707,507  |       | 1,333,568  |       | 1,037,330  |       | 373,939                   |       | 28                        | %          | 296,238 |   | 29 | % |
|                 |       |       |       |       |       |       |       |                      |       |                      |       |   |   |   |   |
| **Total**            |       | $          | 6,846,035  |       | $          | 2,979,904  |       | $                         | 1,037,330  |                      | $          | 3,866,131 |   | 130 | % | $ | 1,942,574 |   | 187 | % |

 

*LawEnforcement*

R & Dcosts have increased over 2004 primarily related to the acquisition of MobileGovernment in Q3 of 2004. During 2005 the Company spent significant R&Dresources in sustaining engineering related to the large customer base as wellas developing new version releases that incorporated these changes. Whileremaining focused on achieving these operational objectives the Company alsoundertook cost reduction initiatives which resulted in an approximately 25-30%reduction of the fourth quarter 2004 run rate for R&D costs in the LawEnforcement segment.

*FireSafety*

R & Dcosts have increased over 2004 primarily related to the acquisition of MobileGovernment in Q3 of 2004. Additionally, subsequent to the acquisition, thecompany had several engineering initiatives in the Fire segment. As noted abovea number of product enhancements were made to functionality across the entiresoftware suite in addition to focused development of the new FireRMS mobilesolution delivered to the market mid 2005. While remaining focused on achievingthese product objectives, in conjunction with the Company wide cost reductioninitiatives, Fire Safety was able to realize an approximate reduction of 10%the fourth quarter 2004 run rate for R&D costs.

*Biometrics*

R & Dcosts have increased sequentially from 2003 to 2005. This is representative ofthe increased spending to enhance the interoperability and functionality of thesoftware. The company continues to spend in R&D to enhance the productsusability in different markets as well as to develop the product forintegration with products from BIO-key’s other segments. During 2005, BIO-keyreleased IdentityMatch, a product which integrates BIO-key’s advanced biometricofferings with BIO-key’s mobile data and fire records management solutions.BIO-key continues to develop further integration of its Biometric softwaresolutions in other products with in Company as well as partnering with othersolutions in the marketplace. Additionally, in May of 2005 the Company wasawarded a patent for its award-winning leadership Vector Segment fingerprinttechnology or “Image Identification System.”

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***Other income and expense***
| ** **                             | ** ** | ** **   | ** ** | ** **   | ** ** | ** **   | ** ** | **2005 - 2004** | ** ** | **2004 - 2003** | ** ** |
|----------------------------------------|------------|--------------|------------|--------------|------------|--------------|------------|---------------------------|------------|---------------------------|------------|
| ** **                             | ** ** | **2005**     | ** ** | **2004**     | ** ** | **2003**     | ** ** | **$ Chg**            | ** ** | **%Chg**                  | ** ** | **$ Chg** | ** ** | **% Chg** | ** ** |
| ** **                             | ** ** | **Restated** | ** ** | **Restated** | ** ** | **Restated** | ** ** | ** **                | ** ** | ** **                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest expense                       |       | $            | (4,521,344 | )            | $          | (1,415,535   | )          | $                         | (1,909,788 | )                         | $          | (3,105,809 | ) | 219 | % | $ | 494,253 |   | 26 | % |
| Interest income                        |       | 35,958       |       | 66,824       |       | —       |       | (30,866                   | )          | (46)                      | %          | 66,824 |   | n/a |   |
| Gain on sale of  marketable securities |       | (20,000      | )          | 33,125       |       | —       |       | (53,125                   | )          | (160)                     | %          | 33,125 |   | n/a |   |
| Non-cash  interest income (expense)    |       | 9,154,951    |       | (3,008,419   | )          | 857,545      |       | 12,163,370                |       | (404)                     | %          | (3,865,964 | ) | (451) | % |
| Other income  (expense)           |       | (34,767      | )          | (88,425      | )          | 4,145        |       | 53,658                    |       | (61)                      | %          | (92,570 | ) | (2,233) | % |
|                                   |       |         |       |         |       |         |       |                      |       |                      |       |   |   |   |   |
|                                   |       | $            | 4,614,798  |         | $          | (4,412,430   | )          | $                         | (1,048,098 | )                         | $          | 9,027,228 |   | (205) | % | $ | (3,364,332 | ) | 321 | % |

 

Forthe year ended December 31, 2005, consolidated interest expense increased$3,105,809 or 219% as compared to 2004, which was attributable to the increasein long term debt from issuance of the 2004 and 2005 Senior and Subordinatednotes. For the year ended December 31, 2004, consolidated interest expenseincreased $494,253 or 26% from 2003.

Forthe year ended December 31, 2005, consolidated interest income decreased$30,866 or 46% as compared to 2004, which was attributable to the averageamount of cash held on hand in interest bearing accounts. For the year ended December 31,2004, consolidated interest income increased $66,824 as compared to 2003, whichwas attributable to deposits held in interest bearing accounts in 2004. Nodeposits were held in interest bearing accounts in 2003.

Forthe year ended December 31, 2005, consolidated derivative and warrant fairvalue adjustments increased $12,163,370 or 404% as compared to 2004, which wasattributable to changes in the fair market value of embedded derivatives anddetachable warrants issued with convertible debt. The fair value of thederivatives will fluctuate based on; our stock price at particular points intime, the debt conversion price, the volatility of our stock price over aperiod of time, changes in the value of the risk free interest rate, and thetime to maturity of the outstanding debt at different points in time. The majorfactor contributing to this change was due to the decline in the market priceof our stock from $1.60 as of December 31, 2004 to $.69 as of December 31,2005. For the year ended December 31, 2004, derivative and warrant fairvalue adjustments decreased $3,865,964 or 451% as compared to 2003, which wasalso attributable to changes in the fair value of embedded derivatives anddetachable warrants issued with convertible debt. The major factor contributingto the large fluctuation in the fair value was due to the net increase in themarket price of our stock from $1.03 as of September 29, 2004 to $1.60 asof December 31, 2004.

27

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**LIQUIDITYAND CAPITAL RESOURCES**

***OPERATING ACTIVITIES OVERVIEW***

The net cash used inoperating activities during 2005 was $4,513,497, as compared to $5,644,759 and$2,857,145 in 2004 and 2003, respectively. Some of the major drivers of thischange are discussed in more detail below.

The Company’s incomestatement includes four non-cash items which made the most significantcontributions to the net cash used in operating activities in 2004 and 2005.

·                  The Companyissued notes in 2004 and 2005 which contained embedded derivatives. In 2004,the company recorded a loss of approximately $3,008,419 related to the increasein value of the derivatives. The increase in value was caused by the increasein the value of the underlying BIO-key stock. In 2005, the company recorded again of approximately $9,154,951 related to the decrease in value of thederivatives. The decrease in value is the result of the decline in value of theunderlying BIO-key stock.

·                  A debt discountwas recorded when the notes were initially recorded to reflect the FMV ofderivatives and warrants related to the debt. The discount is amortized ratablyinto earnings over the life of the related debt. In 2004 and 2005, the companyrecorded non-cash interest expense related to the amortization of the debtdiscount of approximately $757,318 and $2,097,973 respectively.

·                  The Companyrecorded a $55,150 and $664,043 charge in 2004 and 2005, respectively, for thenon-cash expense of issuing options and warrants to non employees for services.

·                  Finally, theCompany recorded $550,421 and $1,509,880 in 2004 and 2005, respectively, forthe non-cash expense related to the amortization of intangibles assets.

For the year ended December 31,2005, the Company reported positive cash flows related to a decrease in costsand earnings in excess of billings on uncompleted contracts of $2,468,770.Costs and earnings in excess of billings on uncompleted contracts representservices which have been performed on long term contracts but have not beeninvoiced at year end due to milestones contained within the contracts. In 2005,the Company was able to bill the customer due to the fact that the milestoneshave been reached.

The Company experiencedpositive cash flows of $1,029,404 in 2005 due to increased accrued liabilitiesrelated to interest on the 2005 debt as well as contract related costs notbeing invoiced by vendors. In 2004, the Company experienced positive cash flowsof $955,050 related to interest on the 2004 debt as well as liabilities assumedthrough acquisitions.

The Company alsoexperienced a positive cash flow from an increase of $1,191,958 in deferredrevenue from 2004 to 2005 due to customers who had purchased and paid formaintenance agreements which the company had to earn typically over a one yearperiod.

The overall major driversin operating cash flow are the current operating costs which are greater thanthe current revenues. The company has experienced improvements related to theratio of operating expenses to revenues and expects this trend to continue toimprove until such time as the Company is able to generate sustainedprofitability.

***FINANCING ACTIVITIES OVERVIEW***

***Financing Activities***

**2005Senior and Subordinate Term Notes**

On June 8, 2005, weentered into a Securities Purchase Agreement (the “Senior Purchase Agreement”)with an institutional investor. Under the Senior Purchase Agreement, theCompany issued a Secured Convertible Term Note (the “Senior Convertible Note”)in the aggregate principal amount of $2,000,000, convertible into Common Stockof the Company in certain circumstances at $0.85 per share, and issued awarrant (the “Senior Warrant”) to purchase an aggregate of 444,444 shares ofthe Common Stock at a per share exercise price of $1.00. The aggregateconsideration received by the Company, net of all fees and expenses, for theSenior Convertible Note and the Senior Warrant was approximately $1,841,000.The proceeds from this transaction are to be used for working capital purposes.The Company’s obligations under the Senior Purchase Agreement and the SeniorConvertible Notes are secured by a security interest in all or substantiallyall of the Company’s assets.

Under the terms of theSenior Convertible Note, we are required to make monthly payments of accruedinterest only beginning on July 1, 2005. In addition, the SeniorConvertible Note provides for monthly payments of principal in equal 1/32increments thereof, plus accrued interest, commencing October 1, 2005.

We entered into aSecurities Purchase Agreement, effective as of May 31, 2005, (the “SubordinatedPurchase Agreement”) with existing shareholders of the Company and otheraccredited investors (collectively, the “Subordinated Investors”). Under theSubordinated Purchase Agreement, the Company issued Convertible Term Notes (the“Subordinated Convertible Notes”) in the aggregate principal amount of$2,794,723, respectively convertible into Common Stock of the Company incertain circumstances at $0.70 per share, and issued warrants (the “SubordinatedWarrants”) to purchase an aggregate of 828,066 shares of the Common Stock at aper share exercise price of $1.00. The aggregate consideration received by theCompany, net of all fees and expenses, for such Subordinated Convertible Notesand Subordinated Warrants was approximately $2,411,000. The proceeds from thistransaction are to be used for working capital purposes. The SubordinatedConvertible Notes were issued at a purchase price equal to $900 for each $1,000of principal amount of the Note.

28

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Certain SubordinatedInvestors purchased additional Subordinated Convertible Notes in the aggregateprincipal amount of $450,000 and received additional Subordinated Warrants topurchase an aggregate of 133,333 shares of Common Stock at a per share exerciseprice of $1.00. The aggregate consideration received by the Company net of allfees and expenses for such Subordinated Convertible Notes and SubordinatedWarrants was $404,500, which was paid by the Subordinated Investors on July 8,2005.

Under the terms of theSubordinated Convertible Notes, we are required to make quarterly payments ofaccrued interest only beginning on September 1, 2005. In addition, theSubordinated Convertible Notes provide for quarterly payments of principal inequal increments thereof, plus accrued interest, commencing September 1,2006 through May 31, 2008, which payments may be made in shares of commonstock at the option of each note holder.

**2005Amendment and Waivers**

The Company entered intoan Amendment and Waiver with Laurus, dated as of August 31, 2005, pursuantto which the Company was permitted to defer the payment of the monthlyprincipal amounts due and payable for the months of September, October, November andDecember 2005 under both (a) the Secured Convertible Term Note in theoriginal principal amount of $5,000,000 issued by the Company to Laurus on September 29,2004(the “September 2004 Note”), and (b) the Secured Convertible Term Notein the original principal amount of $2,000,000 issued by the Company to Lauruson June 8, 2005 (the “June 2005 Note”), such aggregate deferredprincipal amounts being equal to $625,000 and $187,500, respectively. Thedeferred principal amount under the September 2004 Note is now due on September 29,2007, the maturity date of that note, and will be paid at the same time thefinal payments due with respect to that note upon maturity. The deferredprincipal amount under the June 2005 Note is now due on June 7, 2008,the maturity date of that note, and will be paid at the same time the finalpayments due with respect to that note upon maturity. The Company will remainobligated to pay all monthly interest amounts under these notes as they arecurrently due.

The Company also enteredinto Amendment and Waivers, dated as of August 31, 2005, pursuant to whichcertain Subordinated Investors allowed the Company to defer the payment of themonthly principal amounts due and payable for the months of September, October,November and December 2005 under the Convertible Term Notes in theaggregate original principal amount of $2,800,000 issued by the Company to theSubordinated Investors on September 29, 2004 (the “Subordinated Notes”),such aggregate deferred principal amount being equal to $350,004. The deferredprincipal amount under each Subordinated Note is now due on September 29,2007, the maturity date of each such note, and will be paid at the same timethe final payments due with respect to each such note upon maturity. TheCompany will remain obligated to pay all monthly interest amounts under thesenotes as they are currently due.

**2006Amendment and Waiver**

The Company entered intoan Amendment No. 1 to its Subordinated Secured Promissory Note, dated asof January 23, 2006, with Aether Systems, Inc. Pursuant to the AetherNote Amendment, the Subordinated Secured Promissory Note issued by the Companyto Aether on September 30, 2004 in the aggregate maximum principal amountof $6,884,588 was amended to increase such aggregate maximum principal amountto $7,884,588.

The Company entered intoa Securities Purchase Agreement, effective as of January 23, 2006, withThe Shaar Fund, Ltd., Longview Fund, L.P. and Longview Special Finance. Underthe Securities Purchase Agreement, the Company issued to the PurchasersConvertible Term Notes in the aggregate principal amount of$1,000,000. The Convertible Notes converted into shares of the Series BPreferred Stock of the Company, which shares are convertible into shares of theCommon Stock of the Company at an initial fixed conversion price of $0.70 pershare.

Effective as of January 23,2006, BIO-key International, Inc. entered into an Amendment and Waiverwith Laurus Master Fund Ltd. in connection with the Secured Convertible Notescurrently held by Laurus. Under the Secured Notes Amendment and Waiver, theSecured Notes issued by the Company to Laurus on September 29, 2004 in theaggregate principal amount of $5,000,000 and on June 7, 2008 in theaggregate principal amount of $2,000,000 were amended as follows: (i) thematurity date of the September 2004 Note was extended to January 1,2008; (ii) the maturity date of the June 2005 Note was extended to December 1,2008, and (iii) the fixed conversion price under each of the Secured Noteswas reset from $1.35 to $0.85 per share. In addition, the exercise price of allwarrants to purchase Common Stock of the Company held by Laurus was reset to$1.00 per share.

Effective as of January 23,2006, the Company also entered into an Amendment and Waiver with certainholders of its Subordinated Convertible Promissory Notes. Under theSubordinated Notes Amendment and Waiver, the Subordinated Notes issued by theCompany on September 29, 2004 in the aggregate principal amount of$5,288,221 and on May 31, 2005 in the aggregate principal amount of$3,244,723 were amended as follows: (i) the maturity dates were extendedfrom September 29,2007 and May 31, 2008, respectively, to January 1,2009; (ii) the interest rate was fixed at fifteen percent (15%); (iii) allprincipal amounts are due at the maturity date and shall be paid in shares ofCommon Stock priced at $0.70 per share if the average closing price of theCommon Stock for the thirty (30) trading days immediately preceding thematurity date is greater than $1.10; (iv) interest shall be paid, at theCompany’s election, in cash or shares of Common Stock, with the Common Stockpriced at the average closing price of the Common Stock for the ten (10) tradingdays immediately preceding the repayment date; and (v) the currentlyapplicable fixed conversion price was amended to $0.70 per share. In addition,the exercise price of all warrants to purchase Common Stock held by theSubordinated Note Holders that currently have an exercise price greater than$1.00 per share was reset to $1.00 per share. In connection with thisfinancing, we also reduced the conversion price of the Series Aconvertible Preferred shares held by the Shaar Fund Ltd. to $0.70 per share.

29

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***Liquidity outlook***

At December 31, 2005our total of cash and cash equivalents was $1,422,827. The total was $956,230and $1,012,790 at December 31, 2004 and 2003, respectively. We havefinanced ourselves through access to the capital markets by issuing debtsecurities, convertible preferred stock and common stock.

As of March 23,2006, we had cash resources of approximately $1,830,000 and $11,277,000 ofconvertible debt as described in the “Long-Term Obligations” footnote of thisreport below. We currently require approximately $1,700,000 per month toconduct our operations. During the fourth quarter of 2005, we generatedapproximately $3,368,000 of revenue and expect to increase quarterly revenue in2006.

TheCompany has undertaken strategic steps to position itself to realize positivecash flows from operations in the future by increasing revenues and bettermanaging expenses. These steps include the acquisition of two enterprises in2004. Although the acquisitions inherently produced a greater demand for cashthan we would have liked, we are confident that many of the initial costs areisolated in nature and will not be recurring year after year. The Company hasalso taken strategic steps to downsize the workforce in areas that we felt wereeither non essential or not in line with where we wanted the Company to developin the near future. The Company has also recently experienced additional costsassociated with various compliance related activities.

We may need to obtainadditional funding to (i) conduct the sales, marketing and technicalsupport necessary to execute our plan to substantially grow operations,increase revenue and serve a significant customer base; and (ii) provideworking capital. Due to, among other factors, our history of losses and limitedrevenue, our independent auditors have included an explanatory paragraph intheir opinion for the year ended December 31, 2005 as to the substantialdoubt about our ability to continue as a going concern. Our long-term viabilityand growth will depend upon the successful commercialization of ourtechnologies and our ability to obtain adequate financing. To the extent thatwe require such additional financing, no assurance can be given that any formof additional financing will be available on terms acceptable to us, thatadequate financing will be obtained to meet our needs, or that such financingwould not be dilutive to existing stockholders. If available financing isinsufficient or unavailable or we fail to continue to generate meaningfulrevenue, we may be required to further reduce operating expenses, delay theexpansion of operations, or be unable to pursue merger or acquisitioncandidates.

As of May 19, 2006, the Company was delinquentwith respect to some interest obligations on certain subordinated notes issuedin September 2004 and May 2005. Due to certain cross defaultprovisions contained in both the senior and subordinated notes, all outstandingdebt is considered to be in default. Accordingly, the Company has reclassifiedapproximately $8,849,000 of principal from long-term to current liabilities asof March 31, 2006 and approximately $9,734,000 of principal from long-termto current liabilities as of December 31, 2005. All of the relateddiscount and embedded derivatives associated with the debt has also beenreclassed to current.

**CONTRACTUALOBLIGATIONS**

Wehave various contractual obligations impacting our liquidity. The followingrepresents some of our contractual obligations as of December 31, 2005:

|                                                | ** ** | **Total** | ** ** | **2006**  | ** ** | **2007**  | ** ** | **2008**  | ** ** | **2009**  | ** ** |
|------------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|-----------|------------|-----------|------------|
| Non-cancelable  operating leases               |       | $         | 3,427,000  |      | $          | 1,260,000 |       | $         | 1,278,000  |      | $          | 866,000 |   | $ | 23,000 |   |
| Senior secured  convertible term notes         |       | 5,599,999 |       | 1,524,211 |       | 3,048,421 |       | 1,027,367 |       | —    |       |
| Subordinated  unsecured convertible term notes |       | 5,677,028 |       | 18,750    |       | 14,063    |       | —    |       | 5,644,215 |       |
|                                           |       |      |       |      |       |      |       |      |       |      |       |
| Total                                          |       | $         | 14,704,027 |      | $          | 2,802,961 |       | $         | 4,340,484  |      | $          | 1,893,367 |   | $ | 5,667,215 |   |

 

The Company doesnot own any real estate but conducts operations from four leased premises.These non-cancelable operating leases expire a various dates through 2009. Inaddition to base rent, the Company pays for property taxes, maintenance,insurance and other occupancy expenses according to the terms of the individualleases.

30

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**RESTATEMENT**

In the process of reviewing our registration statementfor the securities issued in our June 2005 financing, the staff of the Securitiesand Exchange Commission (“SEC”) raised questions with regard to our convertibleterm notes suggesting that we consider EITF 00-19 “Accounting forDerivative Financial Instruments Indexed to, and Potentially Settled in, aCompany’s Own Stock” to evaluate whether there were any embedded derivativeinstruments and if so, whether they should be accounted for as an equity orliability classification. The SEC staff suggested that we review themethodology used in the valuations of the embedded derivative instruments andalso review whether warrants issued with our 2004 financing should be accountedfor as an equity or liability classification. The SEC staff also commented thatthe Company should review the convertible notes issued in fiscal 2003 and 2004.The SEC staff also asked us to review adjustments to revenue made in the fourthquarter of 2004. The SEC staff raised the question of whether the transactionshad a material impact on previously filed Exchange Act reports and would bebetter characterized as restatements. Further, the Company recalculated theconvertible preferred stock dividends and accretion including the accrued butunpaid dividends in accordance with FAS 128 — *Earningsper Share*.

There were several itemsthat were identified as requiring restatement, these items were:

·                  *Revenue Recognition*

The Company reviewed contracts and purchase agreementsrelated to certain non-governmental customers and identified specific contractsfor which the initial accounting inflated annual and quarterly revenues andearnings in violation of generally accepted accounting principles (“GAAP”).These practices were primarily the result of recognizing revenue ontransactions with customers that were not creditworthy and recognizing revenuewhen the earnings process had not been completed. The revenue and related costhas been adjusted on the income statement as well as the related balance sheetaccounts.

·                  *Accounting for Convertible Financing Arrangements*

The Company reviewed the initial accounting for the 7%Convertible Notes issued in 2003, the Senior and Subordinated Convertible TermNotes issued in 2004 and the Senior and Subordinated Convertible Term Notesissued in 2005. During the review the company identified that EITF 00-19should be applied to evaluate whether any embedded derivative instrumentsqualify as equity instruments or as liabilities. As such certain embeddedderivatives were identified that met the conditions set forth under paragraph12 of SFAS No. 133. These embedded derivative instruments have beenevaluated using EITF 00-19 paragraphs 12 to 32 and determined that theseinstruments would not be classified as components of stockholders equity. Theinstruments have been deemed liabilities, and as such will be subject to SFAS133 and should be recorded at fair value. Features that have been evaluated anddetermined to require such treatment include:

·                  Theprincipal conversion option

·                  Themonthly payments conversion option

·                  Theinterest rate adjustment provisions.

Additionally, it was identified that certain othercomponents of the related financings were also incorrectly accounted for. Thisincludes the warrants issued with the above financing and the costs incurred byCompany in obtaining the above financings. The correction of prior errorsaffected the subsequent accounting for debt conversions to equity as well asthe amortization of related discounts and deferred finance charges associatedwith the above financings.

·      *Accounting for WarrantsRelated to the Companies 2004 Debt Financing*

Based on certain registration rights provisions it wasdetermined that the warrants issued with the 2004 Debt Financing would requirecontinued classification as a liability and revalued every quarter. The Companypreviously classified the warrants as equity upon the registration rightsagreement becoming effective during the fourth quarter of 2004.

·      *Valuations of EmbeddedDerivatives*

The initial valuation methodology overstated the valueof the conversion option derivatives. The company’s review of the valuations ofthe embedded derivatives determined that the valuation of the principalconversion option and the monthly payments conversion option shared certaincomponents that resulted in a double counting of the embedded derivativevaluation. As such the company has adjusted its valuations of these embeddedderivatives.

·      *Additional Derivative(Default Provision)*

The company also reviewed the default provisions setforth in the debt instruments and determined that an additional embeddedderivative existed that required bifurcation from the host contract and wouldneed to be revalued on a quarterly basis.

The Company reviewed the earnout calculationsperformed in the prior year for the PSG acquisition and identified an error inthe calculation. As a result the Company has restated the prior year’s impactrelating to this error. At December 31, 2004 the Company had accrued$43,635 for the earnout provision. The corrected calculation resulted in noaccrual being required, and as such the related accrual and goodwillbalances have been reduced by $43,635.

Management believes the scope and process of itsinternal review of previously reported financial information was sufficient toidentify issues of a material nature that could affect our ConsolidatedFinancial Statements and all dates and periods presented herein have beenrestated to fairly present the results of our operations.

The errors in our previously reported financial information,and the failure to prevent them or detect them in our financial reportingprocess, were largely attributable to weak internal controls, an inadequatestaff of competent accounting personnel with an appropriate level of knowledgeof GAAP and to errors in the valuations of the previously identified embeddedderivatives.

As a result of our review and communications with theSEC, we determined that a restatement of previously reported financialinformation was required. Our previously reported financial information shouldno longer be relied upon. Accordingly, we have restated our previously reportedfinancial information for the years ended December 31, 2003 and 2004 andour previously reported unaudited financial statements for the first, secondand third quarters of 2003, 2004 and 2005 (the “restatement”). The restatementcovers a number of separate matters, each of which is described above.

For the quarterly impact of the restatement and therestated financial results for the first, second and third quarters of 2003,2004 and 2005 see Note X, Results by Quarter.

31

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The followingtables summarize the impact of all of these adjustments on previously reportedrevenue and assets, liabilities, and stockholders’ equity (deficit) for theyears ended December 31, 2004 and 2003.
| ** **                  | ** ** | **Impact of Adjustments on Revenue  For the Years Ended December 31,** | ** ** |
|-----------------------------|------------|---------------------------------------------------------------------------------------------------------------------|------------|
| ** **                  | ** ** | **2005**                                                                                                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| **As  previously reported** | ** ** | $                                                                                                                   | 14,226,095 |   | $ | 5,558,231 |   | $ | 524,101 |   |
| Revenue  recognition        |       |                                                                                                                |       | 162,720 |   | (308,620 | ) |
| **As restated**             | ** ** | $                                                                                                                   | 14,226,095 |   | $ | 5,720,951 |   | $ | 215,481 |   |

 

|                                                   | ** ** | **Impact of Adjustments on Consolidated Balance  Sheet Accounts** | ** ** |
|---------------------------------------------------|------------|-------------------------------------------------------------------------------------------------|------------|
| ** **                                        | ** ** | **As of December 31, 2005**                                                 | ** ** |
| ** **                                        | ** ** | ** **                                                                                      | ** ** | ** ** | ** ** | **Stockholders’** | ** ** |
| ** **                                        | ** ** | **Total**                                                                                       | ** ** | ** ** | ** ** | **Equity** | ** ** |
| ** **                                        | ** ** | **Assets**                                                                                      | ** ** | **Liabilities** | ** ** | **(Deficit)** | ** ** |
| **As  previously reported**                       |       | $                                                                                               | 26,357,934 |   | $ | 17,050,206 |   | $ | 9,307,728 |   |
| Revenue  recognition and related SG&A expense |       | —                                                                                          |       | — |   | — |   |
| Debt financing                                    |       | —                                                                                          |       | 3,143,724 |   | (3,143,724 | ) |
| Total  Adjustments                                |       | —                                                                                          |       | 3,143,724 |   | (3,143,724 | ) |
| **As restated**                                   |       | $                                                                                               | 26,357,934 |   | $ | 20,193,930 |   | $ | 6,164,004 |   |

 
| ** **                                        | ** ** | **Impact of Adjustments on Consolidated Balance Sheet Accounts** | ** ** |
|---------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|
| ** **                                        | ** ** | **As of December 31, 2004**                                                     | ** ** | **As of December 31, 2003** | ** ** |
| ** **                                        | ** ** | ** **                                                                                          | ** ** | ** ** | ** ** | **Stockholders’** | ** ** | ** ** | ** ** | ** ** | ** ** | **Stockholders’** | ** ** |
| ** **                                        | ** ** | **Total**                                                                                           | ** ** | ** ** | ** ** | **Equity** | ** ** | **Total** | ** ** | **Total** | ** ** | **Equity** | ** ** |
| ** **                                        | ** ** | **Assets**                                                                                          | ** ** | **Liabilities** | ** ** | **(Deficit)** | ** ** | **Assets** | ** ** | **Liabilities** | ** ** | **(Deficit)** | ** ** |
| **As  previously reported**                       |       | $                                                                                                   | 30,844,681 |   | $ | 20,223,283 |   | $ | 10,621,398 |   | $ | 1,864,742 |   | $ | 11,000,731 |   | $ | (9,135,989 | ) |
| Revenue  recognition and related SG&A expense |       | (122,090                                                                                            | )          | 23,810 |   | (145,900 | ) | (308,620 | ) | (18,200 | ) | (290,420 | ) |
| Debt financing                                    |       | 816,501                                                                                             |       | 4,742,344 |   | (3,925,843 | ) | — |   | (57,543 | ) | 57,543 |   |
| Total  Adjustments                                |       | 694,411                                                                                             |       | 4,766,154 |   | (4,071,743 | ) | (308,620 | ) | (75,743 | ) | (232,877 | ) |
| **As restated**                                   |       | $                                                                                                   | 31,539,092 |   | $ | 24,989,437 |   | $ | 6,549,655 |   | $ | 1,556,122 |   | $ | 10,924,988 |   | $ | (9,368,866 | ) |

 

32

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The followingtables present the effect of the restatement adjustments on the consolidatedStatement of Operations for the years ended December 31, 2005, 2004 and2003.
| ** **                                                                  | ** ** | **Year Ended December 31, 2005** | ** ** |
|-----------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                  | ** ** | **As Previously**                               | ** ** | **Effect of** | ** ** | **As** | ** ** |
| ** **                                                                  | ** ** | **Reported**                                         | ** ** | **Restatement** | ** ** | **Restated** | ** ** |
| **Revenues**                                                                | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Services                                                                    |       | $                                                    | 10,861,649 |   | $ | — |   | $ | 10,861,649 |   |
| License fees and other                                                      |       | 3,364,446                                            |       | — |   | 3,364,446 |   |
|                                                                        |       | 14,226,095                                           |       | — |   | 14,226,095 |   |
| **Costs and other expenses**                                                | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Services                                                                    |       | 2,906,142                                            |       | — |   | 2,906,142 |   |
| Cost of license fees and other                                              |       | 937,491                                              |       | — |   | 937,491 |   |
| Selling, general and administrative                                         |       | 11,824,609                                           |       | — |   | 11,824,609 |   |
| Research, development and engineering                                       |       | 6,846,035                                            |       | — |   | 6,846,035 |   |
|                                                                        |       | 22,514,277                                           |       | — |   | 22,514,277 |   |
| **Operating  loss**                                                         |       | (8,288,182                                           | )          | — |   | (8,288,182 | ) |
| **Other income (deductions)**                                               | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest income                                                             |       | 35,958                                               |       | — |   | 35,958 |   |
| Interest expense                                                            |       | (6,548,130                                           | )          | 2,026,786 |   | (4,521,344 | ) |
| Derivative and warrant fair value adjustments                               |       | 15,213,186                                           |       | (6,058,235 | ) | 9,154,951 |   |
| Loss on sale of marketable securities                                       |       | (20,000                                              | )          | — |   | (20,000 | ) |
| Other expense                                                               |       | (34,767                                              | )          | — |   | (34,767 | ) |
| Total other income (deductions)                                             |       | 8,646,247                                            |       | (4,031,449 | ) | 4,614,798 |   |
| **NET  INCOME (LOSS)**                                                      |       | $                                                    | 358,065    |   | $ | (4,031,449 | ) | $ | (3,673,384 | ) |
|                                                                        |       |                                                 |       |   |   |   |   |
| **Basic Loss per Share:**                                                   | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                                 | * *   | * *                                             | * *   | * * | * * | * * | * * |
| Net loss                                                                    |       | $                                                    | 358,065    |   | $ | (4,031,449 | ) | $ | (3,673,384 | ) |
|                                                                        |       |                                                 |       |   |   |   |   |
| Convertible preferred stock dividends and accretion                         |       | (313,517                                             | )          |   |   | (313,517 | ) |
| Net Income (Loss) attributable to common  shareholders                      |       | $                                                    | 44,548     |   | $ | (4,031,449 | ) | $ | (3,986,901 | ) |
|                                                                        |       |                                                 |       |   |   |   |   |
| *Denominator*                                                               | * *   | * *                                             | * *   | * * | * * | * * | * * |
| Weighted average common shares outstanding                                  |       | 44,787,807                                           |       | 44,787,807 |   | 44,787,807 |   |
| ***Basic  Loss per Share***                                                 |       | $                                                    | 0.00       |   | $ | (0.09 | ) | $ | (0.09 | ) |
|                                                                        |       |                                                 |       |   |   |   |   |
| **Diluted Loss per Share:**                                                 | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                                 | * *   | * *                                             | * *   | * * | * * | * * | * * |
| Net Income (loss) attributable to common  shareholders                      |       | $                                                    | 44,548     |   | $ | (4,031,449 | ) | $ | (3,986,901 | ) |
|                                                                        |       |                                                 |       |   |   |   |   |
| Effect of Dilutive Securities: Convertible  Debentures                      |       | (8,795,834                                           | )          | 6,758,889 |   | (2,036,945 | ) |
|                                                                        |       |                                                 |       |   |   |   |   |
| Net loss attributable to common shareholders and  assumed conversions  |       | $                                                    | (8,751,286 | ) | $ | 2,727,440 |   | $ | (6,023,846 | ) |
|                                                                        |       |                                                 |       |   |   |   |   |
| *Denominator*                                                               | * *   | * *                                             | * *   | * * | * * | * * | * * |
| Weighted average shares outstanding                                         |       | 44,787,807                                           |       | — |   | 44,787,807 |   |
|                                                                        |       |                                                 |       |   |   |   |   |
| Effect of Dilutive Securities: Convertible  Debentures                      |       | 7,258,496                                            |       | — |   | 7,258,496 |   |
|                                                                        |       |                                                 |       |   |   |   |   |
| Diluted weighted average common shares and common  equivalents outstanding  |       | 52,046,303                                           |       | 52,046,303 |   | 52,046,303 |   |
| ***Diluted  Loss per Share***                                               |       | $                                                    | (0.17      | ) | $ | 0.05 |   | $ | (0.12 | ) |

 

33

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| ** **                                                                              | ** ** | **Year Ended December 31, 2004** | ** ** |
|-----------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                              | ** ** | **As Previously**                               | ** ** | **Effect of** | ** ** | **As** | ** ** |
| ** **                                                                              | ** ** | **Reported**                                         | ** ** | **Restatement** | ** ** | **Restated** | ** ** |
| **Revenues**                                                                            | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Services                                                                                |       | $                                                    | 3,351,406  |   | $ | — |   | $ | 3,351,406 |   |
| License fees and other                                                                  |       | 2,206,825                                            |       | 162,720 |   | 2,369,545 |   |
|                                                                                    |       | 5,558,231                                            |       | 162,720 |   | 5,720,951 |   |
| **Costs and other expenses**                                                            | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Services                                                                                |       | 1,174,324                                            |       | — |   | 1,174,324 |   |
| Cost of license fees and other                                                          |       | 889,896                                              |       | — |   | 889,896 |   |
| Selling, general and administrative                                                     |       | 7,096,088                                            |       | 18,200 |   | 7,114,288 |   |
| Research, development and engineering                                                   |       | 2,979,904                                            |       | — |   | 2,979,904 |   |
|                                                                                    |       | 12,140,212                                           |       | 18,200 |   | 12,158,412 |   |
| **Operating  loss**                                                                     |       | (6,581,981                                           | )          | 144,520 |   | (6,437,461 | ) |
| **Other income (deductions)**                                                           | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest income                                                                         |       | 66,824                                               |       | — |   | 66,824 |   |
| Interest expense                                                                        |       | (667,008                                             | )          | (748,527 | ) | (1,415,535 | ) |
| Derivative and warrant fair value adjustments                                           |       | —                                               |       | (3,008,419 | ) | (3,008,419 | ) |
| Other expense                                                                           |       | (55,300                                              | )          | — |   | (55,300 | ) |
| Total other income (deductions)                                                         |       | (655,484                                             | )          | (3,756,946 | ) | (4,412,430 | ) |
| **NET  LOSS**                                                                           |       | $                                                    | (7,237,465 | ) | $ | (3,612,426 | ) | $ | (10,849,891 | ) |
|                                                                                    |       |                                                 |       |   |   |   |   |
| **Basic Loss per Share:**                                                               | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                                             | * *   | * *                                             | * *   | * * | * * | * * | * * |
| Net loss                                                                                |       | $                                                    | (7,237,465 | ) | $ | (3,612,426 | ) | $ | (10,849,891 | ) |
|                                                                                    |       |                                                 |       |   |   |   |   |
| Convertible preferred stock dividends and accretion                                     |       | (414,240                                             | )          | 28,885 |   | (385,355 | ) |
| Net Loss attributable to common shareholders                                            |       | $                                                    | (7,651,705 | ) | $ | (3,583,541 | ) | $ | (11,235,246 | ) |
|                                                                                    |       |                                                 |       |   |   |   |   |
| *Denominator*                                                                           | * *   | * *                                             | * *   | * * | * * | * * | * * |
| Weighted average common shares outstanding                                              |       | 34,806,201                                           |       | 34,806,201 |   | 34,806,201 |   |
| ***Basic  Loss per Share***                                                             |       | $                                                    | (0.22      | ) | $ | (0.10 | ) | $ | (0.32 | ) |
|                                                                                    |       |                                                 |       |   |   |   |   |
| **Diluted Loss per Share:**                                                             | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                                             | * *   | * *                                             | * *   | * * | * * | * * | * * |
| Net loss attributable to common shareholders                                            |       | $                                                    | (7,651,705 | ) | $ | (3,583,541 | ) | $ | (11,235,246 | ) |
|                                                                                    |       |                                                 |       |   |   |   |   |
| Effect of Dilutive Securities: Convertible  Debentures                                  |       | —                                               |       | — |   | — |   |
|                                                                                    |       |                                                 |       |   |   |   |   |
| Net loss attributable to common shareholders and  assumed conversions    |       | $                                                    | (7,651,705 | ) | $ | (3,583,541 | ) | $ | (11,235,246 | ) |
|                                                                                    |       |                                                 |       |   |   |   |   |
| *Denominator*                                                                           | * *   | * *                                             | * *   | * * | * * | * * | * * |
| Weighted average shares outstanding                                                     |       | 34,806,201                                           |       | 34,806,201 |   | 34,806,201 |   |
|                                                                                    |       |                                                 |       |   |   |   |   |
| Effect of Dilutive Securities: Convertible  Debentures                                  |       | —                                               |       | — |   | — |   |
|                                                                                    |       |                                                 |       |   |   |   |   |
| Diluted weighted average common shares and common  equivalents outstanding              |       | 34,806,201                                           |       | 34,806,201 |   | 34,806,201 |   |
| ***Diluted  Loss per Share***                                                           |       | $                                                    | (0.22      | ) | $ | (0.10 | ) | $ | (0.32 | ) |

 

34

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| ** **                                                                 | ** ** | **Year Ended December 31, 2003** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                 | ** ** | **As Previously**                               | ** ** | **Effect of** | ** ** | **As** | ** ** |
| ** **                                                                 | ** ** | **Reported**                                         | ** ** | **Restatement** | ** ** | **Restated** | ** ** |
| **Revenues**                                                               | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Services                                                                   |       | $                                                    | 10,694     |   | $ | — |   | $ | 10,694 |   |
| License fees and other                                                     |       | 513,407                                              |       | (308,620 | ) | 204,787 |   |
|                                                                       |       | 524,101                                              |       | (308,620 | ) | 215,481 |   |
| **Costs and other expenses**                                               | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cost of services                                                           |       | 1,694                                                |       | — |   | 1,694 |   |
| Cost of license fees and other                                             |       | 87,387                                               |       | — |   | 87,387 |   |
| Selling, general and administrative                                        |       | 2,118,122                                            |       | (18,200 | ) | 2,099,922 |   |
| Research, development and engineering                                      |       | 1,037,330                                            |       | — |   | 1,037,330 |   |
|                                                                       |       | 3,244,533                                            |       | (18,200 | ) | 3,226,333 |   |
| **Operating  loss**                                                        |       | (2,720,432                                           | )          | (290,420 | ) | (3,010,852 | ) |
| **Other income (deductions)**                                              | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest expense                                                           |       | (1,109,786                                           | )          | (800,002 | ) | (1,909,788 | ) |
| Derivative and warrant fair value adjustments                              |       | —                                               |       | 857,545 |   | 857,545 |   |
| Other income                                                               |       | 4,145                                                |       | — |   | 4,145 |   |
| Total other income (deductions)                                            |       | (1,105,641                                           | )          | 57,543 |   | (1,048,098 | ) |
| **NET LOSS**                                                               |       | $                                                    | (3,826,073 | ) | $ | (232,877 | ) | $ | (4,058,950 | ) |
|                                                                       |       |                                                 |       |   |   |   |   |
| **Basic Loss per Share:**                                                  | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                                | * *   | * *                                             | * *   | * * | * * | * * | * * |
| Net loss                                                                   |       | $                                                    | (3,826,073 | ) | $ | (232,877 | ) | $ | (4,058,950 | ) |
|                                                                       |       |                                                 |       |   |   |   |   |
| Convertible preferred stock dividends and accretion                        |       | (136,755                                             | )          | — |   | (136,755 | ) |
|                                                                       |       |                                                 |       |   |   |   |   |
| Net loss attributable to common shareholders                               |       | $                                                    | (3,962,828 | ) | $ | (232,877 | ) | $ | (4,195,705 | ) |
|                                                                       |       |                                                 |       |   |   |   |   |
| *Denominator*                                                              | * *   | * *                                             | * *   | * * | * * | * * | * * |
| Weighted average common shares outstanding                                 |       | 17,543,586                                           |       | 17,543,586 |   | 17,543,586 |   |
|                                                                       |       |                                                 |       |   |   |   |   |
| ***Basic  Loss per Share***                                                |       | $                                                    | (0.23      | ) | $ | (0.01 | ) | $ | (0.24 | ) |
|                                                                       |       |                                                 |       |   |   |   |   |
| **Diluted Loss per Share:**                                                | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                                | * *   | * *                                             | * *   | * * | * * | * * | * * |
| Net loss attributable to common shareholders                               |       | $                                                    | (3,962,828 | ) | $ | (232,877 | ) | $ | (4,195,705 | ) |
|                                                                       |       |                                                 |       |   |   |   |   |
| Effect of Dilutive Securities: Convertible  Debentures                     |       | —                                               |       | — |   | — |   |
|                                                                       |       |                                                 |       |   |   |   |   |
| Net loss attributable to common shareholders and  assumed conversions      |       | $                                                    | (3,962,828 | ) | $ | (232,877 | ) | $ | (4,195,705 | ) |
|                                                                       |       |                                                 |       |   |   |   |   |
| *Denominator*                                                              | * *   | * *                                             | * *   | * * | * * | * * | * * |
| Weighted average shares outstanding                                        |       | 17,543,586                                           |       | 17,543,586 |   | 17,543,586 |   |
|                                                                       |       |                                                 |       |   |   |   |   |
| Effect of Dilutive Securities: Convertible  Debentures                     |       | —                                               |       | — |   | — |   |
|                                                                       |       |                                                 |       |   |   |   |   |
| Diluted weighted average common shares and common  equivalents outstanding |       | 17,543,586                                           |       | 17,543,586 |   | 17,543,586 |   |
|                                                                       |       |                                                 |       |   |   |   |   |
| ***Diluted  Loss per Share***                                              |       | $                                                    | (0.23      | ) | $ | (0.01 | ) | $ | (0.24 | ) |

 

35

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The following tablespresent the effect of the restatement adjustments on the Consolidated BalanceSheet as of December 31, 2005, 2004 and 2003.

**CONSOLIDATED BALANCE SHEET**
| ** **                                                                                                                                                                        | ** ** | **As of December 31, 2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                                                                                                                        | ** ** | **As Previously  Reported**                | ** ** | **Effect of  Restatement** | ** ** | **As Restated** | ** ** |
| **ASSETS**                                                                                                                                                                        | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash and cash  equivalents                                                                                                                                                        |       | $                                               | 1,422,827  |   | $ | — |   | $ | 1,422,827 |   |
| Receivables                                                                                                                                                                       |       |                                            |       |   |   |   |   |
| Billed less allowance for doubtful receivables as of  $160,000                                                                                                                    |       | 1,635,371                                       |       | — |   | 1,635,371 |   |
| Unbilled                                                                                                                                                                          |       | 201,942                                         |       | — |   | 201,942 |   |
| Costs and  earnings in excess of billings on uncompleted contracts                                                                                                                |       | 4,321,392                                       |       | — |   | 4,321,392 |   |
| Inventory                                                                                                                                                                         |       | 8,760                                           |       | — |   | 8,760 |   |
| Prepaid expenses                                                                                                                                                                  |       | 137,000                                         |       | — |   | 137,000 |   |
| Total current assets                                                                                                                                                              |       | 7,727,292                                       |       |   |   | 7,727,292 |   |
| Equipment and  leasehold improvements, net                                                                                                                                        |       | 548,267                                         |       | — |   | 548,267 |   |
| Deposits                                                                                                                                                                          |       | 1,828,560                                       |       | — |   | 1,828,560 |   |
| Intangible  assets—less accumulated amortization                                                                                                                             |       | 3,301,823                                       |       | — |   | 3,301,823 |   |
| Deferred  financing costs, net                                                                                                                                                    |       | 1,562,338                                       |       | — |   | 1,562,338 |   |
| Goodwill                                                                                                                                                                          |       | 11,389,654                                      |       | — |   | 11,389,654 |   |
| Total non-current assets                                                                                                                                                          |       | 18,630,642                                      |       | — |   | 18,630,642 |   |
| TOTAL ASSETS                                                                                                                                                                      |       | $                                               | 26,357,934 |   | $ | — |   | $ | 26,357,934 |   |
| **LIABILITIES**                                                                                                                                                                   | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Current  maturities of long-term obligations                                                                                                                                      |       | $                                               | 4,924,224  |   | $ | 3,143,724 |   | $ | 8,067,948 |   |
| Accounts payable                                                                                                                                                                  |       | 833,608                                         |       | — |   | 833,608 |   |
| Billing in  excess of costs and earnings on uncompleted contracts                                                                                                                 |       | 32,385                                          |       | — |   | 32,385 |   |
| Accrued  liabilities                                                                                                                                                              |       | 5,520,515                                       |       | — |   | 5,520,515 |   |
| Deferred rent                                                                                                                                                                     |       | 443,603                                         |       | — |   | 443,603 |   |
| Deferred revenue                                                                                                                                                                  |       | 3,264,283                                       |       | — |   | 3,264,283 |   |
| Total current liabilities                                                                                                                                                         |       | 15,018,618                                      |       | 3,143,724 |   | 18,162,342 |   |
| Long-term  obligations, net of discount and current maturities                                                                                                                    |       | —                                          |       | — |   | — |   |
| Deferred rent                                                                                                                                                                     |       | 867,850                                         |       | — |   | 867,850 |   |
| Deferred revenue                                                                                                                                                                  |       | 1,163,738                                       |       | — |   | 1,163,738 |   |
| Total non-current liabilities                                                                                                                                                     |       | 2,031,588                                       |       | — |   | 2,031,588 |   |
| TOTAL  LIABILITIES                                                                                                                                                                |       | 17,050,206                                      |       | 3,143,724 |   | 20,193,930 |   |
| **STOCKHOLDERS’  EQUITY (DEFICIT)**                                                                                                                                          | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Preferred  stock-authorized, 5,000,000 shares (liquidation preference of $100 per share)  Series A 7% Convertible; issued and outstanding, 44,557shares of $.0001  par value |       | 4                                               |       | — |   | 4 |   |
| Common  stock-authorized, 85,000,000 shares, 46,306,589 issued and outstanding of  $.0001 par value                                                                               |       | 4,632                                           |       | — |   | 4,632 |   |
| Additional  paid-in capital                                                                                                                                                       |       | 51,529,332                                      |       | (2,608,016 | ) | 48,921,316 |   |
| Accumulated  deficit                                                                                                                                                              |       | (42,226,240                                     | )          | (535,708 | ) | (42,761,948 | ) |
| TOTAL  STOCKHOLDERS’ EQUITY (DEFICIT)                                                                                                                                        |       | 9,307,728                                       |       | (3,143,724 | ) | 6,164,004 |   |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)                                                                                                                         |       | $                                               | 26,357,934 |   | $ | — |   | $ | 26,357,934 |   |

** **

36

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**CONSOLIDATED BALANCE SHEET**
| ** **                                                                                                                                                                       | ** ** | **As of December 31, 2004** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                                                                                                                       | ** ** | **As Previously  Reported**                | ** ** | **Effect of  Restatement** | ** ** | **As Restated** | ** ** |
| **ASSETS**                                                                                                                                                                       | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash and cash  equivalents                                                                                                                                                       |       | $                                               | 956,230    |   | $ | — |   | $ | 956,230 |   |
| Marketable debt  securities                                                                                                                                                      |       | 1,000,000                                       |       | — |   | 1,000,000 |   |
| Receivables                                                                                                                                                                      |       |                                            |       |   |   |   |   |
| Billed less allowance for doubtful receivables as of  $422,393                                                                                                                   |       | 1,698,144                                       |       | (90,090 | ) | 1,608,054 |   |
| Unbilled                                                                                                                                                                         |       | 310,523                                         |       | — |   | 310,523 |   |
| Due from selling  stockholders and other                                                                                                                                         |       | 60,793                                          |       | (32,000 | ) | 28,793 |   |
| Costs and  earnings in excess of billings on uncompleted contracts                                                                                                               |       | 6,292,603                                       |       | — |   | 6,292,603 |   |
| Inventory                                                                                                                                                                        |       | 29,599                                          |       | — |   | 29,599 |   |
| Prepaid expenses                                                                                                                                                                 |       | 113,130                                         |       | — |   | 113,130 |   |
| Total current assets                                                                                                                                                             |       | 10,461,022                                      |       | (122,090 | ) | 10,338,932 |   |
| Equipment and  leasehold improvements, net                                                                                                                                       |       | 644,101                                         |       | — |   | 644,101 |   |
| Costs and  earnings in excess of billings on uncompleted contracts                                                                                                               |       | 657,000                                         |       | — |   | 657,000 |   |
| Deposits                                                                                                                                                                         |       | 2,838,031                                       |       | — |   | 2,838,031 |   |
| Intangible  assets—less accumulated amortization                                                                                                                            |       | 4,177,279                                       |       | (77,982 | ) | 4,099,297 |   |
| Deferred  financing costs, net                                                                                                                                                   |       | —                                          |       | 938,118 |   | 938,118 |   |
| Goodwill                                                                                                                                                                         |       | 12,067,248                                      |       | (43,635 | ) | 12,023,613 |   |
| Total non-current assets                                                                                                                                                         |       | 20,383,659                                      |       | 816,501 |   | 21,200,160 |   |
| TOTAL ASSETS                                                                                                                                                                     |       | $                                               | 30,844,681 |   | $ | 694,411 |   | $ | 31,539,092 |   |
| **LIABILITIES**                                                                                                                                                                  | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Current  maturities of long-term obligations                                                                                                                                     |       | $                                               | 3,255,182  |   | $ | (192,460 | ) | $ | 3,062,722 |   |
| Advances from  stockholders                                                                                                                                                      |       | 12,753                                          |       | — |   | 12,753 |   |
| Accounts payable                                                                                                                                                                 |       | 1,325,282                                       |       | 23,810 |   | 1,349,092 |   |
| Billing in  excess of costs and earnings on uncompleted contracts                                                                                                                |       | 760,807                                         |       | — |   | 760,807 |   |
| Accrued  liabilities                                                                                                                                                             |       | 4,639,619                                       |       | (43,635 | ) | 4,595,984 |   |
| Deferred rent                                                                                                                                                                    |       | 393,676                                         |       | — |   | 393,676 |   |
| Deferred revenue                                                                                                                                                                 |       | 3,166,356                                       |       | — |   | 3,166,356 |   |
| Total current liabilities                                                                                                                                                        |       | 13,553,675                                      |       | (212,285 | ) | 13,341,390 |   |
| Long-term obligations,  net of discount and current maturities                                                                                                                   |       | 5,286,951                                       |       | 4,978,439 |   | 10,265,390 |   |
| Deferred rent                                                                                                                                                                    |       | 1,311,454                                       |       | — |   | 1,311,454 |   |
| Deferred revenue                                                                                                                                                                 |       | 71,203                                          |       | — |   | 71,203 |   |
| Total non-current liabilities                                                                                                                                                    |       | 6,669,608                                       |       | 4,978,439 |   | 11,648,047 |   |
| TOTAL  LIABILITIES                                                                                                                                                               |       | 20,223,283                                      |       | 4,766,154 |   | 24,989,437 |   |
| **STOCKHOLDERS’  EQUITY (DEFICIT)**                                                                                                                                         | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Preferred  stock-authorized, 5,000,000 shares (liquidation preference of $100 per share)  Series C 7% Convertible; issued and outstanding, 62,182 shares of $.01  par value |       | 623                                             |       | — |   | 623 |   |
| Common  stock-authorized, 85,000,000 shares, 40,680,691 issued and outstanding of  $.01 par value                                                                                |       | 406,808                                         |       | — |   | 406,808 |   |
| Additional  paid-in capital                                                                                                                                                      |       | 45,325,172                                      |       | (226,441 | ) | 45,098,731 |   |
| Accumulated  deficit                                                                                                                                                             |       | (35,111,205                                     | )          | (3,845,302 | ) | (38,956,507 | ) |
| TOTAL  STOCKHOLDERS’ EQUITY (DEFICIT)                                                                                                                                       |       | 10,621,398                                      |       | (4,071,743 | ) | 6,549,655 |   |
| TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY (DEFICIT)                                                                                                                       |       | $                                               | 30,844,681 |   | $ | 694,411 |   | $ | 31,539,092 |   |

 

37

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**CONSOLIDATED BALANCE SHEET**
| ** **                                                                                                                                                                      | ** ** | **As of December 31, 2003** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                                                                                                                      | ** ** | **As Previously  Reported**                | ** ** | **Effect of  Restatement** | ** ** | **As Restated** | ** ** |
| **ASSETS:**                                                                                                                                                                     | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash and cash  equivalents                                                                                                                                                      |       | $                                               | 1,012,790  |   | $ | — |   | $ | 1,012,790 |   |
| Receivables  billed                                                                                                                                                             |       | 409,803                                         |       | (308,620 | ) | 101,183 |   |
| Inventory                                                                                                                                                                       |       | 65,857                                          |       | — |   | 65,857 |   |
| Prepaid expenses                                                                                                                                                                |       | 165,929                                         |       | — |   | 165,929 |   |
| Total current assets                                                                                                                                                            |       | 1,654,379                                       |       | (308,620 | ) | 1,345,759 |   |
| Equipment and  leasehold improvements, net                                                                                                                                      |       | 60,157                                          |       | — |   | 60,157 |   |
| Intangible  assets—less accumulated amortization                                                                                                                           |       | 68,306                                          |       | — |   | 68,306 |   |
| Deferred  financing costs, net                                                                                                                                                  |       | 81,900                                          |       | — |   | 81,900 |   |
| Total non-current assets                                                                                                                                                        |       | 210,363                                         |       | — |   | 210,363 |   |
| TOTAL ASSETS                                                                                                                                                                    |       | $                                               | 1,864,742  |   | $ | (308,620 | ) | $ | 1,556,122 |   |
| **LIABILITIES:**                                                                                                                                                                | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Advances from  stockholders                                                                                                                                                     |       | $                                               | 34,030     |   | $ | — |   | $ | 34,030 |   |
| Accounts payable                                                                                                                                                                |       | 351,742                                         |       | — |   | 351,742 |   |
| Accrued  liabilities                                                                                                                                                            |       | 173,736                                         |       | (18,200 | ) | 155,536 |   |
| Deferred revenue                                                                                                                                                                |       | 10,000                                          |       | — |   | 10,000 |   |
| Total current liabilities                                                                                                                                                       |       | 569,508                                         |       | (18,200 | ) | 551,308 |   |
| Long-term  obligations, net of discount and current maturities                                                                                                                  |       | 10,431,223                                      |       | (57,543 | ) | 10,373,680 |   |
| Total  non-current liabilities                                                                                                                                                  |       | 10,431,223                                      |       | (57,543 | ) | 10,373,680 |   |
| TOTAL LIABILITIES                                                                                                                                                               |       | 11,000,731                                      |       | (75,743 | ) | 10,924,988 |   |
| **STOCKHOLDERS’  EQUITY (DEFICIT)**                                                                                                                                        | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Preferred  stock-authorized, 5,000,000 shares (liquidation preference of $100 per share)  Series B 9% Convertible; issued and outstanding, 4,180 shares of $.01  par value |       | 42                                              |       | — |   | 42 |   |
| Common  stock-authorized, 85,000,000 shares, issued and outstanding 21,222,990 of  $.01 par value                                                                               |       | 212,229                                         |       | — |   | 212,229 |   |
| Additional  paid-in capital                                                                                                                                                     |       | 18,327,992                                      |       | — |   | 18,327,992 |   |
| Accumulated  deficit                                                                                                                                                            |       | (27,676,252                                     | )          | (232,877 | ) | (27,909,129 | ) |
| TOTAL STOCKHOLDERS’  EQUITY (DEFICIT)                                                                                                                                      |       | (9,135,989                                      | )          | (232,877 | ) | (9,368,866 | ) |
| TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY (DEFICIT)                                                                                                                      |       | $                                               | 1,864,742  |   | $ | (308,620 | ) | $ | 1,556,122 |   |

 

38

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**CRITICALACCOUNTING POLICIES**

1.             *Basis of Consolidation*

The accompanyingconsolidated financial statements include the accounts of BIO-key International, Inc.and its wholly owned subsidiary (collectively, the Company) and are stated inconformity with accounting principles generally accepted in the United States,pursuant to the rules and regulations of the Securities and ExchangeCommission. Intercompany accounts and transactions have been eliminated inconsolidation.

2.             *Revenue Recognition*

Revenuesfrom software licensing are recognized in accordance with Statement of Position(SOP) No. 97-2, Software Revenue Recognition, as amended by SOP No. 98-9.Accordingly, revenue from software licensing is recognized when all of thefollowing criteria are met: persuasive evidence of an arrangement exists,delivery has occurred, the fee is fixed or determinable, and collectability isprobable.

TheCompany intends to enter into arrangements with end users for items which mayinclude software license fees, usage fees and services or various combinationsthereof. For each arrangement, revenues will be recognized when evidence of anagreement has been documented, the fees are fixed or determinable, collectionof fees is probable, delivery of the product has occurred and no othersignificant obligations remain.

Multiple-ElementArrangements: For multiple-element arrangements, each element of thearrangement will be analyzed and the Company will allocate a portion of thetotal fee under the arrangement to the elements using vendor specific objectiveevidence of fair value of the element, regardless of any separate prices statedwithin the contract for each element. Vendor specific objective evidence isbased on the price the customer is required to pay when the element is soldseparately (i.e., software license fees charged when consulting or otherservices are not provided, hourly rates charged for consulting services whensold separately from a software license or usage fees). If vendor specificobjective evidence of fair value does not exist for any undelivered elements,all revenue is deferred and recognized ratably over the service period if theundelivered element is services, or until sufficient objective evidence of fairvalue exists or all elements have been delivered.

LicenseRevenues: Amounts allocated to license revenues are recognized at the time ofdelivery of the software and all other revenue recognition criteria discussedabove have been met.

Revenuefrom licensing software, which requires significant customization andmodification, is recognized using the percentage of completion method, based onthe hours of effort incurred by the company in relation to the total estimatedhours to complete. In instances where third party hardware, software orservices form a significant portion of a customer’s contract, the companyrecognizes revenue for the element of software customization by the percentageof completion method described above. Third party hardware, software, andservices are recognized upon shipment or acceptance as appropriate. If thecompany makes different judgments or utilizes different estimates of the totalamount of work expected to be required to customize or modify the software, thetiming and revenue recognition, from period to period, and the margins on theproject in the reporting period, may differ materially from amounts reported.Revenues earned but not yet billed are shown as an asset in Costs and Earningsin Excess of Billings in the balance sheet. Billings in excess of cost andearnings are reflected as a liability in the balance sheet. Anticipatedcontract losses are recognized as soon as they become known and are estimable.

ServiceRevenues: Revenues from services are comprised of maintenance and consultingand implementation services. Maintenance revenues include providing forunspecified when-and-if available product updates and customer telephonesupport services, and are recognized ratably over the term of the serviceperiod. Consulting services are generally sold on a time-and-materials basisand include a range of services including installation of software andassisting in the design of interfaces to allow the software to operate incustomized environments. Services are generally separable from other elementsunder the arrangement since performance of the services are not essential tothe functionality of any other element of the transaction and are described inthe contract such that the total price of the arrangement would be expected tovary as the result of the inclusion or exclusion of the services. Revenues fromservices are generally recognized as the services are performed.

UsageFees: Usage fees are charged on certain applications based on the customer’svolume of use. Usage revenue is recognized based on the actual level ofactivity used by the customer or, in the case of fixed-fee arrangements,ratably over the arranged time period.

TheCompany provides customers, free of charge or at a minimal cost, testing kitswhich potential licensing customers may use to test compatibility/acceptance ofthe Company’s technology with the customer’s intended applications.

3.             Accounting for Acquisitions

Wehave completed our acquisitions of PSG and AMG. These acquisitions have beenaccounted for under the purchase method of accounting, which has resulted inrecording significant goodwill and other intangible asset balances. Thepurchase prices have been allocated to 

39

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assets acquiredand liabilities assumed at their estimated fair values on the date of theacquisitions, as determined by management, and by appraisals with respect toidentifiable intangible assets. Our accounting for these acquisitions involvessignificant judgments and estimates regarding fair values of acquiredintangible assets, which are based on projections of future revenues and cashflows, assumptions regarding discount factors, royalty rates, tax rates,amortization methodologies and related useful lives. The developed technology(software), copyrighted software, marketing agreements, customer relationshipsand trademarks were valued using the income approach and are being amortized ona straight line basis over their estimated useful lives, which range from 5 to7 years.

4.             *Marketable Debt Securities*

TheCompany accounts for marketable securities pursuant to Statement of FinancialAccounting Standards No. 115—”Accounting for Certain Investments in Debtand Equity Securities (“SFAS 115”). SFAS 115 requires classificationof debt and equity securities in three categories: trading securities,available-for-sale securities and held-to-maturity securities. Debt and equitysecurities classified as trading securities are carried at fair value withunrealized gains or losses included in income. Debt and equity securitiesdesignated as available-for-sale, whose fair values are readily determinable,are carried at fair value with unrealized gains or losses included as acomponent of accumulated other comprehensive income, net of applicable taxes.Debt securities that are expected to be held-to-maturity are carried atamortized cost. On December 31, 2004, the Company’s investments were allclassified as available-for-sale. In January 2005 the Company sold theseinvestments and did not purchase any additional Marketable Debt Securities asof December 31, 2005.

5.             *Derivative and Warrant financial instruments*

Inconnection with the sale of debt or equity instruments, we may sell options orwarrants to purchase our common stock. In certain circumstances, these optionsor warrants may be classified as derivative liabilities, rather than as equity.Additionally, the debt or equity instruments may contain embedded derivativeinstruments, such as conversion options, which in certain circumstances may berequired to be bifurcated from the associated host instrument and accounted forseparately as a derivative instrument asset or liability.

Theidentification of, and accounting for, derivative instruments is complex. Ourderivative instrument liability is re-valued at the end of each reportingperiod, with changes in the fair value of the derivative liability recorded ascharges or credits to income, in the period in which the changes occur. For options,warrants and bifurcated conversion options that are accounted for as derivativeinstrument liabilities, we determine the fair value of these instruments usingthe Black-Scholes option pricing model. That model requires assumptions relatedto the remaining term of the instruments and risk-free rates of return, ourcurrent common stock price and expected dividend yield, and the expectedvolatility of our common stock price over the life of the option. Theidentification of, and accounting for, derivative instruments and theassumptions used to value them can significantly affect our financialstatements.

6.             *Goodwill and Intangible Assets*

Goodwillrepresents the excess of costs of an acquired entity over the net of theamounts assigned to assets acquired and liabilities assumed. The Company hasadopted Statement of Financial Accounting Standards (“SFAS”) No. 142,Goodwill and Other Intangible Assets., which requires the Company to testgoodwill for impairment annually or whenever events or changes in circumstancesindicate that the carrying value of an asset may not be recoverable, ratherthan amortize. Accordingly, the Company has not amortized goodwill. As providedby SFAS No. 142, the Company has elected to perform the annual assessmentof the carrying value of all goodwill as of September 30th of each year using a number of criteria,including the value of the overall enterprise. As of December 31, 2005,the Company believes that no material impairment exists. Future impairmentcharges from previous or future acquisitions, if any, will be reflected as anoperating expense in the statement of operations.

7.             *Deferred Revenue*

Deferred revenue includes customer advances andamounts that have been billed per the contractual terms but have not beenrecognized as revenue. The majority of these amounts are related to maintenancecontracts for which the revenue is recognized ratably over the applicable term,which generally is 12 months from the date the customer accepts the products.

8.             *Research and Development Expenditures*

Researchand development expenses include costs directly attributable to the conduct ofresearch and development programs primarily related to the development of oursoftware products and improving the efficiency and capabilities of our existingsoftware. Such costs include salaries, payroll taxes, employee benefit costs,materials, supplies, depreciation on research equipment, services provided byoutside contractors, and the allocable portions of facility costs, such asrent, utilities, insurance, repairs and maintenance, depreciation and generalsupport services. All costs associated with research and development isexpensed as incurred.

9.             *Earnings Per Share Common Stock*

Earningsper share of common stock-basic is computed by dividing Net Income applicableto common stockholders by the weighted-average number of common sharesoutstanding for the period. Earnings per share of common stock-assumingdilution reflects the maximum potential dilution that could occur if securitiesor other contracts to issue common stock were exercised or converted intocommon stock and would then share in the net income of the company. See note U “EarningsPer Share of Common Stock,” for additional information.

10.           *Income Taxes*

Theprovision for, or benefit from, income taxes includes deferred taxes resultingfrom the temporary differences in income for financial and tax purposes usingthe liability method. Such temporary differences result primarily from thedifferences in the carrying value of assets and liabilities. Future realizationof deferred income tax assets requires sufficient taxable income within thecarry back, carry forward period available under tax law. The Companyevaluates, on a quarterly basis whether, based on all available evidence, if itis probable that the deferred income tax assets are realizable. Valuationallowances are established when it is more likely than not that the tax benefitof the deferred tax asset will not be realized. The evaluation, as prescribedby Statement of Financial Accounting Standards No. 109, “Accounting forIncome Taxes,” includes the consideration of all available evidence, bothpositive and negative, regarding historical operating results including recentyears with reported losses, the estimated timing of future reversals ofexisting taxable temporary differences, estimated future taxable incomeexclusive of reversing temporary differences and carryforwards, and potentialtax planning strategies which may be employed to prevent an operating loss ortax credit carry forward from expiring unused. Because of the Companieshistorical performance and estimated future taxable income a full valuationallowance has been established.

11.           *Accounting for Stock-Based Compensation*

TheCompany’s employee stock compensation plans are accounted for in accordancewith Accounting Principles Board Opinion No. 25, “Accounting for StockIssued to Employees” (“APB 25”) and related interpretations. Under thismethod, no compensation expense is recognized as long as the exercise priceequals or exceeds the market price of the underlying stock on the date of thegrant. The Company elected the disclosure-only alternative permitted underStatement of Financial Accounting Standards No. 123, “Accounting forStock-Based Compensation” (“FAS 123”), as amended by FAS 148, forfixed stock-based awards to employees. All non-employee stock-based awards areaccounted for at fair value and recorded as compensation expense over theperiod of service in accordance with FAS 123 and related interpretations.

On December 31,2005, the Company accelerated the vesting of certain of the outstanding optionsto purchase shares of the Company’s common stock with option exercise pricesgreater than the fair market value of the Company’s common stock on such date. Theacceleration applies to all such options outstanding as of December 31,2005 under the Company’s 1996 Stock Option Plan, 1999 Stock Option Plan and2004 Stock Option Plan, except for options held by the Company’s executiveofficers subject to Section 16(b) of the Securities Exchange Act of1934, as amended, and the members of the Company’s Board of Directors. Optionsto purchase up to 897,614 shares of the Company’s common stock, or 14% of thetotal shares of the Company’s common stock subject to outstanding options, witha weighted average exercise price of approximately $1.09 and varying remainingvesting schedules, are subject to this acceleration and become immediatelyvested and exercisable as of December 31, 2005. The number of shares,exercise prices and other terms of the options subject to the accelerationremain unchanged.

As aresult of this acceleration, the Company expects to reduce its exposure to theeffects of the Financial Accounting Standards Board’s Statement of FinancialAccounting Standards No. 123 (revised 2004), Share-Based Payment (FAS123R), which requires companies to recognize stock-based compensation expenseassociated with stock options based on the fair value method. The Companycurrently expects a reduction in stock-based compensation expense associatedwith this acceleration of approximately $330,000 for fiscal year 2006 andapproximately $225,000 for fiscal year 2007.

In December 2002,the Financial Accounting Standards Board (FASB) issued SFASB No.148, Accountingfor Stock-Based Compensation-Transition and Disclosure. SFAS No. 148amends SFAS No. 123, Accounting for Stock-Based Compensation, to providealternative methods of transition for a voluntary charge to the fair valuebased method of accounting for stock-based employee compensation. In addition,SFAS No. 149 requires expanded more prominent disclosure in both annualand interim financial statements about the method of stock-based employeecompensation and the effect of the method on reported results.

TheCompany has not adopted a method under SFAS No. 148 to expense stockoptions but rather continues to apply the recognition and measurementprovisions of APB Opinion No. 25, Accounting for Stock issued toEmployees, and related interpretations in accounting for those plans. Nostock-based employee compensation expense for options is reflected in netincome or loss for the fiscal periods presented as all options granted underthose plans had an exercise price equal to or lower than the market price ofthe underlying common stock at the date of grant.

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12.           *Use of Estimates*

Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities atthe date of the financial statements, the reported amounts of revenues andexpenses during the reporting period, and disclosure of contingent assets andliabilities. Actual results could differ from those estimates.

Estimatesand assumptions which, in the opinion of management are used in accounting for,among other things, long-term contracts, allowances for uncollectiblereceivables, recoverability of goodwill and other long-lived assets,depreciation and amortization, valuation of deferred income taxes, convertiblenotes and related preferred stock, and stock options, discounts, embeddedderivatives, and warrants outstanding.

**OTHERMATTERS**

**NotApplicable**

**RECENTACCOUNTING STANDARDS**

In November 2005,FASB issued FSP FAS 115-1 and FAS 124-1, “The Meaning ofOther-Than-Temporary Impairment and Its Application to Certain Investments” (“FSPFAS 115-1”), which provides guidance on determining when investmentsin certain debt and equity securities are considered impaired, whether that impairmentis other-than-temporary, and on measuring such impairment loss. FSP FAS 115-1also includes accounting considerations subsequent to the recognition of another-than temporary impairment and requires certain disclosures aboutunrealized losses that have not been recognized as other-than-temporaryimpairments. FSP FAS 115-1 is required to be applied to reportingperiods beginning after December 15, 2005. We are required to adopt FSPFAS 115-1 in the first quarter of fiscal 2006. We do not expect that theadoption of the statement will have a material impact on our consolidatedresults or financial condition.

In May 2005,FASB issued SFAS 154, “Accounting Changes and Error Corrections—a replacementof APB Opinion No. 20 and FASB Statement No. 3”. SFAS 154 changes therequirements for the accounting for and reporting of a change in accountingprinciple, and applies to all voluntary changes in accounting principle. Italso applies to changes required by an accounting pronouncement in the unusualinstance that the pronouncement does not include specific transitionprovisions. This statement requires retrospective application to prior periods’financial statements of changes in accounting principle, unless it isimpracticable to determine either the period-specific effects or the cumulativeeffect of the change. SFAS 154 is effective for accounting changes made infiscal years beginning after December 15, 2005. We do not expect thatadoption of this statement will have a material impact on our results of operationsor financial condition.

In March 2005,the FASB issued FASB Interpretation No. 47, *Accounting for Conditional Asset Retirement Obligations — aninterpretation of FASB Statement No. 143*(FIN 47), whichrequires companies to recognize a liability for the fair value of a legalobligation to perform asset retirement activities that are conditional on afuture event if the amount can be reasonably estimated. We adopted theprovisions of FIN 47 on December 31, 2005. No conditional asset retirementobligations were recognized and, accordingly, the adoption of FIN 47 had noeffect on our financial statements.

In December 2004,the FASB issued SFAS No. 123 (revised 2004), *Share-Based Payment*(SFAS 123R). This statementreplaces SFAS No. 123 and supersedes *APBOpinion No. 25, Accounting for Stock Issued to Employees.*SFAS 123Rrequires all share-based payments to employees, including grants of employeestock options, to be recognized in the financial statements based on their fairvalue. The pro-forma disclosures previously permitted under SFAS 123 nolonger will be an alternative to financial statement recognition. For theCompany, SFAS 123R is effective for periods beginning after December 15,2005. We plan to adopt SFAS 123R on January 1, 2006 using the modifiedprospective application method described in the statement. Under the modifiedprospective application method, we will apply the standard to new awards and toawards modified, repurchased, or cancelled after the required effective date.Additionally, compensation cost for the unvested portion of awards outstandingas of the required effective date will be recognized as compensation expense asthe requisite service is rendered after the required effective date. We areevaluating the impact of adopting SFAS 123R and expect that we will recordsubstantial non-cash stock compensation expenses. The adoption ofSFAS 123R is not expected to have a significant effect on our cash flowsbut is expected to have a significant adverse effect on our results ofoperations. The future impact of the adoption of SFAS 123R cannot bepredicted at this time because it will depend upon the levels of share-basedpayments granted in the future. However, had we adopted SFAS 123R in priorperiods, the impact would have approximated the impact of SFAS 123 asdescribed in the disclosure of pro forma net loss attributable to commonstockholders included in the Stock-Based Compensation footnote.

In November 2004,the FASB issued Statement No. 151,*Inventory Costs—an amendment of ARB No. 43, Chapter 4*, whichamends and clarifies existing accounting literature regarding abnormal amountsof idle facility expense, freight, handling costs, and wasted material(spoilage). This statement is effective for inventory costs incurred duringfiscal years beginning after June 15, 2005, with earlier applicationpermitted. The provisions of this statement are to be applied prospectively. Theadoption of this standard is not expected to have a material effect on theCompany’s financial position, results of operations, or liquidity.

**ITEM 7.**                    FINANCIALSTATEMENTS

Seefinancial statements appearing at pages 50-139 of this report

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

Not applicable.

**ITEM 8A.**           CONTROLS AND PROCEDURES

### **Remediation of Previously Reported Material Weaknessesin Internal Control over Financial Reporting**

An evaluation of the effectiveness of the Company’s “disclosurecontrols and procedures” (as such term is defined in Rules 13(a)-15(e) or15d-15(e) of the Securities Exchange Act of 1934, as amended (the “ExchangeAct)) as of December 31, 2005 was carried out by the Company under thesupervision and with the participation of the Company’s Co-Chief ExecutiveOfficers (“Co-CEOs”) and Chief Financial Officer (“CFO”). As previouslydescribed in our Quarterly Reports on Form 10-QSB for the periodsended March 31, 2005, June 30, 2005 and September 30, 2005, wenoted that our independent auditors, DS&B, Ltd., in a letter to the AuditCommittee of the Company’s Board of Directors dated April 18, 2005, hadidentified material weaknesses in the Company’s internal control systems.

In order to ensure that the Company adequatelyaddresses all existing internal control issues, the Company initiated follow-updiscussions with its auditors to better determine what constituted thesematerial weaknesses. During these discussions, the auditors and the Companyidentified the following weaknesses in the Company’s internal controls: aninadequate system to capture disclosure items, an inadequate internal processof review for account reconciliations, an inadequate documentation of internalcontrols and an inadequate internal processes around drafting of periodicfilings with the Securities and Exchange Commission.

During the fiscal quarter ended December 31,2005, we have implemented changes that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting. These measures include the following:

·                  InadequateSystem to capture Disclosure Items

·                  The Companyretained the services of a consulting firm that specializes in handling complexaccounting issues to assist with its SB-2 registration statement and theresponses to the SEC Staff’s comments related to that registration statementand its periodic filings.

·                  The Companyreplaced its Assistant Controller with a Corporate Controller. This individualis a Certified Public Accountant with over ten years of experience.

·                  The Companyhired a Manager of Accounting Operations with four years of public accountingexperience.

·                  InadequateInternal Process of Review for Account Reconciliations

·                  The Companyinstituted a more formal general ledger close process. Reconciliations for allbalance sheet accounts are now prepared by the Company’s accounting staff andthen reviewed by either the Manager of Accounting Operations or the CorporateController prior to the preparation of the financial statements.

Other than the foregoing remedial measures, which theCompany believes have, and will continue to, materially improve its internalcontrol over financial reporting, there were no changes in the Company’s internalcontrol over financial reporting that occurred during the fiscal quarter ended December 31,2005 that have materially affected, or are reasonably likely to materiallyaffect, the Company’s internal control over financial reporting. From January 1,2006 through the date of this Report, we have continued to implement additionalchanges that have materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting. These measures includethe following:

·                  InadequateSystem to capture Disclosure Items

·                  In March 2006,the Company hired a Manager of Reporting who is a Certified Public Accountantwith eighteen years of experience.

·                  InadequateDocumentation of Internal Controls

·                  The Company isin the process of identifying, analyzing and documenting the internal controlsthat it believes are critical to ensuring the accuracy of the transactions thatare being recorded in the Company’s accounting system. Some of the areas thatare currently being documented include the revenue cycle, the disbursementcycle and equity transactions.

·                  InadequateInternal Process Around Drafting of periodic filings with the Securities andExchange Commission

·                  As part of the drafting of this Report, theCompany’s Audit Committee increased its oversight of the disclosure andreporting processes.

·                  In preparingthis Report, the Company utilized a more formal disclosure checklist to ensureaccuracy.

As noted above, the Company has identified four areasof material weakness in its internal control systems. While significantprogress has been made to date to correct these weaknesses, we believe that allfour areas still constitute material weaknesses. Based upon their evaluation ofthese conditions, the Company’s Co-CEOs and CFO concluded that, as of December 31,2005, the Company’s disclosure controls and procedures were not effective toprovide reasonable assurance that information the Company is required todisclose in reports that it files or submits under the Exchange Act isrecorded, processed, summarized and reported within the time periods specifiedin the Securities and Exchange Commission rules and forms.

Most of the process improvements detailed above wereinitiated during the fourth quarter of 2005 and several of our key financial personnelwere also hired during that period. The Company intends to continue toimplement changes to its internal control system during the remainder of 2006to remediate the material weaknesses that have been identified. In particular,we will continue to make additions to our finance organization and relatedprocesses in an effort to further strengthen our internal controls. We willcontinue to retain the services of outside consultants to assist us withaccounting for complex, non-routine transactions such as the financingtransactions which we have completed during the prior two years. We will alsocontinue to formalize our internal procedures to assure that all complex,non-routine transactions, as well as all aspects of our periodic filings, arereviewed by senior management and other accounting personnel with sufficienttechnical accounting expertise to evaluate and document such transactions andto provide related disclosure in our periodic filings. The Company believesthat it will take two to three quarters from the date of this Report before thefull benefit of all of these remedial measures will be realized.

### **Evaluationof Disclosure Controls and Procedures as of December 31, 2005**

An evaluation of the effectiveness of the Company’s “disclosurecontrols and procedures” (as such term is defined in Rules 13a-15(e) or15d-15(e) of the Securities Exchange Act of 1934, as amended (the “ExchangeAct”)) as of December 31, 2005,was carried out by the Company under thesupervision and with the participation of the Company’s Co-Chief ExecutiveOfficers (“Co-CEOs”) and Chief Financial Officer (“CFO”).

As noted above, the Company has identified four areasof material weakness in its internal controls systems. While significantprogress was made in 2005 to correct these weaknesses, we believe that all fourareas still constitute material weaknesses. Based upon their evaluation ofthese conditions, the Company’s CO-CEOs and CFO concluded that, as of December 31,2005, the Company’s disclosure controls and procedures were not effective toprovide reasonable assurance that information the Company is required todisclose in reports that it files or submits under the Exchange Act isrecorded, processed, summarized and reported within the time periods specifiedin the Securities and Exchange Commission rules and forms.

The Company intends to continue to implement changesto its internal control system in 2006 to remediate the material weaknessesthat have previously been identified. Also, we will continue to make additionsto our finance organization and related processes in an effort to strengthenour internal controls.

**ITEM 8B.**           OTHER INFORMATION

Not applicable.

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**PART III**

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

The following sets forthcertain information about each director and executive officer of the Company.
| **NAME**               | ** ** | **AGE** | ** ** | **POSITIONS HELD**                                              |
|------------------------|------------|---------|------------|-----------------------------------------------------------------|
| Thomas J.  Colatosti   |       | 58      |       | Co-Chief Executive Officer, Chairman of the Board of  Directors |
| Michael W.  DePasquale |       | 51      |       | Co-Chief Executive Officer and Director                         |
| Jeffrey J. May         |       | 46      |       | Director                                                        |
| Charles P.  Romeo(a)   |       | 64      |       | Director                                                        |
| John Schoenherr        |       | 53      |       | Director                                                        |
|                   |       |    |       |                                                            |
| Francis J.  Cusick     |       | 51      |       | Chief Financial Officer                                         |
| Randy Fodero           |       | 47      |       | Vice President of Sales                                         |
| Kenneth S. Souza       |       | 51      |       | General Manager, Law Enforcement and Chief  Technology Officer  |

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(a)             FromApril 2004 to February 2005, Mr.Romeo was employed by the Company.

The following is a briefsummary of the business experience of each of the above-named individuals:

**THOMASJ. COLATOSTI**has served as a Director of the Company since September 2002and as Chairman of the Board since January 3, 2003. He has served asCo-Chief Executive Officer since July 2005. Mr. Colatosti alsocurrently serves as the Chief Executive Officer of American Security Ventures,a Lexington, Massachusetts based consulting firm he founded which specializesin providing strategic management consulting services to emerging anddeveloping companies in the homeland security industry. From 1997 through June 2002,Mr. Colatosti served as the Chief Executive Officer of Viisage Technology, Inc.,a publicly traded biometric technology company focusing on biometricface-recognition technology and delivering highly secure identificationdocuments and systems. Between 1995 and 1997, Mr. Colatosti served asPresident and Chief Executive Officer of CIS Corporation, a higher educationindustry leader that designed and implemented integrated and flexible systemssolutions to manage entire university administrative operations. Prior to CIS, Mr. Colatostihad a 20-year career with Digital Equipment Corporation. His most recentresponsibility was Vice President and General Manager, Northeast Area, where hewas responsible for a business unit with annual revenues of more than $1.2 billionand 3,000 people. Mr. Colatosti is an active industry securityspokesperson testifying before Congressional Committees and advising the WhiteHouse and other Federal security agencies on homeland security issues. Since August 18,2005, Mr. Colatosti has served as a Director and Chief Financial Officerof Good Harbor Partners Acquisition Corp., a publicly-traded blank checkcompany formed to acquire businesses in the security sectors. Mr. Colatostiearned a Bachelor of Science degree in Management and Finance as well as aMasters degree in Business Administration from Suffolk University.

**MICHAELW. DEPASQUALE**has served as the Chief Executive Officer and aDirector of the Company since January 3, 2003. He has served as Co-ChiefExecutive Officer since July 2005. Mr. DePasquale brings more than20 years of executive management, sales and marketing experience to theCompany. Prior to joining the Company, Mr. DePasquale served as thePresident and Chief Executive Officer of Prism eSolutions, Inc., a Pennsylvaniabased provider of professional consulting services and online solutions for ISO-9001/14000certification for customers in manufacturing, healthcare and governmentmarkets, since February 2001. From December 1999 through December 2000,Mr. DePasquale served as Group Vice President for WRC Media, a New Yorkbased distributor of supplemental education products and software. From January 1996until December 1999, Mr. DePasquale served as Senior Vice Presidentof Jostens Learning Corp., a California based provider of multi mediacurriculum. Prior to Jostes, Mr. DePasquale held sales and marketingmanagement positions with McGraw-Hill and Digital Equipment Corporation. Mr. DePasqualeearned a Bachelor of Science degree from the New Jersey Institute of Technology.

**JEFFREYJ. MAY **has served as a Director of the Company since October 29,2001. Since 1997, Mr. May has served as the President of GideonsPoint Capital, a Tonka Bay Minnesota based financial consulting firm and angelinvestor focusing on assisting and investing in start-up technology companies.In 1983, Mr. May co-found Advantek, Inc., a manufacturer ofequipment and materials which facilitate the automatic handling ofsemi-conductors and other electrical components which was sold in 1993. Mr. May continuedto serve as a director and Vice-President of Operations of Advantek until 1997,at which time it had over 600 employees and sales in excess of$100 million. Mr. May earned a Bachelor of Science degree inElectrical Engineering from the University of Minnesota in 1983.

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**CHARLESP. ROMEO**has served as a director of the Company since February 28,2005 and from January 29, 2003 to April 19, 2004. From April 2004until February 2005, he served as Vice President of Sales, Public SafetyDivision of the Company. From September 2002 until April 2004 Mr. Romeohas served as the President and Chief Executive Officer of FreedomBridgeTechnologies, Inc., a Rhode Island based consulting firm to technologycompanies in the homeland security industry specializing in implementing directand channel selling programs, strategic alliances and partnerships in the lawenforcement market. Prior to founding FreeedomBridge, Mr. Romeo had a33 year sales and marketing management career with Digital EquipmentCorporation, Compaq Computer Corporation and Hewlett Packard. During hiscareer, Mr. Romeo served as Vice President of Service Sales for a$500 million business unit, and Director of Public Sector Sales, a$275 million division of Hewlett Packard. Mr. Romeo authored *The Sales Manager’s Troubleshooter,*PrenticeHall 1998, which was named as one of the “top 10 must reads” by Sales andMarketing Magazine. Mr. Romeo earned a Bachelor of Science degree inMathematics and Economics from the University of Massachusetts and an ExecutiveMBA from Babson College.

**JOHNSCHOENHERR**has served as a Director of the Company since December 30,2004. Mr. Schoenherr serves as Vice President of Corporate PerformanceManagement for Oracle Corporation, and has served as an Oracle Vice Presidentfor over five years. Mr. Schoenherr has over 25 years of experiencein the area of business intelligence. His career includes a number of productdevelopment and management positions.

**FRANCISJ. CUSICK** has served as the Chief Financial of the Company sinceFebruary 28, 2005. Mr. Cusick joined the Company as the CorporateController in September 2004. Mr. Cusick served as an independentbusiness consultant to public and private companies in a variety of strategicand financial executive roles from March 2002 until September 2004.From January 2001 through February 2002, Mr. Cusick was ChiefFinancial Officer for SANgate Systems, a multi-national provider of storagehardware and software. Between November 1999 and December 2000, Mr. Cusickserved as Corporate Controller for Equipe Communications Corporation and wasresponsible for all accounting and finance functions. Prior to Equipe, Mr. Cusickheld senior financial management positions at Parametric Technology Corp.,Cascade Communications Corp. and Synernetics Inc.

**RANDYFODERO**has served as the Vice President of Sales since February 1,2006. From July 22, 2005 until February 1, 2006, he was a salesconsultant to the Company. Between July 18, 2003 and July 22, 2005, Mr. Foderowas the Vice President of Sales and Marketing of the Company. Mr. Foderojoined the Company as a member of the sales organization in March 2003. Mr. Foderobrings more than 20 years of successful executive and sales managementexperience to the Company. Prior to joining the Company, Mr. Fodero servedas director of Global Accounts from Veritas Software from February 2002until January 2003. Between 1999 and February 2002, Mr. Foderoserved in executive sales capacities with both companies in the enterprisesoftware industry, including Agile Software. From 1998 to 1999, Mr. Foderoserved as Regional Vice President of Sales for Memco Software, a leadingprovider of information security software to Fortune 1000 companies, where hewas instrumental in increasing sales and enhancing shareholder value inconnection with the sale of Memco to Platinum Technology. From 1990 through1998, Mr. Fodero served as Vice President of Sales of AT&T CommVaultSystems, where he grew sales from startup to over $36 million andparticipated in a management buyout.

**KENNETHS. SOUZA**has served as Chief Technology Officer of theCompany since October 4, 2004 and the General Manager, Law Enforcementsince October 18, 2005. Prior to joining the Company, Mr. Souza wasVice President of Industry Solutions for EMC Corporation. Prior to joining EMC,he was Vice President for e-Commerce Enterprise Systems Solutions for CompaqComputer Corporation. His 25-year technology and market career includesserving in a number of executive positions with Digital Equipment Corporationincluding Vice President Worldwide Solutions Services and Training, andDirector of Workstations Marketing. In the early 1980’s, Mr. Souza heldtechnical sales management positions with Hewlett Packard and Burroughs. Mr. Souzaalso held executive positions with a venture funded MRP software company.

**Directors’ Terms of Office**

Mr. May wasinitially elected to serve as a director in 2001, and was re-elected in 2004. Mr. Colatostiwas initially elected to serve as a director in 2002, and was re-elected in 2004.Mr. DePasquale was initially elected as a director in 2003, and wasre-elected in 2004. Mr. Schoenherr was initially elected as a director in2004. Mr. Romeo was initially elected as a director in 2005. Each suchdirector was elected to serve until the Company’s next annual meeting or untilhis successor is duly elected and qualified in accordance with the By-laws ofthe Company.

**Board of Directors and AuditCommittee Financial Expert**

All directors hold officeuntil the next annual meeting of shareholders and the election andqualification of their successors. Officers are elected annually by the Boardof Directors and serve at the discretion of the Board.

The Audit Committee iscomprised of John Schoenherr and Jeffrey J. May, who may not qualify as “financialexperts” under the rule adopted by the Securities and Exchange Commission.However, the Board believes that each Audit Committee member has sufficientknowledge in financial and auditing matters to serve on the Audit Committee.Additionally, the Audit Committee has the ability on its own to retainindependent accountants or consultants whenever it deems appropriate.

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**Directors Compensation**

Directors who are alsoofficers of the Company receive no additional compensation for serving on theBoard of Directors, other than reimbursement of reasonable expenses incurred inattending meetings. The Company’s 1996 stock incentive plan provides for thegrant of options to purchase 50,000 shares of common stock to each non-employeedirector upon first being elected or appointed to the Board of Directors. TheCompany’s current policy is to issue options to purchase 50,000 shares ofcommon stock to each non-employee director on an annual basis.

**Section 16(a) BeneficialOwnership Reporting Compliance**

Section 16(a) ofthe U.S. Securities and Exchange Act of 1934, as amended (the “Exchange Act”),requires the Company’s officers and directors and persons who own more than tenpercent (10%) of the Company’s Common Stock to file with the Securities andExchange Commission (“SEC”) initial reports of ownership and reports of changesin ownership of the Company’s Common Stock. Such officers, directors and tenpercent (10%) stockholders are also required by applicable SEC rules tofurnish the Company with copies of all forms filed with the SEC pursuant to Section 16(a) ofthe Exchange Act. Based solely on its review of the copies of such formsreceived by it, or written representations from such persons that no otherreports were required for such persons, the Company believes that during thefiscal year ended December 31, 2005, all Section 16(a) filingrequirements applicable to the Company’s officers, directors and ten percent(10%) stockholders were satisfied in a timely fashion.

**ITEM 10.**             EXECUTIVECOMPENSATION

The following table setsforth a summary of the compensation paid to or accrued by our chief executiveofficer and all of our other executive officers as of December 31, 2005(the “named executive officers”) for each of the fiscal years ended December 31,2003, 2004 and 2005:

**SUMMARYCOMPENSATION TABLE**
|                                           | ** ** | **Annual Compensation** | ** ** | **Long Term Compensation** | ** ** |
|-------------------------------------------|------------|------------------------------|------------|--------------------------------------|------------|
| ** **                                | ** ** | ** **                   | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Payouts** | ** ** | ** ** | ** ** |
| ** **                                | ** ** | **Fiscal  Year**             | ** ** | **Salary ($ )**            | ** ** | **Bonus ($ )** | ** ** | **Other Annual  Compensation  ($ )** | ** ** | **Restricted  Stock  Award** | ** ** | **Awards  Securities  Underlying  Options/SARs** | ** ** | **LTIP  Payouts** | ** ** | **All  Other** | ** ** |
| **Michael W. DePasquale (1)**   |       | 2005                         |       | 250,000                              |       | — |   | — |   | — |   | — |   | — |   | — |   |
| Chief Executive Officer                   |       | 2004                         |       | 210,000                              |       | 35,000 |   | — |   | — |   | — |   | — |   | — |   |
|                                           |       | 2003                         |       | 148,943                              |       | 25,000 |   | — |   | — |   | 1,080,000 |   | — |   | — |   |
| **Francis J. Cusick (2)**                 |       | 2005                         |       | 168,333                              |       | — |   | — |   | — |   | 155,000 |   | — |   | — |   |
| Chief Financial  Officer                  |       | 2004                         |       | 36,196                               |       | — |   | — |   | — |   | 45,000 |   | — |   | — |   |
| ** **                                |       | 2003                         |       | —                               |       | — |   | — |   | — |   | — |   | — |   | — |   |
| **Randy Fodero (3)**                      |       | 2005                         |       | 237,681                              | (4)        | — |   | — |   | — |   | 600,000 |   | — |   | — |   |
| Vice President Sales                      |       | 2004                         |       | 197,674                              |       | — |   | — |   | — |   | — |   | — |   | — |   |
|                                           |       | 2003                         |       | 125,986                              |       | 10,000 |   | — |   | — |   | 600,000 | (5) | — |   | — |   |
| **Kenneth S. Souza (6)**                  |       | 2005                         |       | 200,000                              |       | — |   | — |   | — |   | — |   | — |   | — |   |
| General Manager,  Law                     |       | 2004                         |       | 50,000                               |       | 19,000 |   | — |   | — |   | 300,000 |   | — |   | — |   |
| Enforcement and Chief  Technology Officer |       | 2003                         |       | —                               |       | — |   | — |   | — |   | — |   | — |   | — |   |

 

45

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(1)             Mr. DePasqualebecame employed as our Chief Executive Officer on January 3, 2003.

(2)             Mr. Cusickbecame our Chief Financial Officer on February 28, 2005.

(3)             Mr. Foderobecame Vice President of Sales on February 1, 2006. He was a salesconsultant to the Company from July 22, 2005 until February 1, 2006.Between July 18, 2003 and July 22, 2005, Mr. Fodero was theSenior Vice President of Sales and Marketing of the Company.

(4)             Includes$48,176, $47,674 and $10,282 of commission income in 2005, 2004 and 2003,respectively.

(5)             Theseoptions expired unexercised on October 20, 2005.

(6)             Mr. Souzabecame an executive officer of the Company on October 4, 2004.

**OPTIONGRANTS IN YEAR ENDED DECEMBER 31, 2005**

The following table sets forth all options grantedduring the year ended December 31, 2005 to each of the named executiveofficers.
| **Name**               | ** ** | **Number of  Securities  Underlying  Options Granted** | ** ** | **Percent of Total  Options Granted to  Employees in  Fiscal Year** | ** ** | **Exercise  Price  $ /Share** | ** ** | **Expiration  Date** | ** ** |
|------------------------|------------|------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------|------------|------------------------------------|------------|----------------------|------------|
| Francis J.  Cusick (1) |       | 155,000                                                          |       | 10.0                                                                                              | %          | $                                  | 1.33       |                 | 02/27/2012 |   |
|                   |       |                                                             |       |                                                                                              |       |                               |       |                 |       |
| Randy Fodero           |       | 600,000                                                          |       | 38.7                                                                                              | %          | 0.60                               |       | 11/10/2012           |       |
|                        |            |                                                                  |            |                                                                                                   |            |                                    |            |                      |            |  |

----

(1)             Optionsvested in three (3) annual installments commencing February 28, 2006.

(2)             Optionsvest 33.3% upon grant and thereafter at 22.2222% in three (3) annualinstallments commencing November 11, 2006.

**AGGREGATEDOPTION EXERCISES IN THE YEAR ENDEDDECEMBER 31, 2005 AND FISCAL YEAR-END OPTION VALUE**

The following table sets forth for each namedexecutive officer, information regarding stock options exercised by suchofficer during the year ended December 31, 2005, together with the numberand value of stock options held at December 31, 2005, each on anaggregated basis.
| **Name**              | ** ** | **Number Of  Shares  Acquired On  Exercise** | ** ** | **Value  Realized** | ** ** | **Number Of  Unexercised  Options At Fiscal  Year-End  Exercisable/  Unexercisable(#)** | ** ** | **Value Of  Unexercised  In-The-Money  Options At Fiscal  Year-End  Exercisable/  Unexercisable($ )(1)** | ** ** |
|-----------------------|------------|--------------------------------------------------------|------------|---------------------|------------|--------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------|------------|
| Michael W. DePasquale |       | —                                                 |       | —              |       | 1,080,000                                                                                              |       | 92,800/0                                                                                                                     |       |
| Francis J.  Cusick    |       | —                                                 |       | —              |       | 15,000/185,000                                                                                         |       | 0/0                                                                                                                          |       |
| Randy Fodero          |       | —                                                 |       | —              |       | 200,000/400,000                                                                                        |       | 18,000/36,000                                                                                                                |       |
| Kenneth S. Souza      |       | —                                                 |       | —              |       | 100,000/200,000                                                                                        |       | 0/0                                                                                                                          |       |

----

(1)             Thelast sales price of the Company’s Common Stock as reported on the OTC BulletinBoard on December 30, 2005 was $0.69.

46

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**Employment Agreements**

**MICHAEL W. DEPASQUALE.**  OnMarch 28, 2006, the Company entered into a two-year employment agreementwith Michael W. DePasquale to serve as the Co-Chief Executive Officer of the Companyat an annual base salary of $250,000 subject to adjustment by the Board ofDirectors as well as $1,000 per month in lieu of participating in the Company’smedical plan. In addition to the Base Salary and Stock Options, a “DiscretionaryBonus” may be awarded to Mr. DePasquale on the basis of merit performanceon an annual basis in the sole discretion of the Board of Directors. Theemployment agreement also provides for the grant of options to purchase up to400,000 shares of Company common stock payable at the discretion of the Boardof Directors.

In the event that Mr. DePasquale is terminatedwithout cause, Mr. DePasquale will receive severance payment equal to hisbase salary for the 6 months. The employment agreement contains standardand customary confidentiality, non-solicitation and “work made for hire”provisions as well as a covenant not to compete which prohibits Mr. DePasqualefrom doing business with any current or prospective customer of the Company orengaging in a business competitive with that of the Company during the term ofhis employment and for the one year period thereafter. The Company mayterminate the agreement at any time with or without cause. In the event oftermination without cause, Mr. DePasquale shall continue to be paid histhen current base salary for the greater of six months from the date of suchtermination or the number of months remaining until the end of the term of theemployment agreement.

**KENNETH S. SOUZA.**  Inconnection with his appointment as Senior Vice President and Chief TechnologyOfficer of the Company on October 4, 2004, we entered into a one (1) yearemployment agreement with Kenneth S. Souza. The employment agreement providesfor an annual base salary of $200,000 and a performance bonus in the amount ofup to $76,000 payable upon achievement of certain performance criteria. Unlessnotice of non-renewal is provided to Mr. Souza at least two months priorto the end of the term, the employment agreement automatically renews forsuccessive one year terms. In the event that Mr. Souza is terminatedwithout cause, Mr. Souza will receive severance payment equal to his basesalary for the greater of 6 months and that number of months remaininguntil the end of the term. The employment agreement contains standard andcustomary confidentiality, non-compete and work made for hire provisions.

Upon execution of theemployment agreement, we issued to Mr. Souza a stock option to purchase300,000 shares of our common stock at an exercise price of $1.11 per share, thelast sale price of our common stock as reported on the OTC Bulletin Board onthe date of grant. The option has a term of seven (7) years and vests inthree equal annual installments commencing on October 4, 2005. Uponcompletion of one (1) year of service, Mr. Souza shall be eligible toreceive a stock option to purchase up to an additional 300,000 shares ofCompany stock based upon his performance as determined by the Company in itssole discretion.

**Change in Control Provisions**

The Company’s 1996 StockOption Plan (as amended to date, the “1996 Plan”), 1999 Stock Option Plan and2004 Stock Incentive Plan (the “1999 Plan” and together with the 1996 Plan and2004 Plan, the “Plans”) provide for the acceleration of the vesting of unvestedoptions upon a “Change in Control” of the Company. A Change in Control isdefined in the Plans to include (i) a sale or transfer of substantiallyall of the Company’s assets; (ii) the dissolution or liquidation of theCompany; (iii) a merger or consolidation to which the Company is a partyand after which the prior shareholders of the Company hold less than 50% of thecombined voting power of the surviving corporation’s outstanding securities; (iv) theincumbent directors cease to constitute at least a majority of the Board ofDirectors; or (v) a change in control of the Company which would otherwisebe reportable under Section 13 or 15(d) of the Exchange Act.

In the event of a “ChangeIn Control” each Plan provides for the immediate vesting of all options issuedthereunder. The 1999 Plan provides for the Company to deliver written notice toeach optionee under the 1999 Plan fifteen (15) days prior to theoccurrence of a Change In Control during which all options issued under the1999 Plan may be exercised. Thereafter, all options issued under the 1999 Planwhich are neither assumed or substituted in connection with such transaction,automatically expire unless otherwise determined by the Board. The 1996 Planprovides for all options to remain exercisable for the remainder of their respectiveterms and permits the Company to make a cash payment to any or all optioneesequal to the difference between the exercise price of any or all such optionsand the fair market value of the Company’s common stock immediately prior tothe Change In Control. The 2004 Plan enables the Board to provide that alloutstanding options be assumed, or equivalent options be substituted by theacquiring or succeeding corporation upon the occurrence of a “ReorganizationEvent” as defined. If such Reorganization Event also constitutes a Change inControl, then such assumed or substituted options shall be immediatelyexercisable in full. If the acquiring or succeeding corporation does not agreeto assume, or substitute for such options, then the Board, upon written noticeto the Participants, may provide that all unexercised options becomeexercisable in full as of a specified time prior to the Reorganization Eventand terminate prior to the consummation of the Reorganization Event.Alternatively, if under the terms and conditions of the Reorganization Event,holders of common stock will receive a cash payment for their shares, then theBoard may provide that all Participants receive a cash payment equal to thedifference between the Acquisition Price and the Option Price multiplied by thenumber of options held by such Participants.

Options issued toexecutive officers outside of the Plans contain change in control provisionssubstantially similar to those contained in the 1999 Plan.

**Code of Ethics**

We have adopted a Code ofEthics that applies to our principal executive officer, principal financialofficer, principal accounting officer or controller, or persons performingsimilar functions. Our Code of Ethics is designed to deter wrongdoing andpromote: (i) honest and ethical conduct, including the ethical handling ofactual or apparent conflicts of interest between personal and professionalrelationships; (ii) full, fair, accurate, timely and understandabledisclosure in reports and documents that we file with, or submit to, the SECand in our other public communications; (iii) compliance with applicablegovernmental laws, rules, and regulations; (iv) the prompt internalreporting of violations of the code to an appropriate person or personsidentified in the code; and (v) accountability for adherence to the code.Any person may obtain a copy of our Code of Ethics free of charge by sending awritten request for such to the attention of the Chief Financial Officer of theCompany.

47

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**ITEM11.**             SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERS

The following table setsforth, as of March 15, 2006, information with respect to the securitiesholdings of all persons which the Company, pursuant to filings with theSecurities and Exchange Commission, has reason to believe may be deemed thebeneficial owners of more than five percent (5%) of the Company’s outstandingcommon stock. The following table also sets forth, as of such date, thebeneficial ownership of the Company’s common stock by all officers anddirectors, individually and as a group. Unless otherwise indicated, the addressof each person listed below is c/o BIO-key International, Inc., 3349Highway 138, Building D, Suite B, Wall, NJ 07719
| Name and Address of Beneficial Owner | ** ** | **Amount and Nature  of Beneficial  Ownership(1)** | ** ** | **Percentage of  Class(1)** | ** ** |
|---------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|----------------------------------|------------|
| Thomas J. Colatosti                                           |       | 905,000                                                           | (2)        | 1.9                              | %          |
|                                                          |       |                                                              |       |                             |       |
| Michael W.  DePasquale                                        |       | 1,100,000                                                         | (3)        | 2.3                              | %          |
|                                                          |       |                                                              |       |                             |       |
| Francis J. Cusick                                             |       | 66,666                                                            | (4)        | *                                |       |
| Jeffrey May                                                   |       | 250,000                                                           | (5)        | *                                |       |
| Charles P. Romeo                                              |       | 300,000                                                           | (6)        | *                                |       |
| John Schoenherr                                               |       | 25,000                                                            | (7)        | *                                |       |
| Randy Fodero                                                  |       | 200,000                                                           | (8)        | *                                |       |
| Kenneth S. Souza                                              |       | 100,000                                                           | (9)        | *                                |       |
| Kingdon Capital Management,  LLC                              |       | 2,696,112                                                         |       | 5.6                              | %          |
| 152 West 57 th Street  50 th Floor  New York, NY 10019        |       |                                                              |       |                             |       |
| Trellus  Mangement Company, LLC                               |       | 5,083,500                                                         |       | 10.6                             | %          |
| 350  Madison Avenue  9th Floor  New York, NY 10017       |       |                                                              |       |                             |       |
| All officers and directors  as a group (8) persons       |       | 2,946,666                                                         |       | 6.1                              | %          |

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*                    Lessthan 1%

(1)             Thesecurities “beneficially owned” by an individual are determined in accordancewith the definition of “beneficial ownership” set forth in the regulationspromulgated under the Securities Exchange Act of 1934 and, accordingly, mayinclude securities owned by or for, among others, the spouse and/or minorchildren of an individual and any other relative who has the same home as suchindividual, as well as, other securities as to which the individual has orshares voting or investment power or which each person has the right to acquirewithin 60 days through the exercise of options or otherwise. Beneficialownership may be disclaimed as to certain of the securities. This table hasbeen prepared based on 48,036,983 shares of common stock outstanding as of March 15,2006.

(2)             Includes550,000 shares assumable upon exercise of options and 350,000 shares issuableupon conversion of series A preferred stock.

(3)             Includes1,080,000 shares issuable upon exercise of options.

(4)             Includes66,666 shares issuable upon exercise of options. Does not include 133,334shares issuable upon exercise of options subject to vesting.

(5)             Consistsof shares issuable upon exercise of options.

(6)             Includes200,000 shares issuable upon exercise of options. Does not include 200,000shares issuable upon exercise of options subject to vesting.

(7)             Includes25,000 shares issuable upon exercise of options. Does not include 25,000 sharesissuable upon exercise of options subject to vesting.

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(8)             Includes 200,000shares issuable upon exercise of options. Does not include 400,000 sharesissuable upon exercise of options subject to vesting.

(9)             Includes 100,000shares issuable upon exercise of options. Does not include 200,000 sharesissuable upon exercise of options subject to vesting.

The following table setsforth, as of December 31, 2005, information with respect to securitiesauthorized for issuance under equity compensation plans.

**EQUITYCOMPENSATION PLAN INFORMATION**
| ** **                                                  | ** ** | **Number of securities to be issued  upon exercise of outstanding  options, warrants and rights  (a)** | ** ** | **Weighted-average  exercise price of outstanding  options, warrants and rights  (b)** | ** ** | **Number of securities  remaining available for  future issuance under  equity compensation plans  (excluding securities  reflected in column (a))  (c)** | ** ** |
|-------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity compensation  plans approved by security holders     |       | 150,000                                                                                                                                                       |       | $                                                                                                                    | 0.45       |                                                                                                                                                                                                                  | —     |   |
| Equity compensation  plans not approved by security holders |       | 6,197,385                                                                                                                                                     |       | $                                                                                                                    | 0.93       |                                                                                                                                                                                                                  | 2,594,272  |   |
| Total                                                       |       | 6,347,835                                                                                                                                                     |       | $                                                                                                                    | 0.92       |                                                                                                                                                                                                                  | 2,594,272  |   |

 

During 1996, the Board ofDirectors and stockholders of the Company adopted the 1996 Stock Option Plan(the 1996 Plan). Under the 1996 Plan, 750,000 shares of common stock arereserved for issuance to employees, officers, directors, and consultants of theCompany at exercise prices which may not be below 100% of fair market value forincentive stock options and 50% for all others. The term of stock optionsgranted may not exceed ten years. Options issued under the Plan vest pursuantto the terms of stock option agreements with the recipients. In the event of achange in control, as defined, all options outstanding vest immediately. ThePlan terminates in May 2005.

The Company’s 1999 StockOption Plan (the “1999 Plan”) was adopted by the Board of Directors of theCompany on or about August 31, 1999. The material terms of the 1999 Planare summarized below.

The 1999 Plan iscurrently administered by the Board of Directors of the Company (the “PlanAdministrator”). The Plan Administrator is authorized to construe the 1999 Planand any option issued under the 1999 Plan, select the persons to whom optionsmay be granted, and determine the number of shares to be covered by any option,the exercise price, vesting schedule and other material terms of such option.

The 1999 Plan providesfor the issuance of options to purchase up to 2,000,000 shares of common stockto officers, employees, directors and consultants of the Company at exerciseprices not less than 85% of the last sale price of the Company’s common stockas reported on the OTC Bulletin Board on the date of grant. Options have termsof not more than 10 years from the date of grant, are subject to vestingas determined by the Plan Administrator and are not transferable without thepermission of the Company except by will or the laws of descent anddistribution or pursuant to a domestic relations order. Options terminate three(3) months after termination of employment or other association with theCompany or one (1) year after termination due to disability, death orretirement. In the event that termination of employment or association is for acause, as that term is defined in the 1999 Plan, options terminate immediatelyupon such termination. The Plan Administrator has the discretion to extendoptions for up to three years from the date of termination or disassociationwith the Company.

The 1999 Plan providesfor the immediate vesting of all options in the event of a “Change In Control”of the Company. In the event of a Change In Control, the Company is required todeliver written notice to each optionee under the 1999 Plan fifteen(15) days prior to the occurrence of a Change in Control, during whichtime all options issued under 1999 Plan may be exercised. Thereafter, alloptions issued under the 1999 Plan which are neither assumed or substituted inconnection with such transaction, automatically expire, unless otherwisedetermined by the Board. Under the 1999 Plan, a “Change In Control” is definedto include (i) a sale or transfer of substantially all of the Company’sassets; (ii) the dissolution or liquidation of the Company; (iii) amerger or consolidation to which the Company is a party and after which theprior shareholders of the Company hold less than 50% of the combined votingpower of the surviving corporation’s outstanding securities; (iv) theincumbent directors cease to constitute at least a majority of the Board ofDirectors; or (v) a change in control of the Company which would otherwisebe reportable under Section 13 or 15(d) of the Exchange Act.

As of December 31,2005, there were outstanding options under the 1996 Plan to purchase 150,000shares of common stock, and no shares were available for future grants.

As of December 31,2005, there were outstanding options under the 1999 Plan to purchase 1,062,125shares of common stock, and options to purchase an aggregate of 647,132 shareswere available for future grants.

On October 12, 2004,the Board of Directors of the Company approved the 2004 Stock Option Plan (the2004 Plan). The 2004 Plan has not yet been presented to stockholders forapproval and thus incentive stock options are not available under this plan.Under the terms of this plan, 4,000,000 shares of common stock are reserved forissuance to employees, officers, directors, and consultants of the Company atexercise prices which may not be below 85% of fair market value. The term ofstock options granted may not exceed ten years. Options issued under the 2004Plan vest pursuant to the terms of stock option agreements with the recipients.In the event of a change in control, as defined, all options outstanding vestimmediately. The 2004 Plan terminates in October 2014.

As of December 31,2005, there were outstanding options under the 2004 Plan to purchase 2,052,860shares of common stock, and options to purchase an aggregate of 1,947,140shares were available for future grants.

In addition to optionsissued under the 1996, 1999 and 2004 Plans, the Company has issued options toemployees, officers, directors and consultants to purchase common stock underthe non plan. As of December 2005, there were outstanding options underthe non plan to purchase 3,082,850 shares of common stock. The terms of theseoptions are substantially similar to the provisions of the 1999 Plan andoptions issued thereunder.

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** **

**ITEM 12.**             CERTAIN RELATIONSHIPSAND RELATED TRANSACTIONS

**Employment Arrangements**

The Company has enteredinto an employment agreements with Michael W. DePasquale and Kenneth S. Souza.See **“EXECUTIVE COMPENSATION—Employment Agreements.”**

**Options Granted to ExecutiveOfficers and Directors**

During 2002, the Companyissued options to purchase 200,000 shares of common stock to Thomas J.Colatosti upon his appointment as a director of the Company. During 2003, 2004and 2005, the Company issued options to purchase an aggregate of 2,180,000,400,000 and 1,155,000 shares, respectively of common stock to its officers anddirectors. The options were issued at exercise prices equal to the last salesprice of the Company’s common stock as reported on the OTC Bulletin Board onthe date of grant, have terms of three (3) to seven (7) years, andvest over a one to three year period.

**Consulting Arrangement withThomas J. Colatosti**

In connection withhis appointment to the Board of Directors in September 2002, the Companyentered into a consulting arrangement with Thomas J. Colatosti. Under thearrangement, the Company paid Mr. Colatosti $4,000 per month through December 2003and issued him options to purchase 150,000 shares of common stock at anexercise price of $0.31 per share, the closing price of the Company’s commonstock on the date of grant. In December 2003, a committee of independentdirectors renewed this arrangement through December 31, 2004. Thecommittee also issued options to Mr. Colatosti to purchase 200,000 sharesof common stock at an exercise price of $1.32 per share, the closing price ofthe Company’s common stock on the date of grant, for serving as Chairman.Effective November 1, 2004, Mr. Colatosti’s monthly consulting feewas increased to $14,500. Mr. Colatosti has substantial experience in thebiometric industry and in addition to his role as the Chairman of the Board ofDirectors of the Company, provides extensive service to the Company in theareas of strategic planning and corporate finance.

In March 2004,Mr. Colatosti entered into a three year consulting arrangement with theShaar Fund Ltd., a principal creditor and shareholder of the Company. Under theterms of the arrangement, The Shaar Fund transferred $375,000 principal amountof our secured convertible notes due October 1, 2005 to Mr. Colatosti.On April 28, 2004 the Company issued 3,750 shares of the Company’s Series A7% convertible preferred stock to Mr. Colatosti in conversion of the$375,000 secured convertible note.

On February 7, 2006,the Company entered into a consulting agreement with Mr. Colatosti, thecurrent Chairman of the Board of Directors and Co-Chief Executive Officer ofthe Company. Pursuant to the Agreement, Mr. Colatosti will provideservices to the Company and its subsidiaries and affiliates for the year endingDecember 31, 2006, at a rate of $14,500 per month.

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**ITEM 13.**             EXHIBITS

(a)   Thefollowing documents are filed as part of this Report. Portions of Item 13are submitted as separate sections of this Report:

(1) Financialstatements filed as part of this Report:

Report of IndependentCertified Public Accountants

Balance Sheets at December 31,2005 and 2004 and 2003

Statements ofOperations—Years ended December 31, 2005, 2004 and 2003

Statement of Stockholders’Equity (Deficit)—Years ended December 31, 2005, 2004 and 2003

Statements of CashFlows—Years ended December 31, 2005, 2004 and 2003

Notes to FinancialStatements—December 31, 2005, 2004 and 2003

(2) The exhibitslisted in the Exhibits Index immediately preceding such exhibits are filed aspart of this Report

**ITEM 14.**             PRINCIPAL ACCOUNTANTFEES AND SERVICES

The followingtable presents fees for professional audit services by DS&B, Ltd. forthe audit of the Company’s annual financial statements for 2005 and 2004, andfees billed for other services rendered by DS&B, Ltd.

|             | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------|------------|----------|------------|----------|------------|
| Audit Fees: |       | $        | 471,140    |     | $          | 213,175 |   |
| Tax Fees:   |       | 25,428   |       | 3,356    |       |
| Total Fees  |       | $        | 496,568    |     | $          | 216,531 |   |

 

*AuditFees*consist of fees billed for professional servicesrendered for the audit of our financial statements and review of the interimfinancial statements included in quarterly reports and services that arenormally provided by DS&B, Ltd. in connection with statutory and regulatoryfilings or engagements. Audit fees also include fees for services provided inconnection with business acquisitions and registration of securities.

*TaxFees*consists of fees billed for professional services fortax compliance, tax advice and tax planning. These services include assistanceregarding federal and state tax compliance, tax audit defense, customs andduties, and mergers and acquisitions.

**AuditCommittee Pre-Approval Procedures**

The AuditCommittee of our Board of Directors, which consists of John Schoenherr andJeffrey J. May, serves as our audit committee. Our Board of Directorsapproves the engagement of our independent auditors to render audit andnon-audit services before they are engaged. All of the services performed by DS & B, Ltd.for us were pre-approved by our the Audit Committee.

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**ITEM7—FINANCIAL STATEMENTS**

The following financial statements of BIO-keyInternational, Inc. are included herein at the indicated page numbers:
|                                                                                                      |   |   |   |
|-----------------------------------------------------------------------------------------------------------|--------|--------|--------|
| Report of Independent  Certified Public Accountants                                                       |   | 53     |   |
| Balance  Sheets at December 31, 2005, 2004 and 2003                                                  |   | 54     |   |
| Statements  of Operations—Years ended December 31, 2005, 2004 and 2003                          |   | 55     |   |
| Statement  of Stockholders’ Equity (Deficit)—Years ended December 31, 2005, 2004  and 2003 |   | 56     |   |
| Statements  of Cash Flows—Years ended December 31, 2005, 2004 and 2003                          |   | 57     |   |
| Notes to the Financial Statements—December 31,  2005, 2004 and 2003                             |   | 58-147 |   |

 

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**Reportof Independent Certified Public Accountants**

Board of Directors andStockholdersBIO-key International, Inc.

We have audited theaccompanying consolidated balance sheets of BIO-key International, Inc.and Subsidiary as of December 31, 2005, 2004 and 2003, and the relatedstatements of operations, stockholders’ equity (deficit) and cash flows foreach of the years in the three year period ended December 31, 2005. Thesefinancial statements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour audits.

We conducted our auditsin accordance with the standards of the Public Company Accounting OversightBoard (United States). Those standards require that we plan and perform theaudit to obtain reasonable assurance about whether the financial statements arefree of material misstatement. The Company is not required to have, nor were weengaged to perform, an audit of its internal control over financial reporting.Our audit included consideration of internal control over financial reportingas a basis for designing audit procedures that are appropriate in thecircumstances, but not for the purpose of expressing an opinion on theeffectiveness of the Company’s internal control over financial reporting.Accordingly, we express no such opinion. An audit includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements. An audit also includes assessing the accounting principles used andsignificant estimates made by management as well as evaluating the overallfinancial statement presentation. We believe our audits provide a reasonablebasis for our opinion.

As described in Note B tothe consolidated financial statements, the Company restated its 2005, 2004, and2003 consolidated financial statements.

In our opinion, thefinancial statements referred to above present fairly, in all materialrespects, the financial position of BIO-key International, Inc. andSubsidiary as of December 31, 2005, 2004 and 2003, and the results of itsoperations and its cash flows for each of the years in the three year periodended December 31, 2005, in conformity with accounting principlesgenerally accepted in the United States.

The accompanyingfinancial statements have been prepared in conformity with accountingprinciples generally accepted in the United States, which contemplatecontinuation of the Company as a going concern. However, as discussed in note Ato the financial statements, the Company has only recently begun to generatesignificant revenues, has suffered recurring losses from operations and has aworking capital deficit. These aforementioned issues, among others, raisesubstantial doubt about the Company’s ability to continue as a going concern.The financial statements do not include any adjustments that might result frontthis uncertainty. Management’s plans in regard to these matters are alsodiscussed in Note A.

/s/ DS&B, Ltd.

 

 

Minneapolis Minnesota

June 14, 2006

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**BIO-keyInternational, Inc and Subsidiary****Consolidated Balance Sheets**
| ** **                                                                                                                                                                                                   | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                   | ** ** | **2005**              | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                                                                                                                                   | ** ** | **(Restated)**        | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
| **ASSETS:**                                                                                                                                                                                                  | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash and cash  equivalents                                                                                                                                                                                   |       | $                     | 1,422,827  |   | $ | 956,230 |   | $ | 1,012,790 |   |
| Marketable debt  securities                                                                                                                                                                                  |       | —                |       | 1,000,000 |   | — |   |
| Receivables                                                                                                                                                                                                  |       |                  |       |   |   |   |   |
| Billed, less allowance for doubtful receivables of  $160,000, $422,393 and $2,000, respectively                                                                                                              |       | 1,635,371             |       | 1,608,054 |   | 101,183 |   |
| Unbilled                                                                                                                                                                                                     |       | 201,942               |       | 310,523 |   | — |   |
| Due from selling  stockholders and other                                                                                                                                                                     |       | —                |       | 28,793 |   | — |   |
| Costs and  earnings in excess of billings on uncompleted contracts                                                                                                                                           |       | 4,321,392             |       | 6,292,603 |   | — |   |
| Inventory                                                                                                                                                                                                    |       | 8,760                 |       | 29,599 |   | 65,857 |   |
| Prepaid expenses                                                                                                                                                                                             |       | 137,000               |       | 113,130 |   | 165,929 |   |
| Total current assets                                                                                                                                                                                         |       | 7,727,292             |       | 10,338,932 |   | 1,345,759 |   |
| Equipment and  leasehold improvements, net                                                                                                                                                                   |       | 548,267               |       | 644,101 |   | 60,157 |   |
| Costs and  earnings in excess of billings on uncompleted contracts                                                                                                                                           |       | —                |       | 657,000 |   | — |   |
| Deposits                                                                                                                                                                                                     |       | 1,828,560             |       | 2,838,031 |   | — |   |
| Intangible  assets—less accumulated amortization                                                                                                                                                        |       | 3,301,823             |       | 4,099,297 |   | 68,306 |   |
| Deferred  financing costs, net                                                                                                                                                                               |       | 1,562,338             |       | 938,118 |   | 81,900 |   |
| Goodwill                                                                                                                                                                                                     |       | 11,389,654            |       | 12,023,613 |   | — |   |
| Total non-current assets                                                                                                                                                                                     |       | 18,630,642            |       | 21,200,160 |   | 210,363 |   |
| **TOTAL  ASSETS**                                                                                                                                                                                            |       | $                     | 26,357,934 |   | $ | 31,539,092 |   | $ | 1,556,122 |   |
| **LIABILITIES:**                                                                                                                                                                                             | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Current  maturities of long-term obligations, net of discount                                                                                                                                                |       | $                     | 8,067,948  |   | $ | 3,062,722 |   | $ | — |   |
| Advances from  stockholders                                                                                                                                                                                  |       | —                |       | 12,753 |   | 34,030 |   |
| Accounts payable                                                                                                                                                                                             |       | 833,608               |       | 1,349,092 |   | 351,742 |   |
| Billings in  excess of costs and earnings on uncompleted contracts                                                                                                                                           |       | 32,385                |       | 760,807 |   | — |   |
| Accrued  liabilities                                                                                                                                                                                         |       | 5,520,515             |       | 4,595,984 |   | 155,536 |   |
| Deferred rent                                                                                                                                                                                                |       | 443,603               |       | 393,676 |   | — |   |
| Deferred revenue                                                                                                                                                                                             |       | 3,264,283             |       | 3,166,356 |   | 10,000 |   |
| Total current liabilities                                                                                                                                                                                    |       | 18,162,342            |       | 13,341,390 |   | 551,308 |   |
| Long-term  obligations, net of discount and current maturities                                                                                                                                               |       | —                |       | 10,265,390 |   | 10,373,680 |   |
| Deferred rent                                                                                                                                                                                                |       | 867,850               |       | 1,311,454 |   | — |   |
| Deferred revenue                                                                                                                                                                                             |       | 1,163,738             |       | 71,203 |   | — |   |
| Total non-current liabilities                                                                                                                                                                                |       | 2,031,588             |       | 11,648,047 |   | 10,373,680 |   |
| **TOTAL  LIABILITIES**                                                                                                                                                                                       |       | 20,193,930            |       | 24,989,437 |   | 10,924,988 |   |
| Commitments and  contingencies                                                                                                                                                                               |       |                  |       |   |   |   |   |
| **STOCKHOLDERS’  EQUITY (DEFICIT):**                                                                                                                                                                    | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Preferred  stock-authorized, 5,000,000 shares (liquidation preference of $100 per share)                                                                                                                     |       |                  |       |   |   |   |   |
| Series A 7% Convertible; issued and outstanding  44,557 Shares of $.0001 par value                                                                                                                      |       | 4                     |       | — |   | — |   |
| Series B 9% Convertible; issued and  outstanding, 4,180 shares of $.01 par value                                                                                                                        |       | —                |       | — |   | 42 |   |
| Series C 7% Convertible; issued and  outstanding, 62,182 shares of $.01 par value                                                                                                                       |       | —                |       | 623 |   | — |   |
| Common stock -  authorized, 85,000,000 shares; issued and outstanding; 46,306,589 shares of  $.0001 par value in 2005 and 40,680,691 and 21,222,889 shares of $.01 par  value in 2004 and 2003, respectively |       | 4,632                 |       | 406,808 |   | 212,229 |   |
| Additional  paid-in capital                                                                                                                                                                                  |       | 48,921,316            |       | 45,098,731 |   | 18,327,992 |   |
| Accumulated  deficit                                                                                                                                                                                         |       | (42,761,948           | )          | (38,956,507 | ) | (27,909,129 |   |
| **TOTAL  STOCKHOLDERS’ EQUITY (DEFICIT)**                                                                                                                                                               |       | 6,164,004             |       | 6,549,655 |   | (9,368,866 |   |
| **TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY (DEFICIT)**                                                                                                                                               |       | $                     | 26,357,934 |   | $ | 31,539,092 |   | $ | 1,556,122 |   |

 

The accompanying notesare an integral part of these statements.

54

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**BIO-keyInternational, Inc. and SubsidiarySTATEMENTS OF OPERATIONS**
| ** **                                    | ** ** | **Years ended December 31,** | ** ** |
|-----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                    | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                    | ** ** | **(Restated)**                              | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
| **Revenues**                                  | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Services                                      |       | $                                           | 10,861,649 |   | $ | 3,351,406 |   | $ | 10,694 |   |
| License fees and other                        |       | 3,364,446                                   |       | 2,369,545 |   | 204,787 |   |
|                                          |       | 14,226,095                                  |       | 5,720,951 |   | 215,481 |   |
| **Costs and other expenses**                  | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Services                                      |       | 2,906,142                                   |       | 1,174,324 |   | 1,694 |   |
| Cost of license fees and other                |       | 937,491                                     |       | 889,896 |   | 87,387 |   |
| Selling, general and administrative           |       | 11,824,609                                  |       | 7,114,288 |   | 2,099,922 |   |
| Research, development and engineering         |       | 6,846,035                                   |       | 2,979,904 |   | 1,037,330 |   |
|                                          |       | 22,514,277                                  |       | 12,158,412 |   | 3,226,333 |   |
| **Operating  loss**                           |       | (8,288,182                                  | )          | (6,437,461 | ) | (3,010,852 | ) |
| **Other income (deductions)**                 | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest income                               |       | 35,958                                      |       | 66,824 |   | — |   |
| Interest expense                              |       | (4,521,344                                  | )          | (1,415,535 | ) | (1,909,788 | ) |
| Derivative and warrant fair value adjustments |       | 9,154,951                                   |       | (3,008,419 | ) | 857,545 |   |
| Gain (Loss) on sale of marketable securities  |       | (20,000                                     | )          | 33,125 |   | — |   |
| Other income (expense)                        |       | (34,767                                     | )          | (88,425 | ) | 4,145 |   |
| Total other income (deductions)               |       | 4,614,798                                   |       | (4,412,430 | ) | (1,048,098 | ) |
| **NET  LOSS**                                 |       | $                                           | (3,673,384 | ) | $ | (10,849,891 | ) | $ | (4,058,950 | ) |
| ** **                                    | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Loss Per Share:**                           | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Basic**                                     |       | $                                           | (0.09      | ) | $ | (0.32 | ) | $ | (0.24 | ) |
| **Diluted**                                   |       | $                                           | (0.12      | ) | $ | (0.32 | ) | $ | (0.24 | ) |
| ** **                                    | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Weighted Average Shares  Outstanding:**     | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Basic**                                     |       | 44,787,807                                  |       | 34,806,201 |   | 17,543,586 |   |
| **Diluted**                                   |       | 52,046,303                                  |       | 34,806,201 |   | 17,543,586 |   |

 

Theaccompanying notes are an integral part of these statements.

55

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**BIO-key International, Inc. andSubsidiary****STATEMENT OF STOCKHOLDERS’ EQUITY (DEFICIT)**
| ** **                                                                                                                            | ** ** | **Series A 7%** | ** ** | **Series B 9%** | ** ** | **Series C 7%** | ** ** | ** **            | ** ** | ** **      | ** ** | ** **      | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------|------------|---------------------------|------------|---------------------------|------------|-----------------------|------------|-----------------|------------|-----------------|------------|------------|------------|
| ** **                                                                                                                            | ** ** | **Convertible**           | ** ** | **Convertible**           | ** ** | **Convertible**           | ** ** | ** **            | ** ** | **Additional**  | ** ** | ** **      | ** ** | ** ** | ** ** |
| ** **                                                                                                                            | ** ** | **Preferred Stock**  | ** ** | **Preferred Stock**  | ** ** | **Preferred Stock**  | ** ** | **Common Stock** | ** ** | **Contributed** | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
| ** **                                                                                                                            | ** ** | **Shares**                | ** ** | **Amount**                | ** ** | **Shares**                | ** ** | **Amount**            | ** ** | **Shares**      | ** ** | **Amount**      | ** ** | **Shares** | ** ** | **Amount** | ** ** | **Capital** | ** ** | **Deficit** | ** ** | **Total** | ** ** |
| **Balance as of December 31, 2002**                                                                                              |       | —                    |       | $                         | —     | ** **                | **18,430** | ** **            | **$**      | **184**         | ** ** | **—**      | ** ** | **$**      | **—** | ** ** | **14,377,406** | ** ** | **$** | **143,774** | ** ** | **$** | **16,284,399** | ** ** | **$** | **(23,605,404** | **)** | **$** | **(7,177,047** | **)** |
| Conversion of series B preferred stock and  cumulative dividends in arrears into common stock                                    |       | —                    |       | —                    |       | (14,250                   | )          | (142                  | )          | —          |       | —          |       | 4,239,206  |       | 42,392 |   | 202,525 |   | (244,775 | ) | — |   |
| Coversion of note, debenture and accrued interest  into common stock                                                                  |       | —                    |       | —                    |       | —                    |       | —                |       | —          |       | —          |       | 2,097,953  |       | 20,980 |   | 1,552,486 |   | — |   | 1,573,466 |   |
| Exercise of options into common stock                                                                                                 |       | —                    |       | —                    |       | —                    |       | —                |       | —          |       | —          |       | 308,324    |       | 3,083 |   | 58,582 |   | — |   | 61,665 |   |
| Options and warrants issued for services and other                                                                                    |       | —                    |       | —                    |       | —                    |       | —                |       | —          |       | —          |       | —     |       | — |   | 156,000 |   | — |   | 156,000 |   |
| Common stock issued in exchange for services and  other                                                                               |       | —                    |       | —                    |       | —                    |       | —                |       | —          |       | —          |       | 200,000    |       | 2,000 |   | 74,000 |   | — |   | 76,000 |   |
| Net loss                                                                                                                              |       | —                    |       | —                    |       | —                    |       | —                |       | —          |       | —          |       | —     |       | — |   | — |   | (4,058,950 | ) | (4,058,950 | ) |
| **Balance as of December 31, 2003 (Restated)**                                                                                   | ** ** | **—**                | ** ** | **$**                     | **—** | ** **                | **4,180**  | ** **            | **$**      | **42**          | ** ** | **—**      | ** ** | **$**      | **—** | ** ** | **21,222,889** | ** ** | **$** | **212,229** | ** ** | **$** | **18,327,992** | ** ** | **$** | **(27,909,129** | **)** | **$** | **(9,368,866** | **)** |
| Issuance of series C preferred stock for  Series B preferred stock and cumulative dividends in arrears                      |       | —                    |       | —                    |       | (4,180                    | )          | (42                   | )          | 5,257           |       | 53              |       | —     |       | — |   | 107,682 |   | (107,693 | ) | — |   |
| Issuance of series C preferred stock in exchange  for debt                                                                       |       | —                    |       | —                    |       | —                    |       | —                |       | 83,275          |       | 833             |       | —     |       | — |   | 8,326,630 |   | — |   | 8,327,463 |   |
| Sale in March 2004 of common stock and warrants  at $1.35 per unit, less offering costs of $743,895                              |       | —                    |       | —                    |       | —                    |       | —                |       | —          |       | —          |       | 8,888,928  |       | 88,889 |   | 11,330,117 |   | — |   | 11,419,006 |   |
| Issuance of common stock in conjunction with PSG  acquisition                                                                         |       | —                    |       | —                    |       | —                    |       | —                |       | —          |       | —          |       | 2,422,108  |       | 24,221 |   | 3,584,719 |   | — |   | 3,608,940 |   |
| Conversion of debentures, bridge notes, convertible  notes, accrued interest and related discounts and derivatives into common  stock |       | —                    |       | —                    |       | —                    |       | —                |       | —          |       | —          |       | 3,455,725  |       | 34,558 |   | 2,462,593 |   | — |   | 2,497,151 |   |
| Conversion of series C preferred stock and  cumulative dividends in arrears into common stock                                    |       | —                    |       | —                    |       | —                    |       | —                |       | (30,100         | )          | (301            | )          | 4,133,060  |       | 41,331 |   | 48,764 |   | (89,794 | ) | — |   |
| Issuance of series C preferred stock in exchange  for note payable to officer                                                    |       | —                    |       | —                    |       | —                    |       | —                |       | 3,750           |       | 38              |       | —     |       | — |   | 374,962 |   | — |   | 375,000 |   |
| Exercise of options and warrants into common stock                                                                                    |       | —                    |       | —                    |       | —                    |       | —                |       | —          |       | —          |       | 557,982    |       | 5,580 |   | 92,554 |   | — |   | 98,134 |   |
| Repurchase warrants                                                                                                                   |       | —                    |       | —                    |       | —                    |       | —                |       | —          |       | —          |       | —     |       | — |   | (221,183 | ) | — |   | (221,183 | ) |
| Options and warrants issued for services and other                                                                                    |       | —                    |       | —                    |       | —                    |       | —                |       | —          |       | —          |       | —     |       | — |   | 129,700 |   | — |   | 129,700 |   |
| Issuance of warrants in conjunction with convertible  notes offering                                                                  |       | —                    |       | —                    |       | —                    |       | —                |       | —          |       | —          |       | —     |       | — |   | 534,201 |   | — |   | 534,201 |   |
| Net loss                                                                                                                              |       |                      |       |                      |       |                      |       |                  |       |            |       |            |       |       |       |   |   |   |   | (10,849,891 | ) | (10,849,891 | ) |
| **Balance as of December 31, 2004 (Restated)**                                                                                   | ** ** | **—**                | ** ** | **$**                     | **—** | ** **                | **—** | ** **            | **$**      | **—**      | ** ** | **62,182**      | ** ** | **$**      | **623**    | ** ** | **40,680,692** | ** ** | **$** | **406,808** | ** ** | **$** | **45,098,731** | ** ** | **$** | **(38,956,507** | **)** | **$** | **6,549,655** | ** ** |
| Conversion of series C preferred stock to  series A preferred stock                                                         |       | 62,182                    |       | 6                         |       | —                    |       | —                |       | (62,182         | )          | (623            | )          | —     |       | — |   | 617 |   | — |   | — |   |
| Adjust par values to $0.0001                                                                                                     |       | —                    |       | —                    |       | —                    |       | —                |       | —          |       | —          |       | —     |       | (402,739 | ) | 402,739 |   | — |   | — |   |
| Costs incurred in conjunction with issuance of debt                                                                                   |       | —                    |       | —                    |       | —                    |       | —                |       | —          |       | —          |       | —     |       | — |   | (56,642 | ) | — |   | (56,642 | ) |
| Issuance of shares in exchange for debt payment delay                                                                                 |       | —                    |       | —                    |       | —                    |       | —                |       | —          |       | —          |       | 875,871    |       | 88 |   | 788,196 |   | — |   | 788,284 |   |
| Conversion of debentures, bridge notes, convertible  notes, accrued interest and related discounts and derivatives into common  stock |       | —                    |       | —                    |       | —                    |       | —                |       | —          |       | —          |       | 1,575,135  |       | 158 |   | 1,179,341 |   | — |   | 1,179,499 |   |
| Conversion of series A preferred stock and  cumulative dividends in arrears into common stock                                    |       | (17,625                   | )          | (2                        | )          | —                    |       | —                |       | —          |       | —          |       | 2,512,426  |       | 251 |   | 121,569 |   | (132,057 | ) | (10,239 | ) |
| Exercise of options and warrants into common stock                                                                                    |       | —                    |       | —                    |       | —                    |       | —                |       | —          |       | —          |       | 662,465    |       | 66 |   | 558,722 |   | — |   | 558,788 |   |
| Issuance of warrants in conjunction with convertible  notes offering                                                                  |       | —                    |       | —                    |       | —                    |       | —                |       | —          |       | —          |       | —     |       | — |   | 234,150 |   | — |   | 234,150 |   |
| Options and warrants issued for services and other                                                                                    |       | —                    |       | —                    |       | —                    |       | —                |       | —          |       | —          |       | —     |       | — |   | 593,893 |   | — |   | 593,893 |   |
| Net loss                                                                                                                              |       | —                    |       | —                    |       | —                    |       | —                |       | —          |       | —          |       | —     |       | — |   | — |   | (3,673,384 | ) | (3,673,384 | ) |
| **Balance  as of December 31, 2005 (Restated)**                                                                                  | ** ** | **44,557**                | ** ** | **$**                     | **4**      | ** **                | **—** | ** **            | **$**      | **—**      | ** ** | **—**      | ** ** | **$**      | **—** | ** ** | **46,306,589** | ** ** | **$** | **4,632** | ** ** | **$** | **48,921,316** | ** ** | **$** | **(42,761,948** | **)** | **$** | **6,164,004** | ** ** |

 

The accompanying notes are an integral part ofthese statements.

56

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**BIO-key International, Inc. andSubsidiary****STATEMENTS OF CASH FLOWS**
| ** **                                                                            | ** ** | **Years ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                            | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                            | ** ** | **(Restated)**                              | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
|                                                                                  |       |                                        |       |   |   |   |   |
| **CASH FLOW FROM OPERATING  ACTIVITIES:**                                             | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net Loss                                                                              |       | $                                           | (3,673,384 | ) | $ | (10,849,891 | ) | $ | (4,058,950 | ) |
| **Adjustments  to reconcile net loss to net cash used in operating activities:**      | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Derivative and warrant fair value adjustments                                         |       | (9,154,951                                  | )          | 3,008,419 |   | (857,545 | ) |
| Depreciation                                                                          |       | 244,450                                     |       | 77,912 |   | 6,386 |   |
| Amortization                                                                          |       |                                        |       |   |   |   |   |
| Intangible assets                                                                     |       | 1,323,601                                   |       | 535,799 |   | — |   |
| Deferred financing costs                                                              |       | 186,279                                     |       | 14,622 |   | — |   |
| Discounts on convertible debt related to warrants  and beneficial conversion features |       | 2,097,973                                   |       | 757,318 |   | 1,215,636 |   |
| Allowance for doubtful receivables                                                    |       | 48,148                                      |       | 71,384 |   | — |   |
| (Gain) Loss on sale of marketable debt securities                                     |       | 20,000                                      |       | (33,125 | ) | — |   |
| Write down of investment                                                              |       | —                                      |       | 50,000 |   | — |   |
| Non-cash interest                                                                     |       | —                                      |       | — |   | 1,131,053 |   |
| Deferred rent                                                                         |       | (393,677                                    | )          | (91,291 | ) | — |   |
| Options and warrants issued for services and other                                    |       | 664,043                                     |       | 55,150 |   | 156,000 |   |
| Common stock issued for services and other                                            |       | —                                      |       | — |   | 76,000 |   |
| **Change  in assets and liabilities:**                                                | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Accounts receivable trade                                                             |       | 345,050                                     |       | 1,268,791 |   | (33,185 | ) |
| Costs and earnings in excess of billings on  uncompleted contracts                    |       | 2,468,770                                   |       | (906,649 | ) | — |   |
| Inventories                                                                           |       | 20,839                                      |       | 36,258 |   | (65,857 | ) |
| Prepaid expenses and other                                                            |       | (65,227                                     | )          | 273,588 |   | (115,032 | ) |
| Accounts payable                                                                      |       | (549,036                                    | )          | (362,505 | ) | (2,951 | ) |
| Billings in excess of costs and earnings on  uncompleted contracts                    |       | (317,737                                    | )          | 899,857 |   | — |   |
| Accrued liabilities                                                                   |       | 1,029,404                                   |       | 955,050 |   | (318,700 | ) |
| Deferred revenue                                                                      |       | 1,191,958                                   |       | (1,405,446 | ) | 10,000 |   |
| Net cash used in operating activities                                                 |       | (4,513,497                                  | )          | (5,644,759 | ) | (2,857,145 | ) |
| **CASH FLOWS FROM INVESTING  ACTIVITIES:**                                            | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Acquisition of PSG                                                                    |       | —                                      |       | (498,937 | ) | — |   |
| Acquisition of AMG                                                                    |       | —                                      |       | (10,431,878 | ) | — |   |
| Capital expenditures                                                                  |       | (148,616                                    | )          | (275,193 | ) | (66,543 | ) |
| Purchases of marketable debt securities                                               |       | —                                      |       | (5,887,500 | ) | — |   |
| Proceeds from sale of marketable debt securities                                      |       | 980,000                                     |       | 4,920,625 |   | — |   |
| Deposits                                                                              |       | 1,009,471                                   |       | (2,760,583 | ) | — |   |
| Patents and patents pending                                                           |       | (65,786                                     | )          | (149,687 | ) | — |   |
| Other                                                                                 |       | 50,000                                      |       | (46,552 | ) | (28,215 | ) |
| Net cash provided by (used in) investing activities                                   |       | 1,825,069                                   |       | (15,129,705 | ) | (94,758 | ) |
| **CASH FLOW FROM FINANCING  ACTIVITIES:**                                             | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net advance from (to) stockholders                                                    |       | (12,753                                     | )          | (54,437 | ) | 34,030 |   |
| Issuance of convertible bridge notes                                                  |       | 250,000                                     |       | — |   | — |   |
| Repayment of convertible bridge notes                                                 |       | (250,000                                    | )          | — |   | — |   |
| Issuance of long-term obligations                                                     |       | 4,822,250                                   |       | 10,601,839 |   | 3,852,250 |   |
| Repayment of long term obligations                                                    |       | (1,908,212                                  | )          | (401,563 | ) | — |   |
| Financing costs                                                                       |       | (248,406                                    | )          | (522,000 | ) | — |   |
| Sale of common stock                                                                  |       | —                                      |       | 11,248,803 |   | 61,665 |   |
| Exercise of warrants                                                                  |       | 558,788                                     |       | 1,950 |   | — |   |
| Repurchase of warrants and other                                                      |       | —                                      |       | (125,000 | ) | — |   |
| Payment of offering costs                                                             |       | (56,642                                     | )          | (31,688 | ) | — |   |
| Net cash provided by financing activities                                             |       | 3,155,025                                   |       | 20,717,904 |   | 3,947,945 |   |
| **NET  INCREASE (DECREASE) IN CASH**                                                  |       | 466,597                                     |       | (56,560 | ) | 996,042 |   |
| **CASH  AND CASH EQUIVALENTS, BEGINNING OF YEAR**                                     |       | 956,230                                     |       | 1,012,790 |   | 16,748 |   |
| **CASH AND CASH EQUIVALENTS, END  OF YEAR**                                           |       | $                                           | 1,422,827  |   | $ | 956,230 |   | $ | 1,012,790 |   |

 

The accompanying notes are an integral part ofthese statements.

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**BIO-keyInternational, Inc. and SubsidiaryNOTES TO THE FINANCIAL STATEMENTSDecember 31, 2005, 2004 and 2003**

**NOTEA—THE COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

*Changein Name of Company and State of Incorporation*

Effective January 1,2005, BIO-key International, Inc., a Minnesota corporation (“Old BIO-key”),reincorporated as BIO-key International, Inc., a Delaware corporation (the“Company,” “BIO-key”). The reincorporation was effected pursuant to anAgreement and Plan of Merger (the “Merger Agreement”); whereby Old BIO-key wasmerged with and into the Company, its wholly owned subsidiary, in order toreincorporate in the State of Delaware (the “Reincorporation”). As a result ofthe Reincorporation, the legal domicile of the registrant is now Delaware.

*Natureof Business*

The Company,founded in 1993, made two strategic acquisitions in 2004. The Company acquiredPublic Safety Group Inc. (“PSG”) in March, 2004, and the Mobile Governmentdivision of Aether Systems, Inc. (“AMG” or “Mobile Government”) inSeptember, 2004. The Company is now focused on delivering advanced finger basedbiometric identification and security solutions and information services to lawenforcement, fire service and emergence medical service agencies as well asother government and private sector customers. The Company’s mobile wirelesstechnology provides first responders throughout North America with critical,reliable, real-time data and images from local, state and national databases.

*Basisof Presentation*

Broad commercialacceptance of the Company’s technology is critical to the Company’s success andability to generate revenues. As a result of two acquisitions, the Company’sonly significant revenues to date have began in the fourth quarter of 2004. TheCompany recorded approximately $14,226,000 in revenues in 2005. The Company hasaccumulated losses during 2003 and 2004 of approximately $14,909,000, of whichapproximately $10,850,000 was incurred during 2004. The Company reported a lossof approximately $3,673,684 in 2005. As of December 31, 2005, there was aworking capital deficit of approximately $10,400,000.

The Company issuednotes in 2004 as well as 2005 in amount of approximately $10,101,000 and$5,300,000, respectively. The Company is also currently considering variousalternatives to improve its operating results. No assurance can be given thatthe Company’s operating results will improve as a result of this additionalfunding or that such funding would not be dilutive to existing stockholders.

The accompanying financialstatements have been prepared in conformity with accounting principlesgenerally accepted in the United States, which contemplate continuation of theCompany as a going concern. The matters described in the preceding paragraphsraise substantial doubt about the Company’s ability to continue as a goingconcern. Recoverability of a major portion of the recorded asset amounts shownin the accompanying balance sheet is dependent upon the Company’s ability toobtain additional funding, meet its funding requirements on a continuing basis,and succeed in its future operations. The accompanying financial statements donot include any adjustments that might be necessary should the Company beunable to continue in existence.

*Summaryof Significant Accounting Policies*

A summary of thesignificant accounting policies consistently applied in the preparation of theaccompanying consolidated financial statements follows:

1.             *Basis of Consolidation*

The accompanyingconsolidated financial statements include the accounts of BIO-key International, Inc.and its wholly owned subsidiary (collectively, the Company) and are stated inconformity with accounting principles generally accepted in the United States,pursuant to the rules and regulations of the Securities and ExchangeCommission. Intercompany accounts and transactions have been eliminated inconsolidation.

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2.             *Revenue Recognition*

Revenues fromsoftware licensing are recognized in accordance with Statement of Position(SOP) No. 97-2, Software Revenue Recognition, as amended by SOP No. 98-9.Accordingly, revenue from software licensing is recognized when all of thefollowing criteria are met: persuasive evidence of an arrangement exists,delivery has occurred, the fee is fixed or determinable, and collectability isprobable.

The Companyintends to enter into arrangements with end users for items whichmay include software license fees, usage fees and services or variouscombinations thereof. For each arrangement, revenues will be recognized whenevidence of an agreement has been documented, the fees are fixed ordeterminable, collection of fees is probable, delivery of the product hasoccurred and no other significant obligations remain.

Multiple-ElementArrangements: For multiple-element arrangements, each element of thearrangement will be analyzed and the Company will allocate a portion of thetotal fee under the arrangement to the elements using vendor specific objectiveevidence of fair value of the element, regardless of any separate prices statedwithin the contract for each element. Vendor specific objective evidence isbased on the price the customer is required to pay when the element is soldseparately (i.e., software license fees charged when consulting or otherservices are not provided, hourly rates charged for consulting services whensold separately from a software license or usage fees). If vendor specificobjective evidence of fair value does not exist for any undelivered elements,all revenue is deferred and recognized ratably over the service period if theundelivered element is services, or until sufficient objective evidence of fairvalue exists or all elements have been delivered.

License Revenues:Amounts allocated to license revenues are recognized at the time of delivery ofthe software and all other revenue recognition criteria discussed above havebeen met.

Revenue fromlicensing software, which requires significant customization and modification,is recognized using the percentage of completion method, based on the hours ofeffort incurred by the company in relation to the total estimated hours tocomplete. In instances where third party hardware, software or servicesform a significant portion of a customer’s contract, the companyrecognizes revenue for the element of software customization by the percentageof completion method described above. Third party hardware, software, andservices are recognized upon shipment or acceptance as appropriate. If thecompany makes different judgments or utilizes different estimates of the totalamount of work expected to be required to customize or modify the software, thetiming and revenue recognition, from period to period, and the margins on theproject in the reporting period, may differ materially from amountsreported. Revenues earned but not yet billed are shown as an asset in Costs andEarnings in Excess of Billings in the balance sheet. Billings in excess of costand earnings are reflected as a liability in the balance sheet. Anticipatedcontract losses are recognized as soon as they become known and are estimable.

Service Revenues:Revenues from services are comprised of maintenance and consulting andimplementation services. Maintenance revenues include providing for unspecifiedwhen-and-if available product updates and customer telephone support services,and are recognized ratably over the term of the service period. Consultingservices are generally sold on a time-and-materials basis and include a rangeof services including installation of software and assisting in the design ofinterfaces to allow the software to operate in customized environments.Services are generally separable from other elements under the arrangementsince performance of the services are not essential to the functionality of anyother element of the transaction and are described in the contract such thatthe total price of the arrangement would be expected to vary as the result ofthe inclusion or exclusion of the services. Revenues from services aregenerally recognized as the services are performed.

Usage Fees: Usagefees are charged on certain applications based on the customer’s volume of use.Usage revenue is recognized based on the actual level of activity used by thecustomer or, in the case of fixed-fee arrangements, ratably over the arrangedtime period.

The Company providescustomers, free of charge or at a minimal cost, testing kits which potentiallicensing customers may use to test compatibility/acceptance of theCompany’s technology with the customer’s intended applications.

3.             *Cash and Cash Equivalents*

Cash equivalentsconsist of certificates of deposit and all other liquid investments withoriginal maturities of three months or less. The Company maintains its cashbalances in a financial institution in Nevada. These balances are insured bythe Federal Deposit Insurance Corporation up to $100,000.

4.             *Accounts Receivable*

Accountsreceivable billed and unbilled are carried at original amount less an estimatemade for doubtful receivables based on a review of all outstanding amounts on amonthly basis. Management determines the allowance for doubtful receivables byregularly evaluating individual customer receivables and considering a customer’sfinancial condition, credit history, and current economic conditions. Accountsreceivable are written off when deemed uncollectible. Recoveries of accountsreceivable previously written off are recorded when received.

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5.             *Accounting for Acquisitions*

The Companycompleted the acquisitions of PSG and AMG. These acquisitions have beenaccounted for under the purchase method of accounting, which has resulted inrecording significant goodwill and other intangible asset balances. Thepurchase prices have been allocated to assets acquired and liabilities assumedat their estimated fair values on the date of the acquisitions, as determinedby management, and by appraisals with respect to identifiable intangibleassets. Our accounting for these acquisitions involves significant judgmentsand estimates regarding fair values of acquired intangible assets, which arebased on projections of future revenues and cash flows, assumptions regardingdiscount factors, royalty rates, tax rates, amortization methodologies andrelated useful lives. The developed technology (software), copyrightedsoftware, marketing agreements, customer relationships and trademarks werevalued using the income approach and are being amortized on a straight linebasis over five years, their estimated useful lives.

6.             *Depreciation and Amortization*

Depreciation isprovided for in amounts sufficient to relate the cost of depreciable assets tooperations over the estimated service lives, principally using straight-linemethods. Leasehold improvements are amortized over the shorter of the life ofthe improvement or the lease term, using the straight-line method. Intangibleassets other than patent costs are amortized on the straight-line method overtheir expected useful lives. Patent costs are capitalized until patents areawarded. Upon award, such costs are amortized over their respective lives. If apatent is denied, all costs are charged to operations in that year. Deferredfinancing fees related to the issuance of long-term obligations are capitalizedand amortized to interest expense over the lives of the related debt using theeffective interest rate method.

The estimated usefullives used to compute depreciation and amortization for financial reportingpurposes are as follows:

| *Equipment and leasehold improvements* | * * | * *            |
|----------------------------------------|----------|---------------------|
| Equipment                              |     | 3-5  years          |
| Furniture and fixtures                 |     | 3-5  years          |
| Software                               |     | 3  years            |
| Leasehold improvements                 |     | life  or lease term |
|                                   |     |                |
| *Intangible assets*                    | * * | * *            |
| Copyrighted software                   |     | 5  years            |
| Customer relationships                 |     | 5  years            |
| Trademarks                             |     | 5  years            |
| Developed technology                   |     | 5  years            |
| Marketing agreements                   |     | 5  years            |
| Patents                                |     | life                |
|                                   |     |                |
| *Deferred financing fees*              |     | 3 years             |

 

The estimatedaggregate amortization expense of intangible assets for the five yearsfollowing December 31, 2005 is approximately as follows:

| Year ending December 31, | ** ** | ** ** | ** ** |
|-----------------------------------------|------------|------------|------------|
| 2006                                    |       | $          | 1,826,000  |   |
| 2007                                    |       | $          | 1,384,000  |   |
| 2008                                    |       | $          | 931,000    |   |
| 2009                                    |       | $          | 430,000    |   |
| 2110                                    |       | $          | —     |   |

 

7.             *Marketable Debt Securities*

The Companyaccounts for marketable securities pursuant to Statement of FinancialAccounting Standards No. 115—“Accounting for Certain Investments in Debtand Equity Securities” (“SFAS 115”). SFAS 115 requires classificationof debt and equity securities in three categories: trading securities,available-for-sale securities and held-to-maturity securities. Debt and equitysecurities classified as trading securities are carried at fair value withunrealized gains or losses included in income. Debt and equity securitiesdesignated as available-for-sale, whose fair values are readily determinable,are carried at fair value with unrealized gains or losses included as acomponent of accumulated other comprehensive income, net of applicable taxes.Debt securities that are expected to be held-to-maturity are carried atamortized cost. On December 31, 2004, the Company’s investments were allclassified as available-for-sale. In January 2005, the Company sold theseinvestments and did not purchase any additional Marketable Debt Securities asof December 31,2005.

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8.             *Derivative and Warrant Financial Instruments*

In connection withthe sale of debt or equity instruments, we may sell options or warrants topurchase our common stock. In certain circumstances, these options or warrantsmay be classified as derivative liabilities, rather than as equity.Additionally, the debt or equity instruments may contain embeddedderivative instruments, such as conversion options, which in certaincircumstances may be required to be bifurcated from the associated hostinstrument and accounted for separately as a derivative instrument asset orliability.

The identificationof, and accounting for, derivative instruments is complex. Our derivativeinstrument liability is re-valued at the end of each reporting period, withchanges in the fair value of the derivative liability recorded as charges orcredits to income, in the period in which the changes occur. For options,warrants and bifurcated conversion options that are accounted for as derivativeinstrument liabilities, we determine the fair value of these instruments usingthe Black-Scholes option pricing model. That model requires assumptions relatedto the remaining term of the instruments and risk-free rates of return, ourcurrent common stock price and expected dividend yield, and the expectedvolatility of our common stock price over the life of the option. Theidentification of, and accounting for, derivative instruments and theassumptions used to value them can significantly affect our financialstatements.

9.             *Goodwill and Intangible Assets*

Goodwillrepresents the excess of costs of an acquired entity over the net of theamounts assigned to assets acquired and liabilities assumed. The Company hasadopted Statement of Financial Accounting Standards (“SFAS”) No. 142,Goodwill and Other Intangible Assets, which requires the Company to testgoodwill for impairment annually or whenever events or changes in circumstancesindicate that the carrying value of an asset may not be recoverable,rather than amortize. Accordingly, the Company has not amortized goodwill. Asprovided by SFAS No. 142, the Company has elected to perform theannual assessment of the carrying value of all goodwill as of September 30th of each year using a number of criteria,including the value of the overall enterprise. As of December 31, 2005,the Company believes that no material impairment exists. Future impairmentcharges from previous or future acquisitions, if any, will be reflected as anoperating expense in the statement of operations.

10.           *Impairment of Long-Lived Assets*

The Company hasadopted SFAS No. 144, Accounting for the Impairment or Disposal ofLong-Lived Assets. In accordance with SFAS No. 144, long-lived assetssubject to depreciation and amortization are reviewed for impairment wheneverevents or changes in circumstances indicate the carrying amount of an assetmay not be recoverable. The Company’s long-lived assets consist primarilyof its equipment and leasehold improvements and its intangible assets. Uponindication of possible impairment, the Company evaluates the recovery ofheld-for-use long-lived assets by measuring the carrying value of the assetsagainst the related estimated undiscounted future cash flows. When anevaluation indicates that the future undiscounted cash flows are not sufficientto recover the carrying value of the asset, the asset is adjusted to itsestimated fair value. The following circumstances would be considered importantand could lead to an impairment review; significant changes in the manner ofour using the asset, negative industry or economic trends and underperformancerelative to projected operating results.

11.           *Advertising Expense*

The Companyexpenses the costs of advertising as incurred. Advertising expenses for theyears ended December 31, 2005, 2004, and 2003, were approximately$108,000, $146,000, and $18,000, respectively.

12.*           Deferred Revenue*

Deferred revenueincludes customer advances and amounts that have been billed per thecontractual terms but have not been recognized as revenue. The majority ofthese amounts are related to maintenance contracts for which the revenue isrecognized ratably over the applicable term, which generally is 12 months fromthe date the customer accepts the products.

13.           *Research and Development Expenditures*

Research anddevelopment expenses include costs directly attributable to the conduct ofresearch and development programs primarily related to the development of oursoftware products and improving the efficiency and capabilities of our existingsoftware. Such costs include salaries, payroll taxes, employee benefit costs,materials, supplies, depreciation on research equipment, services provided byoutside contractors, and the allocable portions of facility costs, such asrent, utilities, insurance, repairs and maintenance, depreciation and generalsupport services. All costs associated with research and development isexpensed as incurred.

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14.           *Earnings Per Share Common Stock*

Earnings per shareof common stock-basic is computed by dividing net income applicable to commonstockholders by the weighted-average number of common shares outstanding forthe period. Earnings per share of common stock-assuming dilution reflects themaximum potential dilution that could occur if securities or other contracts toissue common stock were exercised or converted into common stock and would thenshare in the net income of the company. See Note U, “Earnings Per Share ofCommon Stock,” for additional information.

15.           *Accounting for Stock-Based Compensation*

The Company’semployee stock compensation plans are accounted for in accordance withAccounting Principles Board Opinion No. 25, “Accounting for Stock Issuedto Employees” (“APB 25”) and related interpretations. Under this method,no compensation expense is recognized as long as the exercise price equals orexceeds the market price of the underlying stock on the date of the grant. TheCompany elected the disclosure-only alternative permitted under Statement ofFinancial Accounting Standards No. 123, “Accounting for Stock-BasedCompensation” (“FAS 123”), as amended by FAS 148, for fixedstock-based awards to employees. All non-employee stock-based awards areaccounted for at fair value and recorded as compensation expense over theperiod of service in accordance with FAS 123 and related interpretations.

On December 31,2005, the Company accelerated the vesting of certain of the outstanding optionsto purchase shares of the Company’s common stock with option exercise pricesgreater than the fair market value of the Company’s common stock on such date.The acceleration applies to all such options outstanding as of December 31,2005 under the Company’s 1996 Stock Option Plan, 1999 Stock Option Plan and2004 Stock Option Plan, except for options held by the Company’s executiveofficers subject to Section 16(b) of the Securities Exchange Act of1934, as amended, and the members of the Company’s Board of Directors. Optionsto purchase up to 897,614 shares of the Company’s common stock, or 14% of thetotal shares of the Company’s common stock subject to outstanding options, witha weighted average exercise price of approximately $1.09 and varying remainingvesting schedules, are subject to this acceleration and become immediatelyvested and exercisable as of December 31, 2005. The number of shares,exercise prices and other terms of the options subject to the accelerationremain unchanged.

As a result ofthis acceleration, the Company expects to reduce its exposure to the effects ofthe Financial Accounting Standards Board’s Statement of Financial AccountingStandards No. 123 (revised 2004), Share-Based Payment (FAS 123R), whichrequires companies to recognize stock-based compensation expense associatedwith stock options based on the fair value method. The Company currentlyexpects reductions in stock-based compensation expense associated with thisacceleration of approximately $330,000 for fiscal year 2006 and approximately$225,000 for fiscal year 2007.

*Proforma Compensation Disclosure*

In December 2002,the Financial Accounting Standards Board (FASB) issued SFAS No.148, Accountingfor Stock-Based Compensation-Transition and Disclosure. SFAS No. 148amends SFAS No. 123, Accounting for Stock-Based Compensation, to providealternative methods of transition for a voluntary change to the fair valuebased method of accounting for stock-based employee compensation. In addition,SFAS No. 149 requires expanded, more prominent disclosure in both annualand interim financial statements about the method of stock-based employeecompensation and the effect of the method on reported results.

The Company hasnot adopted a method under SFAS No. 148 to expense stock options, butrather continues to apply the recognition and measurement provisions of APBOpinion No. 25, Accounting for Stock issued to Employees, and relatedinterpretations in accounting for those plans. No stock-based employeecompensation expense for options is reflected in net income or losses for thefiscal periods presented as all options granted under those plans had anexercise price equal to or lower than the market price of the underlying commonstock at the date of grant.

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If compensationexpense for the stock options granted had been determined based on the fairvalue at the grant dates consistent with the method of SFAS No. 123, theCompany’s proforma net income (loss) available to common shareholders andproforma income (loss) available to common shareholders per share would havebeen as follows:

|                                                                             | ** ** | **Years ended December 31,** | ** ** |
|-----------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                  | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                  | ** ** | **(Restated)**                              | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
| Net loss  available to common shareholders                                  |       | (4,013,152                                  | )          | (11,245,689 | ) | (4,195,705 | ) |
| Stock-based  compensation expense if the fair value method had been adopted |       | (1,496,086                                  | )          | (268,000 | ) | (136,000 | ) |
| Pro forma net  loss available to common shareholders                        |       | (5,509,238                                  | )          | (11,513,689 | ) | (4,331,705 | ) |
| Basic loss per  common shares                                               |       | (0.09                                       | )          | (0.32 | ) | (0.24 | ) |
| Basic loss per  common shares - pro forma                                   |       | (0.12                                       | )          | (0.33 | ) | (0.25 | ) |
| Diluted loss per  common shares                                             |       | (0.12                                       | )          | (0.32 | ) | (0.24 | ) |
| Diluted loss per common  shares - pro forma                                 |       | (0.14                                       | )          | (0.33 | ) | (0.25 | ) |

 

In determining theproforma compensation cost of the options granted, the fair value of each grantwas estimated on the date of grant using the Black-Scholes option pricingmodel. The assumptions used to determine the fair value of each grant includedthe following weighted average assumptions:

|                                      | ** ** | **2005**  | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------|------------|-----------|------------|----------|------------|----------|------------|
| Risk free interest  rate             |       | 3.95-4.51 | %          | 3.00     | %          | 1.90     | %          |
| Expected life of  options (in years) |       | 7.00      |       | 3.00     |       | 3.00     |       |
| Expected  dividends                  |       | —    |       | —   |       | —   |       |
| Volatility of stock  price           |       | 132       | %          | 90       | %          | 120      | %          |

 

16.           *Income Taxes*

The provision for,or benefit from, income taxes includes deferred taxes resulting from thetemporary differences in income for financial and tax purposes using theliability method. Such temporary differences result primarily from thedifferences in the carrying value of assets and liabilities. Future realizationof deferred income tax assets requires sufficient taxable income within thecarryback, carryforward period available under tax law. The Company evaluates,on a quarterly basis whether, based on all available evidence, if it isprobable that the deferred income tax assets are realizable. Valuationallowances are established when it is more likely than not that the tax benefitof the deferred tax asset will not be realized. The evaluation, as prescribedby Statement of Financial Accounting Standards No. 109, “Accounting forIncome Taxes,” includes the consideration of all available evidence, bothpositive and negative, regarding historical operating results including recentyears with reported losses, the estimated timing of future reversals ofexisting taxable temporary differences, estimated future taxable incomeexclusive of reversing temporary differences and carryforwards, and potentialtax planning strategies which may be employed to prevent an operating lossor tax credit carryforward from expiring unused. Because of the Company’shistorical performance and estimated future taxable income a full valuationallowance has been established.

17.           *Use of Estimates*

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States requires management to make estimates andassumptions that affect the reported amounts of assets and liabilities at thedate of the financial statements, the reported amounts of revenues and expensesduring the reporting period, and disclosure of contingent assets andliabilities. Actual results could differ from those estimates.

Estimates andassumptions, in the opinion of management are used in accounting for, amongother things, long-term contracts, allowances for uncollectible receivables, recoverabilityof goodwill and other long-lived assets, depreciation and amortization,valuation of deferred income taxes, convertible notes and related discounts,embedded derivates, preferred stock, stock options, and warrants outstanding.

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18.           *Recent Accounting Pronouncements*

In November 2005,FASB issued FSP FAS 115-1 and FAS 124-1, “The Meaning ofOther-Than-Temporary Impairment and Its Application to Certain Investments” (“FSPFAS 115-1”), which provides guidance on determining when investmentsin certain debt and equity securities are considered impaired, whether thatimpairment is other-than-temporary, and on measuring such impairment loss.FSP FAS 115-1 also includes accounting considerations subsequent tothe recognition of an other-than temporary impairment and requires certaindisclosures about unrealized losses that have not been recognized asother-than-temporary impairments. FSP FAS 115-1 is required to beapplied to reporting periods beginning after December 15, 2005. We arerequired to adopt FSP FAS 115-1 in the first quarter of fiscal 2006. Wedo not expect that the adoption of the statement will have a material impact onour consolidated results or financial condition.

In May 2005,FASB issued SFAS 154, “Accounting Changes and Error Corrections—a replacementof APB Opinion No. 20 and FASB Statement No. 3”. SFAS 154 changes therequirements for the accounting for and reporting of a change in accountingprinciple, and applies to all voluntary changes in accounting principle. Italso applies to changes required by an accounting pronouncement in the unusualinstance that the pronouncement does not include specific transitionprovisions. This statement requires retrospective application to prior periods’financial statements of changes in accounting principle, unless it isimpracticable to determine either the period-specific effects or the cumulativeeffect of the change. SFAS 154 is effective for accounting changes made infiscal years beginning after December 15, 2005. We do not expect thatadoption of this statement will have a material impact on our results ofoperations or financial condition.

In March 2005,the FASB issued FASB Interpretation No. 47, *Accounting for Conditional Asset Retirement Obligations — aninterpretation of FASB Statement No. 143*(FIN 47), whichrequires companies to recognize a liability for the fair value of a legalobligation to perform asset retirement activities that are conditional ona future event if the amount can be reasonably estimated. We adopted theprovisions of FIN 47 on December 31, 2005. No conditional asset retirementobligations were recognized and, accordingly, the adoption of FIN 47 had noeffect on our financial statements.

In December 2004,the FASB issued SFAS No. 123 (revised 2004), *Share-Based Payment*(SFAS 123R). This statementreplaces SFAS No. 123 and supersedes *APBOpinion No. 25, Accounting for Stock Issued to Employees.*SFAS 123Rrequires all share-based payments to employees, including grants of employeestock options, to be recognized in the financial statements based on their fairvalue. The pro-forma disclosures previously permitted under SFAS 123 nolonger will be an alternative to financial statement recognition. For theCompany, SFAS 123R is effective for periods beginning after December 15,2005. We plan to adopt SFAS 123R on January 1, 2006 using themodified prospective application method described in the statement. Under themodified prospective application method, we will apply the standard to newawards and to awards modified, repurchased, or cancelled after the requiredeffective date. Additionally, compensation cost for the unvested portion ofawards outstanding as of the required effective date will be recognized ascompensation expense as the requisite service is rendered after the requiredeffective date. We are evaluating the impact of adopting SFAS 123R andexpect that we will record substantial non-cash stock compensation expenses.The adoption of SFAS 123R is not expected to have a significant effect onour cash flows but is expected to have a significant adverse effect on ourresults of operations. The future impact of the adoption of SFAS 123Rcannot be predicted at this time because it will depend upon the levels ofshare-based payments granted in the future. However, had we adoptedSFAS 123R in prior periods, the impact would have approximated the impactof SFAS 123 as described in the disclosure of pro forma net lossattributable to common stockholders included in the Stock-Based Compensationfootnote.

In November 2004,the FASB issued Statement No. 151,*Inventory Costs—an amendment of ARB No. 43, Chapter 4*, whichamends and clarifies existing accounting literature regarding abnormal amountsof idle facility expense, freight, handling costs, and wasted material(spoilage). This statement is effective for inventory costs incurred duringfiscal years beginning after June 15, 2005, with earlier applicationpermitted. The provisions of this statement are to be applied prospectively.The adoption of this standard is not expected to have a material effect on theCompany’s financial position, results of operations, or liquidity.

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**NOTE B—RESTATEMENTOF PREVIOUSLY ISSUED FINANCIAL STATEMENTS**

RESTATEMENT

In the process of reviewing our registration statementfor the securities issued in our June 2005 financing, the Securities andExchange Commission (“SEC”) raised questions with regard to our convertibleterm notes suggesting that we consider EITF 00-19, “Accounting forDerivative Financial Instruments Indexed to, and Potentially Settled in, aCompany’s Own Stock” to evaluate whether there were any embedded derivativeinstruments and if so, whether they should be accounted for as an equity orliability classification. The SEC suggested that we review the methodology usedin the valuations of the embedded derivative instruments and also reviewwhether warrants issued with our 2004 financing should be accounted for as anequity or liability classification. The SEC staff also commented that theCompany should review the convertible notes issued in fiscal 2003 and 2004. TheSEC staff also asked us to review adjustments to revenue made in the fourthquarter of 2004. The SEC staff raised the question of whether the transactionshad a material impact on previously filed Exchange Act reports and would bebetter characterized as restatements.

There were several items that were identified asrequiring restatement, these items were:

·                                          *Revenue Recognition*

The Company reviewedcontracts and purchase agreements related to certain non-governmental customersand identified specific contracts for which the initial accounting inflatedannual and quarterly revenues and earnings in violation of generally acceptedaccounting principles (“GAAP”). These practices were primarily the result ofrecognizing revenue on transactions with customers that were not creditworthyand recognizing revenue when the earnings process had not been completed. Therevenue and related cost has been adjusted on the income statement as well asthe related balance sheet accounts.

·                                          *Accounting for Convertible Financing Arrangements*

The Company reviewed theinitial accounting for the 7% Convertible Notes issued in 2003, the Senior andSubordinated Convertible Term Notes issued in 2004 and the Senior andSubordinated Convertible Term Notes issued in 2005. During the review thecompany identified that EITF 00-19 should be applied to evaluate whetherany embedded derivative instruments qualify as equity instruments or asliabilities. As such certain embedded derivatives were identified that met theconditions set forth under paragraph 12 of SFAS No. 133. These embeddedderivative instruments have been evaluated using EITF 00-19 paragraphs 12to 32 and determined that these instruments would not be classified ascomponents of stockholders equity. The instruments have been deemedliabilities, and as such will be subject to SFAS 133 and should be recorded atfair value. Features that have been evaluated and determined to require suchtreatment include:

·                  Theprincipal conversion option

·                  Themonthly payments conversion option

·                  Theinterest rate adjustment provisions.

Additionally, it wasidentified that certain other components of the related financings were alsoincorrectly accounted for. This includes the warrants issued with the abovefinancing and the costs incurred by Company in obtaining the above financings.The correction of prior errors affected the subsequent accounting for debtconversions to equity as well as the amortization of related discounts anddeferred finance charges associated with the above financings.

·          *Accounting for Warrants Related to the Companies2004 Debt Financing*

Based on certain registration rights provisions it wasdetermined that the warrants issued with the 2004 Debt Financing would requirecontinued classification as a liability and revalued every quarter. The Companypreviously classified the warrants as equity upon the registration rightsagreement becoming effective during the fourth quarter of 2004.

      ·*           Valuations ofEmbedded Derivatives*

The initial valuation methodology overstated the valueof the conversion option derivatives. The company’s review of the valuations ofthe embedded derivatives determined that the valuation of the principalconversion option and the monthly payments conversion option shared certaincomponents that resulted in a double counting of the embedded derivativevaluation. As such the company has adjusted its valuations of these embeddedderivatives.

      ·*           AdditionalDerivative (Default Provision)*

The company also reviewedthe default provisions set forth in the debt instruments and determined that anadditional embedded derivative existed that required bifurcation from the hostcontract and would need to be revalued on a quarterly basis.

The Company reviewed theearnout calculations performed in the prior year for the PSG acquisition andidentified an error in the calculation. As a result, the Company hasrestated the prior year’s impact relating to this error. At December 31,2004 the Company had accrued $43,635 for the earnout provision. Thecorrected calculation resulted in no accrual being required, and as suchthe related accrual and goodwill balances have been reduced by $43,635.

Management believes thescope and process of its internal review of previously reported financialinformation was sufficient to identify issues of a material nature that couldaffect our Consolidated Financial Statements and all dates and periodspresented herein have been restated to fairly present the results of ouroperations.

The errors in ourpreviously reported financial information, and the failure to prevent them ordetect them in our financial reporting process, were largely attributable toweak internal controls and an inadequate staff of competent accountingpersonnel with an appropriate level of knowledge of GAAP.

As a result of our reviewand communications with the SEC, we determined that a restatement of previouslyreported financial information was required. Our previously reported financialinformation should no longer be relied upon. Accordingly, we have restated ourpreviously reported financial information for the years ended December 31,2003, 2004 and 2005 and our previously reported unaudited financial statementsfor the first, second and third quarters of 2003, 2004 and 2005 (the “restatement”).The restatement covers a number of separate matters, each of which is describedabove.

Certain of the previouslyreported amounts below have been reclassified to conform to the 2005presentation. These reclassifications had no effect on the previously reportednet loss or stockholders equity (deficit).

For the quarterly impactof the restatement and the restated financial results for the first, second andthird quarters of 2003, 2004, and 2005, see Note X, Results by Quarter.

65

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The following tablessummarize the impact of all of these adjustments on previously reportedrevenue, and assets, liabilities, and retained stockholders’ equity (deficit)for the years ended December 31, 2005, 2004 and 2003.
| ** **                  | ** ** | **Impact of Adjustments on RevenueFor the Years Ended December 31,** | ** ** |
|-----------------------------|------------|-------------------------------------------------------------------------------------------------------------------|------------|
| ** **                  | ** ** | **2005**                                                                                                          | ** ** | **2004** | ** ** | **2003** | ** ** |
| **As  previously reported** | ** ** | $                                                                                                                 | 14,226,095 |   | $ | 5,558,231 |   | $ | 524,101 |   |
| Revenue  recognition        |       | —                                                                                                            |       | 162,720 |   | (308,620 | ) |
| **As restated**             | ** ** | $                                                                                                                 | 14,226,095 |   | $ | 5,720,951 |   | $ | 215,481 |   |

 
| ** **                                        | ** ** | **Impact of Adjustments on Consolidated Balance Sheet Accounts** | ** ** |
|---------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|
| ** **                                        | ** ** | **As of December 31, 2005**                                                     | ** ** |
| ** **                                        | ** ** | ** **                                                                                          | ** ** | ** ** | ** ** | **Stockholders’** | ** ** |
| ** **                                        | ** ** | **Total**                                                                                           | ** ** | ** ** | ** ** | **Equity** | ** ** |
| ** **                                        | ** ** | **Assets**                                                                                          | ** ** | **Liabilities** | ** ** | **(Deficit)** | ** ** |
| **As  previously reported**                       |       | $                                                                                                   | 26,357,934 |   | $ | 17,050,206 |   | $ | 9,307,728 |   |
| Revenue  recognition and related SG&A expense |       | —                                                                                              |       | — |   | — |   |
| Debt financing                                    |       | —                                                                                              |       | 3,143,724 |   | (3,143,724 | ) |
| Total  Adjustments                                |       | —                                                                                              |       | 3,143,724 |   | (3,143,724 | ) |
| **As restated**                                   |       | $                                                                                                   | 26,357,934 |   | $ | 20,193,930 |   | $ | 6,164,004 |   |

 
| ** **                                        | ** ** | **Impact of Adjustments on Consolidated Balance Sheet Accounts** | ** ** |
|---------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|
| ** **                                        | ** ** | **As of December 31, 2004**                                                     | ** ** | **As of December 31, 2003** | ** ** |
| ** **                                        | ** ** | ** **                                                                                          | ** ** | ** ** | ** ** | **Stockholders’** | ** ** | ** ** | ** ** | ** ** | ** ** | **Stockholders’** | ** ** |
| ** **                                        | ** ** | **Total**                                                                                           | ** ** | ** ** | ** ** | **Equity** | ** ** | **Total** | ** ** | **Total** | ** ** | **Equity** | ** ** |
| ** **                                        | ** ** | **Assets**                                                                                          | ** ** | **Liabilities** | ** ** | **(Deficit)** | ** ** | **Assets** | ** ** | **Liabilities** | ** ** | **(Deficit)** | ** ** |
| **As  previously reported**                       |       | $                                                                                                   | 30,844,681 |   | $ | 20,223,283 |   | $ | 10,621,398 |   | $ | 1,864,742 |   | $ | 11,000,731 |   | $ | (9,135,989 | ) |
| Revenue  recognition and related SG&A expense |       | (122,090                                                                                            | )          | 23,810 |   | (145,900 | ) | (308,620 | ) | (18,200 | ) | (290,420 | ) |
| Debt financing                                    |       | 816,501                                                                                             |       | 4,742,344 |   | (3,925,843 | ) | — |   | (57,543 | ) | 57,543 |   |
| Total  Adjustments                                |       | 694,411                                                                                             |       | 4,766,154 |   | (4,071,743 | ) | (308,620 | ) | (75,743 | ) | (232,877 | ) |
| **As restated**                                   |       | $                                                                                                   | 31,539,092 |   | $ | 24,989,437 |   | $ | 6,549,655 |   | $ | 1,556,122 |   | $ | 10,924,988 |   | $ | (9,368,866 | ) |

 

66

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The following tables present the effect of therestatement adjustments on the consolidated Statement of Operations for theyears ended December 31, 2005, 2004 and 2003.
| ** **                                                                  | ** ** | **Year Ended December 31, 2005** | ** ** |
|-----------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                  | ** ** | **As Previously**                               | ** ** | **Effect of** | ** ** | **As** | ** ** |
| ** **                                                                  | ** ** | **Reported**                                         | ** ** | **Restatement** | ** ** | **Restated** | ** ** |
| **Revenues**                                                                | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Services                                                                    |       | $                                                    | 10,861,649 |   | $ | — |   | $ | 10,861,649 |   |
| License fees and other                                                      |       | 3,364,446                                            |       | — |   | 3,364,446 |   |
|                                                                        |       | 14,226,095                                           |       | — |   | 14,226,095 |   |
| **Costs and other expenses**                                                | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Services                                                                    |       | 2,906,142                                            |       | — |   | 2,906,142 |   |
| Cost of license fees and other                                              |       | 937,491                                              |       | — |   | 937,491 |   |
| Selling, general and administrative                                         |       | 11,824,609                                           |       | — |   | 11,824,609 |   |
| Research, development and engineering                                       |       | 6,846,035                                            |       | — |   | 6,846,035 |   |
|                                                                        |       | 22,514,277                                           |       | — |   | 22,514,277 |   |
| **Operating  loss**                                                         |       | (8,288,182                                           | )          | — |   | (8,288,182 | ) |
| **Other income (deductions)**                                               | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest income                                                             |       | 35,958                                               |       | — |   | 35,958 |   |
| Interest expense                                                            |       | (6,548,130                                           | )          | 2,026,786 |   | (4,521,344 | ) |
| Derivative and warrant fair value adjustments                               |       | 15,213,186                                           |       | (6,058,235 | ) | 9,154,951 |   |
| Loss on sale of marketable securities                                       |       | (20,000                                              | )          | — |   | (20,000 | ) |
| Other expense                                                               |       | (34,767                                              | )          | — |   | (34,767 | ) |
| Total other income (deductions)                                             |       | 8,646,247                                            |       | (4,031,449 | ) | 4,614,798 |   |
| **NET  INCOME (LOSS)**                                                      |       | $                                                    | 358,065    |   | $ | (4,031,449 | ) | $ | (3,673,384 | ) |
| **Basic  Loss per Share:**                                                  | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                                 | * *   | * *                                             | * *   | * * | * * | * * | * * |
| Net loss                                                                    |       | $                                                    | 358,065    |   | $ | (4,031,449 | ) | $ | (3,673,384 | ) |
| Convertible preferred stock dividends and accretion                         |       | (313,517                                             | )          |   |   | (313,517 | ) |
| Net Income (Loss) attributable to common  shareholders                      |       | $                                                    | 44,548     |   | $ | (4,031,449 | ) | $ | (3,986,901 | ) |
| *Denominator*                                                               | * *   | * *                                             | * *   | * * | * * | * * | * * |
| Weighted average common shares outstanding                                  |       | 44,787,807                                           |       | 44,787,807 |   | 44,787,807 |   |
| ***Basic  Loss per Share***                                                 |       | $                                                    | 0.00       |   | $ | (0.09 | ) | $ | (0.09 | ) |
| **Diluted  Loss per Share:**                                                | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                                 | * *   | * *                                             | * *   | * * | * * | * * | * * |
| Net Income (loss) attributable to common  shareholders                      |       | $                                                    | 44,548     |   | $ | (4,031,449 | ) | $ | (3,986,901 | ) |
| Effect of Dilutive Securities: Convertible  Debentures                      |       | (8,795,834                                           | )          | 6,758,889 |   | (2,036,945 | ) |
| Net loss attributable to common shareholders and  assumed conversions  |       | $                                                    | (8,751,286 | ) | $ | 2,727,440 |   | $ | (6,023,846 | ) |
| *Denominator*                                                               | * *   | * *                                             | * *   | * * | * * | * * | * * |
| Weighted average shares outstanding                                         |       | 44,787,807                                           |       | — |   | 44,787,807 |   |
| Effect of Dilutive Securities: Convertible  Debentures                      |       | 7,258,496                                            |       | — |   | 7,258,496 |   |
| Diluted weighted average common shares and common  equivalents outstanding  |       | 52,046,303                                           |       | 52,046,303 |   | 52,046,303 |   |
| ***Diluted  Loss per Share***                                               |       | $                                                    | (0.17      | ) | $ | 0.05 |   | $ | (0.12 | ) |

 

67

----

 
| ** **                                                                              | ** ** | **Year Ended December 31, 2004** | ** ** |
|-----------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                              | ** ** | **As Previously**                               | ** ** | **Effect of** | ** ** | **As** | ** ** |
| ** **                                                                              | ** ** | **Reported**                                         | ** ** | **Restatement** | ** ** | **Restated** | ** ** |
| **Revenues**                                                                            | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Services                                                                                |       | $                                                    | 3,351,406  |   | $ | — |   | $ | 3,351,406 |   |
| License fees and other                                                                  |       | 2,206,825                                            |       | 162,720 |   | 2,369,545 |   |
|                                                                                    |       | 5,558,231                                            |       | 162,720 |   | 5,720,951 |   |
| **Costs and other expenses**                                                            | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Services                                                                                |       | 1,174,324                                            |       | — |   | 1,174,324 |   |
| Cost of license fees and other                                                          |       | 889,896                                              |       | — |   | 889,896 |   |
| Selling, general and administrative                                                     |       | 7,096,088                                            |       | 18,200 |   | 7,114,288 |   |
| Research, development and engineering                                                   |       | 2,979,904                                            |       | — |   | 2,979,904 |   |
|                                                                                    |       | 12,140,212                                           |       | 18,200 |   | 12,158,412 |   |
| **Operating  loss**                                                                     |       | (6,581,981                                           | )          | 144,520 |   | (6,437,461 | ) |
| **Other income (deductions)**                                                           | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest income                                                                         |       | 66,824                                               |       | — |   | 66,824 |   |
| Interest expense                                                                        |       | (667,008                                             | )          | (748,527 | ) | (1,415,535 | ) |
| Derivative and warrant fair value adjustments                                           |       | —                                               |       | (3,008,419 | ) | (3,008,419 | ) |
| Gain on sale of marketable securities                                                   |       | 33,125                                               |       | — |   | 33,125 |   |
| Other expense                                                                           |       | (88,425                                              | )          | — |   | (88,425 | ) |
| Total other income (deductions)                                                         |       | (655,484                                             | )          | (3,756,946 | ) | (4,412,430 | ) |
| **NET  LOSS**                                                                           |       | $                                                    | (7,237,465 | ) | $ | (3,612,426 | ) | $ | (10,849,891 | ) |
| **Basic  Loss per Share:**                                                              | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                                             |       |                                                 |       |   |   |   |   |
| Net loss                                                                                |       | $                                                    | (7,237,465 | ) | $ | (3,612,426 | ) | $ | (10,849,891 | ) |
| Convertible preferred stock dividends and accretion                                     |       | (414,240                                             | )          | 28,885 |   | (385,355 | ) |
| Net loss attributable to common shareholders                                            |       | $                                                    | (7,651,705 | ) | $ | (3,583,541 | ) | $ | (11,235,246 | ) |
| *Denominator*                                                                           |       |                                                 |       |   |   |   |   |
| Weighted average common shares outstanding                                              |       | 34,727,969                                           |       | 34,806,201 |   | 34,727,969 |   |
| ***Basic  Loss per Share***                                                             |       | $                                                    | (0.22      | ) | $ | (0.10 | ) | $ | (0.32 | ) |
| **Diluted  Loss per Share:**                                                            | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                                             |       |                                                 |       |   |   |   |   |
| Net loss attributable to common shareholders                                            |       | $                                                    | (7,651,705 | ) | $ | (3,583,541 | ) | $ | (11,235,246 | ) |
| Net loss attributable to common shareholders and  assumed conversions    |       | $                                                    | (7,651,705 | ) | $ | (3,583,541 | ) | $ | (11,235,246 | ) |
| *Denominator*                                                                           |       |                                                 |       |   |   |   |   |
| Weighted average shares Outstanding                                                     |       | 34,727,969                                           |       | 34,806,201 |   | 34,727,969 |   |
| Effect of  Dilutive Securities:                                                         |       |                                                 |       |   |   |   |   |
| Convertible Debentures                                                                  |       | —                                               |       | — |   | — |   |
| Diluted weighted average common shares and common  equivalents outstanding              |       | 34,727,969                                           |       | 34,806,201 |   | 34,727,969 |   |
| ***Diluted  Loss per Share***                                                           |       | $                                                    | (0.22      | ) | $ | (0.10 | ) | $ | (0.32 | ) |

 

68

----

 
| ** **                                                                 | ** ** | **Year Ended December 31, 2003** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                 | ** ** | **As Previously**                               | ** ** | **Effect of** | ** ** | **As** | ** ** |
| ** **                                                                 | ** ** | **Reported**                                         | ** ** | **Restatement** | ** ** | **Restated** | ** ** |
| **Revenues**                                                               | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Services                                                                   |       | $                                                    | 10,694     |   | $ | — |   | $ | 10,694 |   |
| License fees and other                                                     |       | 513,407                                              |       | (308,620 | ) | 204,787 |   |
|                                                                       |       | 524,101                                              |       | (308,620 | ) | 215,481 |   |
| **Costs and other expenses**                                               | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cost of services                                                           |       | 1,694                                                |       | — |   | 1,694 |   |
| Cost of license fees and other                                             |       | 87,387                                               |       | — |   | 87,387 |   |
| Selling, general and administrative                                        |       | 2,118,122                                            |       | (18,200 | ) | 2,099,922 |   |
| Research, development and engineering                                      |       | 1,037,330                                            |       | — |   | 1,037,330 |   |
|                                                                       |       | 3,244,533                                            |       | (18,200 | ) | 3,226,333 |   |
| **Operating  loss**                                                        |       | (2,720,432                                           | )          | (290,420 | ) | (3,010,852 | ) |
| **Other income (deductions)**                                              | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest expense                                                           |       | (1,109,786                                           | )          | (800,002 | ) | (1,909,788 | ) |
| Derivative and warrant fair value adjustments                              |       | —                                               |       | 857,545 |   | 857,545 |   |
| Other income                                                               |       | 4,145                                                |       | — |   | 4,145 |   |
| Total other income (deductions)                                            |       | (1,105,641                                           | )          | 57,543 |   | (1,048,098 | ) |
| **NET  LOSS**                                                              |       | $                                                    | (3,826,073 | ) | $ | (232,877 | ) | $ | (4,058,950 | ) |
| **Basic  Loss per Share:**                                                 | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                                |       |                                                 |       |   |   |   |   |
| Net loss                                                                   |       | $                                                    | (3,826,073 | ) | $ | (232,877 | ) | $ | (4,058,950 | ) |
| Convertible preferred stock dividends and accretion                        |       | (136,755                                             | )          | — |   | (136,755 | ) |
| Net loss attributable to common shareholders                               |       | $                                                    | (3,962,828 | ) | $ | (232,877 | ) | $ | (4,195,705 | ) |
| *Denominator*                                                              |       |                                                 |       |   |   |   |   |
| Weighted average common shares outstanding                                 |       | 17,543,586                                           |       | 17,543,586 |   | 17,543,586 |   |
| ***Basic  Loss per Share***                                                |       | $                                                    | (0.23      | ) | $ | (0.01 | ) | $ | (0.24 | ) |
| **Diluted  Loss per Share:**                                               | ** ** | ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                                |       |                                                 |       |   |   |   |   |
| Net Loss attributable to common shareholders                               |       | $                                                    | (3,962,828 | ) | $ | (232,877 | ) | $ | (4,195,705 | ) |
| Effect of  Dilutive Securities:                                            |       |                                                 |       |   |   |   |   |
| Convertible Debentures                                                     |       | —                                               |       | — |   | — |   |
| Net loss attributable to common shareholders and assumed  conversions      |       | $                                                    | (3,962,828 | ) | $ | (232,877 | ) | $ | (4,195,705 | ) |
| *Denominator*                                                              |       |                                                 |       |   |   |   |   |
| Weighted average shares outstanding                                        |       | 17,543,586                                           |       | 17,543,586 |   | 17,543,586 |   |
| Effect of  Dilutive Securities:                                            |       |                                                 |       |   |   |   |   |
| Convertible Debentures                                                     |       | —                                               |       | — |   | — |   |
| Diluted weighted average common shares and common  equivalents outstanding |       | 17,543,586                                           |       | 17,543,586 |   | 17,543,586 |   |
| ***Diluted  Loss per Share***                                              |       | $                                                    | (0.23      | ) | $ | (0.01 | ) | $ | (0.24 | ) |

 

69

----

 

The followingtables present the effect of the restatement adjustments on the ConsolidatedBalance Sheet as of December 31, 2005, 2004 and 2003.

**CONSOLIDATED BALANCE SHEET**
| ** **                                                                                                                                                                        | ** ** | **As of December 31, 2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                                                                                                                        | ** ** | **As Previously   Reported**          | ** ** | **Effect of   Restatement** | ** ** | **As Restated** | ** ** |
| **ASSETS**                                                                                                                                                                        | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash and cash  equivalents                                                                                                                                                        |       | $                                               | 1,422,827  |   | $ | — |   | $ | 1,422,827 |   |
| Receivables                                                                                                                                                                       |       |                                            |       |   |   |   |   |
| Billed less allowance for doubtful receivables as of  $160,000                                                                                                                    |       | 1,635,371                                       |       | — |   | 1,635,371 |   |
| Unbilled                                                                                                                                                                          |       | 201,942                                         |       | — |   | 201,942 |   |
| Costs and  earnings in excess of billings on uncompleted contracts                                                                                                                |       | 4,321,392                                       |       | — |   | 4,321,392 |   |
| Inventory                                                                                                                                                                         |       | 8,760                                           |       | — |   | 8,760 |   |
| Prepaid expenses                                                                                                                                                                  |       | 137,000                                         |       | — |   | 137,000 |   |
| Total current assets                                                                                                                                                              |       | 7,727,292                                       |       |   |   | 7,727,292 |   |
| Equipment and  leasehold improvements, net                                                                                                                                        |       | 548,267                                         |       | — |   | 548,267 |   |
| Deposits                                                                                                                                                                          |       | 1,828,560                                       |       | — |   | 1,828,560 |   |
| Intangible  assets—less accumulated amortization                                                                                                                             |       | 3,301,823                                       |       | — |   | 3,301,823 |   |
| Deferred  financing costs, net                                                                                                                                                    |       | 1,562,338                                       |       | — |   | 1,562,338 |   |
| Goodwill                                                                                                                                                                          |       | 11,389,654                                      |       | — |   | 11,389,654 |   |
| Total non-current assets                                                                                                                                                          |       | 18,630,642                                      |       | — |   | 18,630,642 |   |
| TOTAL ASSETS                                                                                                                                                                      |       | $                                               | 26,357,934 |   | $ | — |   | $ | 26,357,934 |   |
| **LIABILITIES**                                                                                                                                                                   | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Current  maturities of long-term obligations                                                                                                                                      |       | $                                               | 4,924,224  |   | $ | 3,143,724 |   | $ | 8,067,948 |   |
| Accounts payable                                                                                                                                                                  |       | 833,608                                         |       | — |   | 833,608 |   |
| Billing in  excess of costs and earnings on uncompleted contracts                                                                                                                 |       | 32,385                                          |       | — |   | 32,385 |   |
| Accrued  liabilities                                                                                                                                                              |       | 5,520,515                                       |       | — |   | 5,520,515 |   |
| Deferred rent                                                                                                                                                                     |       | 443,603                                         |       | — |   | 443,603 |   |
| Deferred revenue                                                                                                                                                                  |       | 3,264,283                                       |       | — |   | 3,264,283 |   |
| Total current liabilities                                                                                                                                                         |       | 15,018,618                                      |       | 3,143,724 |   | 18,162,342 |   |
| Deferred rent                                                                                                                                                                     |       | 867,850                                         |       | — |   | 867,850 |   |
| Deferred revenue                                                                                                                                                                  |       | 1,163,738                                       |       | — |   | 1,163,738 |   |
| Total non-current liabilities                                                                                                                                                     |       | 2,031,588                                       |       | — |   | 2,031,588 |   |
| TOTAL  LIABILITIES                                                                                                                                                                |       | 17,050,206                                      |       | 3,143,724 |   | 20,193,930 |   |
| **STOCKHOLDERS’ EQUITY (DEFICIT)**                                                                                                                                           | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Preferred  stock-authorized, 5,000,000 shares (liquidation preference of $100 per share)  Series A 7% Convertible; issued and outstanding, 44,557shares of $.0001  par value |       | 4                                               |       | — |   | 4 |   |
| Common  stock-authorized, 85,000,000 shares, 46,306,589 issued and outstanding of  $.0001 par value                                                                               |       | 4,632                                           |       | — |   | 4,632 |   |
| Additional  paid-in capital                                                                                                                                                       |       | 51,529,332                                      |       | (2,608,016 | ) | 48,921,316 |   |
| Accumulated  deficit                                                                                                                                                              |       | (42,226,240                                     | )          | (535,708 | ) | (42,761,948 | ) |
| TOTAL  STOCKHOLDERS’ EQUITY (DEFICIT)                                                                                                                                        |       | 9,307,728                                       |       | (3,143,724 | ) | 6,164,004 |   |
| TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY (DEFICIT)                                                                                                                        |       | $                                               | 26,357,934 |   | $ | — |   | $ | 26,357,934 |   |

 

70

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**CONSOLIDATED BALANCESHEET**
| ** **                                                                                                                                                                       | ** ** | **As of December 31, 2004** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                                                                                                                       | ** ** | **As Previously**                          | ** ** | **Effect of** | ** ** | **As** | ** ** |
| ** **                                                                                                                                                                       | ** ** | **Reported**                                    | ** ** | **Restatement** | ** ** | **Restated** | ** ** |
| **ASSETS:**                                                                                                                                                                      | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash and cash  equivalents                                                                                                                                                       |       | $                                               | 956,230    |   | $ | — |   | $ | 956,230 |   |
| Marketable debt  securities                                                                                                                                                      |       | 1,000,000                                       |       | — |   | 1,000,000 |   |
| Receivables                                                                                                                                                                      |       |                                            |       |   |   |   |   |
| Billed, less allowance for doubtful receivables of  $422,393                                                                                                                     |       | 1,698,144                                       |       | (90,090 | ) | 1,608,054 |   |
| Unbilled                                                                                                                                                                         |       | 310,523                                         |       | — |   | 310,523 |   |
| Due from selling  stockholders and other                                                                                                                                         |       | 60,793                                          |       | (32,000 | ) | 28,793 |   |
| Costs and  earnings in excess of billings on uncompleted contracts                                                                                                               |       | 6,292,603                                       |       | — |   | 6,292,603 |   |
| Inventory                                                                                                                                                                        |       | 29,599                                          |       | — |   | 29,599 |   |
| Prepaid expenses                                                                                                                                                                 |       | 113,130                                         |       | — |   | 113,130 |   |
| Total current assets                                                                                                                                                             |       | 10,461,022                                      |       | (122,090 | ) | 10,338,932 |   |
| Equipment and  leasehold improvements, net                                                                                                                                       |       | 644,101                                         |       | — |   | 644,101 |   |
| Costs and  earnings in excess of billings on uncompleted contracts                                                                                                               |       | 657,000                                         |       | — |   | 657,000 |   |
| Deposits                                                                                                                                                                         |       | 2,838,031                                       |       | — |   | 2,838,031 |   |
| Intangible  assets—less accumulated amortization                                                                                                                            |       | 4,177,279                                       |       | (77,982 | ) | 4,099,297 |   |
| Deferred  financing costs, net                                                                                                                                                   |       | —                                          |       | 938,118 |   | 938,118 |   |
| Goodwill                                                                                                                                                                         |       | 12,067,248                                      |       | (43,635 | ) | 12,023,613 |   |
| Total non-current assets                                                                                                                                                         |       | 20,383,659                                      |       | 816,501 |   | 21,200,160 |   |
| TOTAL ASSETS                                                                                                                                                                     |       | $                                               | 30,844,681 |   | $ | 694,411 |   | $ | 31,539,092 |   |
| **LIABILITIES:**                                                                                                                                                                 | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Current  maturities of long-term obligations                                                                                                                                     |       | $                                               | 3,255,182  |   | $ | (192,460 | ) | $ | 3,062,722 |   |
| Advances from  stockholders                                                                                                                                                      |       | 12,753                                          |       | — |   | 12,753 |   |
| Accounts payable                                                                                                                                                                 |       | 1,325,282                                       |       | 23,810 |   | 1,349,092 |   |
| Billings in  excess of costs and earnings on uncompleted contracts                                                                                                               |       | 760,807                                         |       | — |   | 760,807 |   |
| Accrued  liabilities                                                                                                                                                             |       | 4,639,619                                       |       | (43,635 | ) | 4,595,984 |   |
| Deferred rent                                                                                                                                                                    |       | 393,676                                         |       | — |   | 393,676 |   |
| Deferred revenue                                                                                                                                                                 |       | 3,166,356                                       |       | — |   | 3,166,356 |   |
| Total current liabilities                                                                                                                                                        |       | 13,553,675                                      |       | (212,285 | ) | 13,341,390 |   |
| Long-term  obligations, net of discount and current maturities                                                                                                                   |       | 5,286,951                                       |       | 4,978,439 |   | 10,265,390 |   |
| Deferred rent                                                                                                                                                                    |       | 1,311,454                                       |       | — |   | 1,311,454 |   |
| Deferred revenue                                                                                                                                                                 |       | 71,203                                          |       | — |   | 71,203 |   |
| Total non-current liabilities                                                                                                                                                    |       | 6,669,608                                       |       | 4,978,439 |   | 11,648,047 |   |
| TOTAL  LIABILITIES                                                                                                                                                               |       | 20,223,283                                      |       | 4,766,154 |   | 24,989,437 |   |
| **STOCKHOLDERS’ EQUITY (DEFICIT)**                                                                                                                                          | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Preferred  stock-authorized, 5,000,000 shares (liquidation preference of $100 per share)  Series C 7% Convertible; issued and outstanding, 62,182 shares of $.01  par value |       | 623                                             |       | — |   | 623 |   |
| Common stock—authorized,  85,000,000 shares, 40,680,691 issued and outstanding of $.01 par value                                                                            |       | 406,808                                         |       | — |   | 406,808 |   |
| Additional  paid-in capital                                                                                                                                                      |       | 45,325,172                                      |       | (226,441 | ) | 45,098,731 |   |
| Accumulated  deficit                                                                                                                                                             |       | (35,111,205                                     | )          | (3,845,302 | ) | (38,956,507 | ) |
| TOTAL  STOCKHOLDERS’ EQUITY (DEFICIT)                                                                                                                                       |       | 10,621,398                                      |       | (4,071,743 | ) | 6,549,655 |   |
| TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY (DEFICIT)                                                                                                                       |       | $                                               | 30,844,681 |   | $ | 694,411 |   | $ | 31,539,092 |   |

 

71

----

**CONSOLIDATED BALANCE SHEET**
| ** **                                                                                                                                                                     | ** ** | **As of December 31, 2003** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                                                                                                                     | ** ** | **As Previously**                          | ** ** | **Effect of** | ** ** | **As** | ** ** |
| ** **                                                                                                                                                                     | ** ** | **Reported**                                    | ** ** | **Restatement** | ** ** | **Restated** | ** ** |
| **ASSETS:**                                                                                                                                                                    | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash and cash  equivalents                                                                                                                                                     |       | $                                               | 1,012,790  |   | $ | — |   | $ | 1,012,790 |   |
| Receivables  billed                                                                                                                                                            |       | 409,803                                         |       | (308,620 | ) | 101,183 |   |
| Inventory                                                                                                                                                                      |       | 65,857                                          |       | — |   | 65,857 |   |
| Prepaid expenses                                                                                                                                                               |       | 165,929                                         |       | — |   | 165,929 |   |
| Total current assets                                                                                                                                                           |       | 1,654,379                                       |       | (308,620 | ) | 1,345,759 |   |
| Equipment and  leasehold improvements, net                                                                                                                                     |       | 60,157                                          |       | — |   | 60,157 |   |
| Intangible  assets—less accumulated amortization                                                                                                                          |       | 68,306                                          |       | — |   | 68,306 |   |
| Deferred  financing costs, net                                                                                                                                                 |       | 81,900                                          |       | — |   | 81,900 |   |
| Total non-current assets                                                                                                                                                       |       | 210,363                                         |       | — |   | 210,363 |   |
| TOTAL ASSETS                                                                                                                                                                   |       | $                                               | 1,864,742  |   | $ | (308,620 | ) | $ | 1,556,122 |   |
| **LIABILITIES:**                                                                                                                                                               | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Advances from  stockholders                                                                                                                                                    |       | $                                               | 34,030     |   | $ | — |   | $ | 34,030 |   |
| Accounts payable                                                                                                                                                               |       | 351,742                                         |       | — |   | 351,742 |   |
| Accrued  liabilities                                                                                                                                                           |       | 173,736                                         |       | (18,200 | ) | 155,536 |   |
| Deferred revenue                                                                                                                                                               |       | 10,000                                          |       | — |   | 10,000 |   |
| Total current liabilities                                                                                                                                                      |       | 569,508                                         |       | (18,200 | ) | 551,308 |   |
| Long-term obligations,  net of discount and current maturities                                                                                                                 |       | 10,431,223                                      |       | (57,543 | ) | 10,373,680 |   |
| Total non-current liabilities                                                                                                                                                  |       | 10,431,223                                      |       | (57,543 | ) | 10,373,680 |   |
| TOTAL  LIABILITIES                                                                                                                                                             |       | 11,000,731                                      |       | (75,743 | ) | 10,924,988 |   |
| **STOCKHOLDERS’ EQUITY (DEFICIT)**                                                                                                                                        | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Preferred stock-authorized,  5,000,000 shares (liquidation preference of $100 per share) Series B 9%  Convertible; issued and outstanding, 4,180 shares of $.01 par value |       | 42                                              |       | — |   | 42 |   |
| Common stock -  authorized, 85,000,000 shares, issued and outstanding 21,222,990 of $.01 par  value                                                                            |       | 212,229                                         |       | — |   | 212,229 |   |
| Additional  paid-in capital                                                                                                                                                    |       | 18,327,992                                      |       | — |   | 18,327,992 |   |
| Accumulated  deficit                                                                                                                                                           |       | (27,676,252                                     | )          | (232,877 | ) | (27,909,129 | ) |
| TOTAL  STOCKHOLDERS’ EQUITY (DEFICIT)                                                                                                                                     |       | (9,135,989                                      | )          | (232,877 | ) | (9,368,866 | ) |
| TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY (DEFICIT)                                                                                                                     |       | $                                               | 1,864,742  |   | $ | (308,620 | ) | $ | 1,556,122 |   |

 

72

----

 

**BIO-keyInternational, Inc. and Subsidiary STATEMENTS OF CASH FLOWS**

 
| ** **                                                                            | ** ** | **As of December 31, 2005** | ** ** |
|---------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                            | ** ** | **As Previously  Reported**                | ** ** | **Effect of  Restatement** | ** ** | **As Restated** | ** ** |
|                                                                                  |       |                                            |       |   |   |   |   |
| **CASH FLOW FROM OPERATING  ACTIVITIES:**                                             |       |                                            |       |   |   |   |   |
| Net  Loss                                                                             |       | $                                               | 358,065    |   | $ | (4,031,449 | ) | $ | (3,673,384 | ) |
| **Adjustments  to reconcile net loss to net cash used in operating activities:**      |       |                                            |       |   |   |   |   |
| Derivative and  warrant fair value adjustments                                        |       | (15,213,186                                     | )          | 6,058,235 |   | (9,154,951 | ) |
| Depreciation                                                                          |       | 244,450                                         |       | — |   | 244,450 |   |
| Amortization:                                                                         |       |                                            |       |   |   |   |   |
| Intangible  assets                                                                    |       | 1,323,601                                       |       | — |   | 1,323,601 |   |
| Deferred  financing costs                                                             |       | 186,279                                         |       | — |   | 186,279 |   |
| Discounts on  convertible debt related to warrants and beneficial conversion features |       | 4,124,759                                       |       | (2,026,786 | ) | 2,097,973 |   |
| Allowance for  doubtful receivables                                                   |       | 48,148                                          |       | — |   | 48,148 |   |
| (Gain) Loss on  sale of marketable debt securities                                    |       | 20,000                                          |       | — |   | 20,000 |   |
| Deferred rent                                                                         |       | (393,677                                        | )          | — |   | (393,677 | ) |
| Options and  warrants issued for services and other                                   |       | 664,043                                         |       | — |   | 664,043 |   |
| **Change  in assets and liabilities:**                                                |       |                                            |       |   |   |   |   |
| Accounts  receivable trade                                                            |       | 345,050                                         |       | — |   | 345,050 |   |
| Costs and  earnings in excess of billings on uncompleted contracts                    |       | 2,468,770                                       |       | — |   | 2,468,770 |   |
| Inventories                                                                           |       | 20,839                                          |       | — |   | 20,839 |   |
| Prepaid expenses  and other                                                           |       | (65,227                                         | )          | — |   | (65,227 | ) |
| Accounts payable                                                                      |       | (549,036                                        | )          | — |   | (549,036 | ) |
| Billings in  excess of costs and earnings on uncompleted contracts                    |       | (317,737                                        | )          | — |   | (317,737 | ) |
| Accrued  liabilities                                                                  |       | 1,029,404                                       |       | — |   | 1,029,404 |   |
| Deferred revenue                                                                      |       | 1,191,958                                       |       | — |   | 1,191,958 |   |
| Net cash used in  operating activities                                                |       | (4,513,497                                      | )          | — |   | (4,513,497 | ) |
| **CASH FLOWS FROM INVESTING  ACTIVITIES:**                                            | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Capital  expenditures                                                                 |       | (148,616                                        | )          | — |   | (148,616 | ) |
| Proceeds from  sale of marketable debt securities                                     |       | 980,000                                         |       | — |   | 980,000 |   |
| Deposits                                                                              |       | 1,009,471                                       |       | — |   | 1,009,471 |   |
| Patents and  patents pending                                                          |       | (65,786                                         | )          | — |   | (65,786 | ) |
| Other                                                                                 |       | 50,000                                          |       | — |   | 50,000 |   |
| Net cash  provided by (used in)investing activities                                   |       | 1,825,069                                       |       | — |   | 1,825,069 |   |
| **CASH FLOW FROM FINANCING  ACTIVITIES:**                                             | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net advance from  (to) stockholders                                                   |       | (12,753                                         | )          | — |   | (12,753 | ) |
| Issuance of  convertible bridge notes                                                 |       | 250,000                                         |       | — |   | 250,000 |   |
| Repayment of  convertible bridge notes                                                |       | (250,000                                        | )          | — |   | (250,000 | ) |
| Issuance of long-term  obligations                                                    |       | 4,822,250                                       |       | — |   | 4,822,250 |   |
| Repayment of  long term obligations                                                   |       | (1,908,212                                      | )          | — |   | (1,908,212 | ) |
| Financing costs                                                                       |       | (248,406                                        | )          | — |   | (248,406 | ) |
| Exercise of  warrants                                                                 |       | 558,788                                         |       | — |   | 558,788 |   |
| Payment of  offering costs                                                            |       | (56,642                                         | )          | — |   | (56,642 | ) |
| Net cash  provided by financing activities                                            |       | 3,155,025                                       |       | — |   | 3,155,025 |   |
| **NET INCREASE (DECREASE) IN CASH**                                                   |       | 466,597                                         |       | — |   | 466,597 |   |
| **CASH AND CASH EQUIVALENTS,  BEGINNING OF YEAR**                                     |       | 956,230                                         |       | — |   | 956,230 |   |
| **CASH AND CASH EQUIVALENTS, END  OF YEAR**                                           |       | $                                               | 1,422,827  |   | $ | — |   | $ | 1,422,827 |   |
|                                                                                  |       |                                            |       |   |   |   |   |

 

The accompanyingnotes are an integral part of these statements.

 

 

73

----

**BIO-keyInternational, Inc. and SubsidiarySTATEMENTS OF CASH FLOWS**

 
| ** **                                                                            | ** ** | **As of December 31, 2004** | ** ** |
|---------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                            | ** ** | **As Previously  Reported**                | ** ** | **Effect of  Restatement** | ** ** | **As Restated** | ** ** |
|                                                                                  |       |                                            |       |   |   |   |   |
| **CASH  FLOW FROM OPERATING ACTIVITIES:**                                             |       |                                            |       |   |   |   |   |
| Net Loss                                                                              |       | $                                               | (7,237,465 | ) | $ | (3,612,426 | ) | $ | (10,849,891 | ) |
| **Adjustments to reconcile net loss to net cash  used in operating activities:**      |       |                                            |       |   |   |   |   |
| Derivative and warrant fair value adjustments                                         |       | —                                          |       | 3,008,419 |   | 3,008,419 |   |
| Depreciation                                                                          |       | 77,912                                          |       | — |   | 77,912 |   |
| Amortization:                                                                         |       |                                            |       |   |   |   |   |
| Intangible assets                                                                     |       | 424,574                                         |       | 111,225 |   | 535,799 |   |
| Deferred financing costs                                                              |       | 14,622                                          |       | — |   | 14,622 |   |
| Discounts on convertible debt related to warrants  and beneficial conversion features |       | 120,016                                         |       | 637,302 |   | 757,318 |   |
| Allowance for doubtful receivables                                                    |       | 71,384                                          |       | — |   | 71,384 |   |
| (Gain) Loss on sale of marketable debt securities                                     |       | (33,125                                         | )          | — |   | (33,125 | ) |
| Write down of investment                                                              |       | 50,000                                          |       | — |   | 50,000 |   |
| Deferred rent                                                                         |       | (91,291                                         | )          | — |   | (91,291 | ) |
| Options and warrants issued for services and other                                    |       | 55,150                                          |       | — |   | 55,150 |   |
| **Change  in assets and liabilities:**                                                |       |                                            |       |   |   |   |   |
| Accounts receivable trade                                                             |       | 1,455,321                                       |       | (186,530 | ) | 1,268,791 |   |
| Costs and earnings in excess of billings on  uncompleted contracts                    |       | (906,649                                        | )          | — |   | (906,649 | ) |
| Inventories                                                                           |       | 36,258                                          |       | — |   | 36,258 |   |
| Prepaid expenses and other                                                            |       | 273,588                                         |       | — |   | 273,588 |   |
| Accounts payable                                                                      |       | (386,315                                        | )          | 23,810 |   | (362,505 | ) |
| Billings in excess of costs and earnings on  uncompleted contracts                    |       | 899,857                                         |       | — |   | 899,857 |   |
| Accrued liabilities                                                                   |       | 936,850                                         |       | 18,200 |   | 955,050 |   |
| Deferred revenue                                                                      |       | (1,405,446                                      | )          | — |   | (1,405,446 | ) |
| Net cash used in operating activities                                                 |       | (5,644,759                                      | )          | — |   | (5,644,759 | ) |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                                            | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Acquisition of PSG                                                                    |       | (498,937                                        | )          | — |   | (498,937 | ) |
| Acquisition of AMG                                                                    |       | (10,431,878                                     | )          | — |   | (10,431,878 | ) |
| Capital expenditures                                                                  |       | (275,193                                        | )          | — |   | (275,193 | ) |
| Purchases of marketable debt securities                                               |       | (5,887,500                                      | )          | — |   | (5,887,500 | ) |
| Proceeds from sale of marketable debt securities                                      |       | 4,920,625                                       |       | — |   | 4,920,625 |   |
| Deposits                                                                              |       | (2,760,583                                      | )          | — |   | (2,760,583 | ) |
| Patents and patents pending                                                           |       | (149,687                                        | )          | — |   | (149,687 | ) |
| Other                                                                                 |       | (46,552                                         | )          | — |   | (46,552 | ) |
| Net cash provided by (used in)investing activities                                    |       | (15,129,705                                     | )          | — |   | (15,129,705 | ) |
| **CASH  FLOW FROM FINANCING ACTIVITIES:**                                             | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net advance from (to) stockholders                                                    |       | (54,437                                         | )          | — |   | (54,437 | ) |
| Issuance of long-term obligations                                                     |       | 10,164,680                                      |       | 437,159 |   | 10,601,839 |   |
| Repayment of long term obligations                                                    |       | (401,563                                        | )          | — |   | (401,563 | ) |
| Financing costs                                                                       |       | (84,841                                         | )          | (437,159 | ) | (522,000 | ) |
| Sale of common stock                                                                  |       | 11,248,803                                      |       | — |   | 11,248,803 |   |
| Exercise of warrants                                                                  |       | 1,950                                           |       | — |   | 1,950 |   |
| Repurchase of warrants and other                                                      |       | (125,000                                        | )          | — |   | (125,000 | ) |
| Payment of offering costs                                                             |       | (31,688                                         | )          | — |   | (31,688 | ) |
| Net cash provided by financing activities                                             |       | 20,717,904                                      |       | — |   | 20,717,904 |   |
| **NET  INCREASE (DECREASE) IN CASH**                                                  |       | (56,560                                         | )          | — |   | (56,560 | ) |
| **CASH  AND CASH EQUIVALENTS, BEGINNING OF YEAR**                                     |       | 1,012,790                                       |       | — |   | 1,012,790 |   |
| **CASH AND CASH EQUIVALENTS, END  OF YEAR**                                           |       | $                                               | 956,230    |   | $ | — |   | $ | 956,230 |   |

 

The accompanyingnotes are an integral part of these statements.

 

74

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**BIO-keyInternational, Inc. and SubsidiarySTATEMENTS OF CASH FLOWS**
| ** **                                                                            | ** ** | **As of December 31, 2003** | ** ** |
|---------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                                            | ** ** | **As Previously  Reported**                | ** ** | **Effect of  Restatement** | ** ** | **As Restated** | ** ** |
|                                                                                  |       |                                            |       |   |   |   |   |
| **CASH  FLOW FROM OPERATING ACTIVITIES:**                                             |       |                                            |       |   |   |   |   |
| Net Loss                                                                              |       | $                                               | (3,826,073 | ) | $ | (232,877 | ) | $ | (4,058,950 | ) |
| **Adjustments to reconcile net loss to net cash  used in operating activities:**      |       |                                            |       |   |   |   |   |
| Derivative and warrant fair value adjustments                                         |       | —                                          |       | (857,545 | ) | (857,545 | ) |
| Depreciation                                                                          |       | 6,386                                           |       | — |   | 6,386 |   |
| Amortization:                                                                         |       |                                            |       |   |   |   |   |
| Discounts on convertible debt related to warrants  and beneficial conversion features |       | 415,634                                         |       | 800,002 |   | 1,215,636 |   |
| Non-cash interest                                                                     |       | 1,131,053                                       |       | — |   | 1,131,053 |   |
| Options and warrants issued for services and other                                    |       | 156,000                                         |       | — |   | 156,000 |   |
| Common stock issued for services and other                                            |       | 76,000                                          |       | — |   | 76,000 |   |
| **Change  in assets and liabilities:**                                                |       |                                            |       |   |   |   |   |
| Accounts receivable trade                                                             |       | (341,805                                        | )          | 308,620 |   | (33,185 | ) |
| Inventories                                                                           |       | (65,857                                         | )          | — |   | (65,857 | ) |
| Prepaid expenses and other                                                            |       | (115,032                                        | )          | — |   | (115,032 | ) |
| Accounts payable                                                                      |       | (2,951                                          | )          | — |   | (2,951 | ) |
| Accrued liabilities                                                                   |       | (300,500                                        | )          | (18,200 | ) | (318,700 | ) |
| Deferred revenue                                                                      |       | 10,000                                          |       | — |   | 10,000 |   |
| Net cash used in operating activities                                                 |       | (2,857,145                                      | )          | — |   | (2,857,145 | ) |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                                            | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Capital expenditures                                                                  |       | (66,543                                         | )          | — |   | (66,543 | ) |
| Other                                                                                 |       | (28,215                                         | )          | — |   | (28,215 | ) |
| Net cash provided by (used in)investing activities                                    |       | (94,758                                         | )          | — |   | (94,758 | ) |
| **CASH  FLOW FROM FINANCING ACTIVITIES:**                                             | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net advance from (to) stockholders                                                    |       | 34,030                                          |       | — |   | 34,030 |   |
| Issuance of long-term obligations                                                     |       | 3,852,250                                       |       | — |   | 3,852,250 |   |
| Sale of common stock                                                                  |       | 61,665                                          |       | — |   | 61,665 |   |
| Net cash provided by financing activities                                             |       | 3,947,945                                       |       | — |   | 3,947,945 |   |
| **NET  INCREASE (DECREASE) IN CASH**                                                  |       | 996,042                                         |       | — |   | 996,042 |   |
| **CASH  AND CASH EQUIVALENTS, BEGINNING OF YEAR**                                     |       | 16,748                                          |       | — |   | 16,748 |   |
| **CASH  AND CASH EQUIVALENTS, END OF YEAR**                                           |       | $                                               | 1,012,790  |   | $ | — |   | $ | 1,012,790 |   |

 

 

The accompanyingnotes are an integral part of these statements

** **

75

----

**NOTE C—ACQUISITIONS**

*Acquisitionof Public Safety Group, Inc.*

On March 30,2004, we acquired all of the outstanding capital stock of Public Safety Group, Inc.(PSG), a privately-held leader in wireless solutions for law enforcement andpublic safety markets based in Winter Park, Florida. The acquisition wascompleted pursuant to the terms of an Agreement and Plan of Merger (the MergerAgreement) by and among the Company, BIO-Key Acquisition Corp., a wholly-ownedsubsidiary of the Company, PSG and all of the shareholders of PSG. As a resultof this transaction PSG became a wholly-owned subsidiary of the Company and nowconstitutes a division of our business specializing in the law enforcement andpublic safety markets (the Public Safety Division). The business combinationwas accounted for using the purchase method.

Pursuant to the MergerAgreement, we purchased all of the outstanding capital stock of PSG from theformer shareholders of PSG in exchange for an aggregate of 2,416,108 shares ofour common stock issued to the former shareholders of PSG, 6,000 shares of ourcommon stock issued to Harward Investments, Inc. (Harward) pursuant to anarrangement involving the discharge of certain outstanding debt obligations ofPSG to Harward as of March 30, 2004, $500,000 in cash, and our assumptionof $600,000 in aggregate net liabilities of PSG. The Merger Agreement providesany liability or obligation of PSG in excess of such $600,000 limitation,whether arising before or after the effective date of the merger, will besolely the responsibility of the former shareholders of PSG. Additional earnoutconsideration, determined as a proportion of revenues attained by the PublicSafety Division over fiscal years 2004 and 2005, may be paid to the formershareholders of PSG. The Company will make payments of such additionalconsideration on the last day of the month following each month in which thePublic Safety Division achieves specified revenue milestones during fiscalyears 2004 and 2005. Such payments will be made in cash, unless the aggregateamount of earnout consideration exceeds sixty percent (60%) of the aggregateconsideration paid by the Company in the merger transaction. Any such excessamounts will be paid in shares of our common stock priced as of two (2) daysprior to the date on which any earnout payment becomes due. No earn out waspaid in 2004 and 2005, nor does the Company expect to pay any in 2006. Inconnection with this acquisition, three former employees of PSG, who were alsoshareholders of PSG, entered into two-year employment agreements with theCompany to serve within the Public Safety Division.

The 2,416,108 sharesissued to the PSG shareholders (the Merger Shares) are subject to escrowprovisions contained in the Merger Agreement and a related escrow agreement,which provide for periodic releases of the shares from escrow on a schedule determinedby the revenues achieved by the Public Safety Division during fiscal years 2004and 2005. The owners of such escrowed shares, however, will continue to enjoyall the rights and privileges attributable to the shares, including, without limitation,the right to vote and receive dividends. The principal terms of the escrowarrangement are as follows:

·                  One-twelfth (1/12 ) of the Merger Shares were held inescrow for the purpose of securing certain prior obligations of PSG to Harward.

·                  The remainingeleven-twelfths (11/12) of the Merger Shares will bereleased to the former shareholders of PSG at quarterly intervals, on adistribution schedule determined by the revenues achieved by the PublicSafety Division during 2004. According to the distribution schedule, all of theMerger Shares will be released as early as September 30, 2006 but no laterthan December 31, 2007.

·                  Of the remainingeleven-twelfths (11/12) of the Merger Shares, thoseshares owned by former employees of PSG who became our employees by virtue ofthe merger transaction are subject to repurchase by us under certaincircumstances involving the termination of such employee’s employment. Sharesremaining in escrow may also be used to fund indemnification obligationsof the former PSG shareholders pursuant to the Merger Agreement.

Through March 15,2006, 1,298,541 Merger Shares have been released from escrow under the MergerAgreement. The Company did not finalize the purchase price until March 31,2005.

A summary of theestimated fair value of the net assets acquired and liabilities assumed,pertaining to PSG, is as follows:

| Current Assets         |   | $         | 8,573     |   |
|------------------------|--------|-----------|-----------|--------|
| Goodwill               |   | 2,660,242 |      |
| Copyrighted  software  |   | 1,181,429 |      |
| Marketing  agreements  |   | 605,340   |      |
| Trademarks             |   | 379,807   |      |
| Other assets           |   | 5,857     |      |
| Total assets acquired  |   | 4,841,248 |      |
| Current  Liabilities   |   | (332,307  | )         |
| Long-term  obligations |   | (400,000  | )         |
| Purchase price         |   | $         | 4,108,941 |   |

 

76

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*Acquisitionof Mobile Government*

On September 30,2004, we acquired certain assets and assumed certain liabilities of the MobileGovernment division of Aether Systems, Inc (Aether). The aggregate purchaseprice of the acquisition was $12,198,171, which includes a $311,537 postclosing reduction in deferred rent and a working capital adjustment payment of$341,878 made to Aether during December 2004. The Company did not finalizethe purchase price of Aether Mobile Government until September 30, 2005.

A summary of the adjusted estimated fair value of thenet assets acquired and liabilities assumed is as follows:

| Current assets               |   | 9,706,935  |   |
|------------------------------|--------|------------|--------|
| Goodwill                     |   | 8,729,412  |   |
| Developed  Technology        |   | 710,000    |   |
| Customer  relationships      |   | 1,009,000  |   |
| Trademarks                   |   | 428,065    |   |
| Fixed Assets                 |   | 381,358    |   |
| Total assets acquired        |   | 20,964,770 |   |
| Current  liabilities assumed |   | (8,766,599 | )      |
| Total purchase price         |   | 12,198,171 |   |

 

The components of the adjusted purchase price are asfollows:

| Cash paid                                             |   | 10,341,878 |   |
|-------------------------------------------------------|--------|------------|--------|
| Deferred rent as  a result of a sub-lease with Aether |   | 1,766,293  |   |
| Acquisition  costs                                    |   | 90,000     |   |
| Total purchase  price                                 |   | 12,198,171 |   |

 

In connection withthis acquisition, the Company issued a subordinated secured promissory note toAether in the face amount of $6,884,588 (the “Aether Note”). The Aether Noteevidences a contingent reimbursement obligation of the Company to Aether and asurety fee payable by the Company to Aether, in each case with respect to aletter of credit maintained by Aether for the Company’s benefit in connectionwith the acquisition. The Company’s obligations under the Aether Note aresecured by a security interest granted to Aether in all or substantially all ofthe Company’s assets subordinate to the security interest described in theLong-Term Obligations footnote.

In conjunctionwith the acquisition of the Mobile Government division, the company wasrequired to place approximately $2,750,000 in escrow as of September 30,2004, for the following:

$1,000,000 in escrowdeposit supporting a $6,884,588 subordinated secured promissory note issued toAether to secure performance obligations assumed under a contract with HamiltonCounty, Ohio. The obligation is expected to extend for one year after finalacceptance of the system by the customer. Acceptance is expected to occur in2006.

$1,000,000 inescrow available to Lockheed Martin in the event of non-payment of liabilitiesfor work performed on a contract with the Pennsylvania State Police. The escrowis available to Lockheed Martin until conditional acceptance of certain definedmilestones. During 2005, the entire escrow was returned to the Company uponsuccessful completion of a project milestone.

There isapproximately $750,000 in escrow which is available to the landlord of asubleased facility in the event the company defaults on a lease. The funds willnot be available for use by the company until the termination of the lease in August 2008.

77

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The acquisitionsof the Mobile Government Division from Aether Systems, Inc., (“MobileGovernment”) and of Public Safety Group (“PSG) required a significant increasein accounting operations on the part of the Company. At the time of theacquisitions the Company received some detailed information, however the periodthat was required to identify and measure the fair value of all of the assetsacquired and the liabilities assumed through the acquisition was not feasiblegiven the existing staffing constraints of the organization. In order to complywith the fair value requirement noted in paragraph 6 of EITF 01-03, theCompany conducted it’s review of the acquired net assets of both PSG and MobileGovernment as of the dates of acquisition, March 30, 2004 and September 30,2004 respectively, and determined an initial price allocation. The Company,subsequent to this initial price allocation and through the course of ongoingreviews and assessments of the assets acquired and the liabilities assumedthrough the acquisition, determined that there were several adjustments thatwere required. The information that helped determine these adjustments becameavailable and obtainable subsequent to the acquisition date. Thus, the Companyhas made adjustments accordingly subsequent to the acquisition date inaccordance with the definition of “allocation period” in Appendix F of FAS 141.These adjustments consisted of deferred revenue adjustments, recalculation ofdeferred rent, working capital adjustments, and contingent purchase pricesadjustments and project related adjustments. The Company finalized theallocation of purchase price for PSG and Mobile Government as of March 30,2005 and September 30, 2005, respectively.

*Liquidated Damages*

The Company may have topay liquidated damages to customers in certain circumstance, includinginstances where its sub-contractors do not perform on time. In addition, theCompany sometimes indemnifies certain of its customers against damages, if any,they might incur as a result of a claim brought against them related to thirdparty software imbedded in the Company’s products.

The Company’s mostsignificant exposure to liquidated and other damages is with its two largestuncompleted contracts with the Pennsylvania State Police (PSP) and HamiltonCounty, Ohio (Hamilton). The PSP and Hamilton contracts limit the Company’sliability for damage to approximately $7,000,000 and $10,000,000, respectively.The Company’s management believes both contracts will be completed withincontract terms including defined specification for performance, andaccordingly, payments of damages under the contracts are not likely. However,the projects are not complete and there can be no assurances damages will notbe incurred in the future. If damages are incurred there can be no assurancethat any amounts required to be paid will not be material to the financialstatements.

*Warranty Reserve*

In some instances theCompany may make commitments to provide additional products or services tocustomers beyond those obligations specified in the contract or those providedin standard maintenance agreements or ordinary upgrades. These commitmentsusually arise in complex customer installations and are granted to help ensurecustomer satisfaction. As of December 31, 2005, 2004 and 2003 there was nomaterial requirement for an accrued warranty liability reserve.

*Summary of Operations*

A summary of theaggregate operating results of the two acquired businesses for the year ended December 31,2003 is as follows:

|                                                                                         | ** ** | **2003**   | ** ** |
|-----------------------------------------------------------------------------------------|------------|------------|------------|
| ** **                                                                              | ** ** | ** ** | ** ** |
| Revenues                                                                                |       | $          | 21,833,661 |   |
| Costs and other  expenses                                                               |       | 25,072,263 |       |
| Operating loss                                                                          |       | (3,238,602 | )          |
| Other income  (deductions)                                                              |       | (13,142    | )          |
| Loss before income tax benefit and cumulative effect  of change in accounting principle |       | (3,251,744 | )          |
| Income tax  benefit                                                                     |       | —     |       |
| Loss before cumulative effect of change in accounting  principle                        |       | (3,251,744 | )          |
| Cumulative  effect of change in accounting principle                                    |       | —     |       |
| Net loss                                                                                |       | $          | (3,251,744 | ) |

 

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*Pro Forma Information*

The followingunaudited financial data reflects revenue, loss from continuing operations, netloss and loss applicable per common share of the Company for the years ended December 31,2004 and 2003 as though the PSG and Mobile Government transactions had occurredas of January 1, 2003.

|                                   | ** ** | **Years ended December 31,** | ** **  |
|-----------------------------------|------------|---------------------------------------------|-------------|
| ** **                        | ** ** | **2004**                                    | ** **  | **2003** | ** ** |
| Revenue                           |       | $                                           | 19,251,001  |   | $ | 22,357,762 |   |
| Loss from  continuing operations  |       | $                                           | (11,817,800 | ) | $ | (5,873,834 | ) |
|                              |       |                                        |        |   |   |
| Net loss                          |       | $                                           | (11,817,800 | ) | $ | (5,873,834 | ) |
| Loss applicable per  common share |       | $                                           | (0.32       | ) | $ | (0.30 | ) |

 

**NOTE D—CONCENTRATION OF RISK**

Financial instruments andlong-term contracts, which potentially subject the Company to risk, primarilyconsist of receivables and costs and earnings in excess of billings onuncompleted contracts. The company extends credit to customers on an unsecuredbasis in the normal course of business. The company’s policy is to perform ananalysis of the recoverability of its accounts receivable and costs andearnings in excess of billings on uncompleted contracts at the end of eachreporting period and to establish allowances where appropriate. The companyanalyzes historical bad debts and contract losses, customer concentrations, andcustomer credit-worthiness when evaluating the adequacy of the allowances.

As of December 31,2005, 2004, and 2003, one, two, and three customers accounted for approximately11%, 27%, and 82% of the company’s outstanding accounts receivable balance,respectively. As of December 31, 2005 and 2004 one customer accounted forapproximately 86% of the costs and earnings in excess of billings onuncompleted contracts. For the years ended December 31, 2005, 2004 and2003, two, one, and one customer(s) accounted for approximately 16%, 21%and 46% of the Company’s revenue, respectively.

For the years ended December 31,2005 and 2004 the customers generating 16% and 21% of the Company’s revenue,respectively, were customers of the Law Enforcement segment. For the year endedDecember 31, 2003, the customer generating 46% of the Company’s revenuewas a customer of the Biometrics segment.

For the years ended December 31,2005 and 2004 sales to governmental entities amounted to approximately 79% and89% of total revenue. As of December 31, 2005 and 2004 governmentalcustomers amounted to approximately 74% and 62% of total accounts receivable.

**NOTE E—COSTS AND EARNINGS IN EXCESSOF BILLINGS ON UNCOMPLETED CONTRACTS**

The components ofuncompleted contracts consisted of the following as of December 31, 2005,2004 and 2003:

|                                                                    | ** ** | **2005**    | ** ** | **2004**    | ** ** |
|--------------------------------------------------------------------|------------|-------------|------------|-------------|------------|
| ** **                                                         | ** ** | ** **  | ** ** | ** **  | ** ** |
| Cost and  Earnings incurred on uncompleted contracts               |       | $           | 17,505,796 |        | $          | 20,610,050 |   |
|                                                               |       |        |       |        |       |
| Less billings to  date                                             |       | (13,216,789 | )          | (14,421,254 | )          |
|                                                               |       |        |       |        |       |
|                                                               |       | $           | 4,289,007  |        | $          | 6,188,796 |   |
|                                                               |       |        |       |        |       |
| Costs and  earnings in excess of billings on uncompleted contracts |       | $           | 4,321,392  |        | $          | 6,949,603 |   |
|                                                               |       |        |       |        |       |
| Billings in  excess of costs and earnings on uncompleted contracts |       | (32,385     | )          | (760,807    | )          |
|                                                               |       |        |       |        |       |
|                                                               |       | $           | 4,289,007  |        | $          | 6,188,796 |   |

 

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**NOTE F—PREPAID EXPENSES**

Prepaid expensesconsisted of the following as of December 31:

|                      | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|----------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Consulting fees      |       | $          | —     |       | $          | —     |       | $ | 90,000 |   |
|                 |       |       |       |       |       |       |       |
| Insurance and  other |       | 137,000    |       | 113,130    |       | 75,929     |       |
|                 |       |       |       |       |       |       |       |
| Total                |       | $          | 137,000    |       | $          | 113,130    |       | $ | 165,929 |   |

 

In October 2003, theCompany entered into a twelve-month consulting agreement with a financialadvisory services company. The terms of the consulting agreement required$108,000 to be paid in fees over the term of the agreement. The consulting feeswere amortized to expense over the term of the agreement, which expired October 31,2004.

**NOTE G—EQUIPMENT AND LEASEHOLD IMPROVEMENTS**

Equipment andleasehold improvements consisted of the following as of December 31:

|                                                 | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|-------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Equipment                                       |       | $          | 458,847    |       | $          | 348,298    |       | $ | 66,543 |   |
| Furniture and  fixtures                         |       | 179,349    |       | 162,593    |       | 36,550     |       |
| Software                                        |       | 104,414    |       | 88,302     |       | —     |       |
| Leasehold  improvements                         |       | 170,955    |       | 165,756    |       | —     |       |
|                                            |       | 913,565    |       | 764,949    |       | 103,093    |       |
|                                            |       |       |       |       |       |       |       |
| Less accumulated  depreciation and amortization |       | (365,298   | )          | (120,848   | )          | (42,936    | )          |
|                                            |       |       |       |       |       |       |       |
| Total                                           |       | $          | 548,267    |       | $          | 644,101    |       | $ | 60,157 |   |

 

**NOTE H—OTHER ASSETS**

*Intangible Assets*

Intangible assetsconsisted of the following as of December 31:

|                                | ** ** | **2005**     | ** ** | **2004**  | ** ** | **2003**  | ** ** |
|--------------------------------|------------|--------------|------------|-----------|------------|-----------|------------|
| ** **                     | ** ** | **Restated** | ** ** |
|                           |       |         |       |      |       |      |       |
| Copyrighted  software          |       | $            | 1,181,429  |      | $          | 1,181,429 |       | $ | — |   |
| Customer  relationships        |       | 1,009,000    |       | 1,009,000 |       | —    |       |
| Trademarks                     |       | 807,872      |       | 807,872   |       | —    |       |
| Developed  technology          |       | 710,000      |       | 710,000   |       | —    |       |
| Marketing  agreements          |       | 605,340      |       | 605,340   |       | —    |       |
| Patents and  patents pending   |       | 283,779      |       | 217,994   |       | 68,306    |       |
|                           |       | 4,597,420    |       | 4,531,635 |       | 68,306    |       |
|                           |       |         |       |      |       |      |       |
| Less Accumulated  Amortization |       | (1,295,597   | )          | (432,338  | )          | —    |       |
|                           |       |         |       |      |       |      |       |
| Total                          |       | $            | 3,301,823  |      | $          | 4,099,297 |       | $ | 68,306 |   |

 

#### Deferredfinancing costs

Debt issuancecosts are amortized based upon the lives of the respective debt obligations. Thegross carrying amount of deferred loan costs at December 31, 2005, 2004and 2003 was $1,763,238, $952,741 and $81,900, respectively, and accumulatedamortization was $200,901 and $14,622 at December 31, 2005 and 2004,respectively. Amortization of deferred loan costs is included in interestexpense and was $186,279 and $14,622 for 2005 and 2004, respectively.

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*Goodwill*

|                                                                    | ** ** | **Mobile  Government** | ** ** | **Public  Safety Group** | ** ** | **Total** | ** ** |
|--------------------------------------------------------------------|------------|------------------------|------------|-------------------------------|------------|-----------|------------|
| **Initial  allocation**                                            |       | $                      | 9,636,186  |                          | $          | 2,535,445 |       | $ | 12,171,631 |   |
| Recalculation of deferred rent                                     |       | (311,537               | )          | —                        |       | (311,537  | )          |
| Working capital purchase price adjustment                          |       | 341,878                |       | —                        |       | 341,878   |       |
| Allocation adjustment                                              |       | (303,156               | )          | 124,797                       |       | (178,359  | )          |
|                                                               |       |                   |       |                          |       |      |       |
| **December 31,  2004**                                        |       | $                      | 9,363,371  |                          | $          | 2,660,242 |       | $ | 12,023,613 |   |
|                                                               |       |                   |       |                          |       |      |       |
| Adjustment to allowance for doubtful accounts                      |       | (310,541               | )          | —                        |       | (310,541  | )          |
| Billings in excess of costs and earnings on  uncompleted contracts |       | (410,684               | )          | —                        |       | (410,684  | )          |
| Working capital purchase price adjustment                          |       | 87,266                 |       | —                        |       | 87,266    |       |
|                                                               |       |                   |       |                          |       |      |       |
| **December 31, 2005 (Final  Price Allocation)**               |       | $                      | 8,729,412  |                          | $          | 2,660,242 |       | $ | 11,389,654 |   |

 

*Deferred Offering Costs*

In March 2002, theCompany engaged an investment banking firm to advise the Company regardingraising additional capital through the potential future issuance of the Company’sequity, debt or convertible securities. The firm received a nonrefundableretainer fee of $50,000, out of pocket costs of $14,900 and has been granted awarrant to purchase 25,000 shares of the Company’s common stock at an exerciseprice of $1.00 per share through March 22, 2006. The estimated value ofthe warrant is $17,000. These deferred costs were charged to operations in 2004when this engagement terminated.

The Company also engagedthe services of an investment banking firm in connection with the issuance ofthe Company’s debt securities in 2004 and 2005. The Company issued the firmwarrants to purchase the Company’s common stock on three separate occasions. OnSeptember 29, 2004, the investment banking firm was issued 620,667warrants with a fair market value of $534,201. These warrants have an exerciseprice of $1.55 and are exercisable through September 29, 2009. On June 8,2005, the Company issued the investment firm 248,615 warrants with a fairmarket value of $211,310. The warrants have an exercise price of $1.35 and areexercisable through June 8, 2009. Finally, on July 14, 2005 theCompany issued the investment firm 23,333 warrants with a fair market value of$22,839. These warrants have an exercise price of $1.35 and are exercisablethrough July 14, 2009. The fair market value of the warrants is amortizedover the life of the associated debt. As of December 31, 2004, the 2004warrants have a fair market value $474,478 and $59,723 has been charged to noncash interest expense in 2004. As of December 31, 2005, the 2004 and 2005warrants have a combined fair market value of $442,248 and $266,379 has beencharged to non cash interest expense in 2005.

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*Deposits*

Deposits consistedof the following as of December 31:

|                                                    | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|----------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Contract  performance deposit with Lockheed Martin |       | $          | —     |       | $          | 1,000,000  |       | $ | — |   |
| Deposit securing  a promissory note with Aether    |       | 1,000,000  |       | 1,000,000  |       | —     |       |
| Lease deposit  with Aether                         |       | 750,000    |       | 750,000    |       | —     |       |
| Other                                              |       | 78,560     |       | 88,031     |       | —     |       |
|                                               |       |       |       |       |       |       |       |
| Total                                              |       | $          | 1,828,560  |       | $          | 2,838,031  |       | $ | — |   |

 

**NOTE I—ACCRUED LIABILITIES**

Accruedliabilities consisted of the following as of December 31:

|                                             | ** ** | **2005**   | ** ** | **2004**     | ** ** | **2003**     | ** ** |
|---------------------------------------------|------------|------------|------------|--------------|------------|--------------|------------|
| ** **                                  | ** ** | ** ** | ** ** | **Restated** | ** ** | **Restated** | ** ** |
| ** **                                  | ** ** | ** ** | ** ** | ** **   | ** ** | ** **   | ** ** |
| Contract costs  not yet invoiced by vendors |       | $          | 3,654,440  |         | $          | 3,301,442    |       | $ | — |   |
| Compensation                                |       | 614,934    |       | 634,894      |       | 149,659      |       |
| Royalties                                   |       | 294,512    |       | 254,055      |       | —       |       |
| Interest                                    |       | 684,253    |       | 227,680      |       | —       |       |
| Other                                       |       | 272,376    |       | 177,913      |       | 5,877        |       |
|                                        |       |       |       |         |       |         |       |
| Total                                       |       | $          | 5,520,515  |         | $          | 4,595,984    |       | $ | 155,536 |   |

 

**NOTE J—RELATED PARTY**

**Consulting Arrangement with Thomas J.Colatosti**

In connection with his appointment to the Board ofDirectors in September 2002, the Company entered into a consultingarrangement with Thomas J. Colatosti. Under the arrangement, the Company paid Mr. Colatosti$4,000 per month through December 2003 and issued him options to purchase150,000 shares of common stock at an exercise price of $0.31 per share, theclosing price of the Company’s common stock on the date of grant. In December 2003,a committee of independent directors renewed this arrangement through December 31,2004. The committee also issued options to Mr. Colatosti to purchase200,000 shares of common stock at an exercise price of $1.32 per share, theclosing price of the Company’s common stock on the date of grant, for servingas Chairman. Effective November 1, 2004, Mr. Colatosti’s monthlyconsulting fee was increased to $14,500. Mr. Colatosti has substantialexperience in the biometric industry and in addition to his role as theChairman of the Board of Directors of the Company, provides extensive serviceto the Company in the areas of strategic planning and corporate finance. Duringthe years ended December 31, 2005 and 2004, approximately $102,000 and$69,000 were paid, respectively. Mr. Colatosti agreed to waive his feesfor five months in 2005.

In March 2004, Mr. Colatosti entered into athree year consulting arrangement with the Shaar Fund Ltd., a principalcreditor of the Company. Under the terms of the arrangement, The Shaar Fundtransferred $375,000 principal amount of our secured convertible notes due October 1,2005 to Mr. Colatosti. On April 28, 2004 the Company issued 3,750shares of the Company’s Series A 7% convertible preferred stock to Mr. Colatostiin conversion of the $375,000 secured convertible note.

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**NOTE K—DEFERRED REVENUE**

Thecomponents of Deferred Revenue are as follows as of December 31,

|                                                              | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|--------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Current Portion**                                          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Maintenance  Contracts                                       |       | $          | 3,004,159  |       | $          | 3,012,205  |       | $ | — |   |
| Fully deferred  systems, installation and acceptance revenue |       | 260,124    |       | 154,151    |       | 10,000     |       |
|                                                         |       | 3,264,283  |       | 3,166,356  |       | 10,000     |       |
| **Long-Term Portion**                                        |       |       |       |       |       |       |       |
| Maintenance  Contracts on uncompleted Projects               |       | 1,091,151  |       | —     |       | —     |       |
| Maintenance  Contracts                                       |       | 72,587     |       | 71,203     |       | —     |       |
|                                                         |       | 1,163,738  |       | 71,203     |       | —     |       |
| **Total**                                                    |       | $          | 4,428,021  |       | $          | 3,237,559  |       | $ | 10,000 |   |

 

Maintenancecontracts on uncompleted projects are recognized ratably over the applicableterm. The term for these contracts begin upon the completion and acceptance ofthe long term projects, which can be delayed based on various criteria rangingfrom customer constraints to project change orders. Because of the uncertaintyof the timing of acceptance on these long-term projects this deferred revenuehas been classified as a long-term liability.

Fully deferredsystems, installation and acceptance revenue relates to projects that have beenbilled per the contractual terms, however because of undelivered elements oracceptance criteria revenue has not yet been recognized. These amounts areexpected to be completed within the next 12 months and are classified ascurrent liabilities.

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**NOTE L—LONG-TERM OBLIGATIONS**

Long-termobligations consisted of the following as of December 31:
| ** **                             | ** ** | **2005**     | ** ** | **2004**     | ** ** | **2003**     | ** ** |
|----------------------------------------|------------|--------------|------------|--------------|------------|--------------|------------|
| ** **                             | ** ** | **Restated** | ** ** | **Restated** | ** ** | **Restated** | ** ** |
| **2001**                               |       |         |       |         |       |         |       |
| 10% secured convertible note           |       | $            | —     |         | $          | —       |       | $ | 3,617,920 |   |
| **2002**                               |       |         |       |         |       |         |       |
| 10% secured convertible note           |       | —       |       | —       |       | 1,080,000    |       |
| 7% convertible note                    |       | —       |       | —       |       | 750,000      |       |
| **2003**                               |       |         |       |         |       |         |       |
| 7% Secured convertible term notes      |       | —       |       | —       |       | 3,852,250    |       |
| Discount                               |       | —       |       | —       |       | (368,146     | )          |
| FMV of embedded derivatives            |       | —       |       | —       |       | 310,603      |       |
| **2004**                               |       |         |       |         |       |         |       |
| Convertible term notes                 |       | 5,992,304    |       | 9,964,437    |       | —       |       |
| Discount                               |       | (2,307,679   | )          | (5,508,021   | )          | —       |       |
| FMV of embedded derivatives            |       | 421,317      |       | 6,024,677    |       | —       |       |
| FMV of warrants                        |       | 828,095      |       | 2,847,019    |       | —       |       |
| **2005**                               |       |         |       |         |       |         |       |
| Convertible term notes                 |       | 5,284,723    |       | —       |       | —       |       |
| Discount                               |       | (3,396,454   | )          | —       |       | —       |       |
| FMV of embedded derivatives            |       | 590,226      |       | —       |       | —       |       |
| FMV of warrants                        |       | 655,416      |       | —       |       | —       |       |
| Long-term  accrued interest payable    |       | —       |       | —       |       | 1,131,053    |       |
|                                   |       | 8,067,948    |       | 13,328,112   |       | 10,373,680   |       |
|                                   |       |         |       |         |       |         |       |
| Less current portion (net of discount) |       | 8,067,948    |       | 3,062,722    |       | —       |       |
|                                   |       |         |       |         |       |         |       |
| **Total**                              |       | $            | —     |         | $          | 10,265,390   |       | $ | 10,373,680 |   |

 

***Senior Convertible Term Notes***

**2004 Notes**

On September 29,2004, we entered into a Securities Purchase Agreement (the “Senior PurchaseAgreement”) with Laurus Master Fund, Ltd. (“Laurus”) and certain otherinstitutional and accredited investors (together with Laurus, the “SeniorInvestors”). Under the Senior Purchase Agreement, the Company issued securedconvertible term notes (the “Senior Convertible Notes”) in the aggregateprincipal amount of $5,050,000, convertible into common stock of the Company at$1.35 per share, and issued warrants (the “Senior Warrants”) to purchase anaggregate of 1,122,222 shares of our common stock at an exercise price of $1.55per share.

The proceeds from thistransaction were used in part to finance the Company’s acquisition of AetherMobile Government (the “Aether Acquisition”). The Company’s obligations underthe Senior Purchase Agreement, the Senior Convertible Notes and the SeniorWarrants are secured by a security interest in all or substantially all of theCompany’s assets.

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Under the terms of theSenior Convertible Notes, we are required to make monthly payments of accruedinterest beginning on November 1, 2004. In addition, the SeniorConvertible Notes provide for monthly payments of principal in equal monthlyincrements of $157,813 thereof, plus accrued interest, commencing December 1,2004. The Company made principal payments of $1,563 in December 2004 and$1,453,831 in 2005, $67,500 was also converted into common stock during 2005.The Senior Convertible Notes bear interest at an initial rate equal to theprime rate plus two percent (2%), subject to a six percent (6%) floor. Theinterest rate on the Senior Convertible Notes is subject to reduction on amonth-by-month basis if specified conditions are met. In particular, if (a) weregister the common stock underlying the Senior Convertible Notes and SeniorWarrants on a registration statement declared effective by the Securities andExchange Commission and (b) our common stock is trading at a 25% orgreater premium to the note conversion price, then the interest rate will beadjusted downward by 2.0% for each incremental 25% increase over the noteconversion price.

Alternatively, if (x) wehave not registered such common stock under an effective registrationstatement, but (y) our common stock is trading at a 25% or greater premiumto the note conversion price, and then the interest rate will be adjusteddownward by 1.0% for each incremental 25% increase over the note conversionprice. The effective interest rate as of December 31, 2004 and 2005 was7.25%.

For any cash payments wemake on the Senior Convertible Notes (e.g., any amounts due that are notconverted into common stock), we are required to pay an amount equal to 102% ofthe principal amount due. Accordingly, an additional principal amount of$101,000 has been included in outstanding Senior Convertible Notes and in therelated discounts on long-term obligations. In addition, we can prepay the noteat any time upon payment of an amount equal to 110% of the then outstandingprincipal balance, plus accrued and unpaid interest.

The Senior Investors havethe option at any time to convert any or all of the outstanding principal andaccrued and unpaid interest on the Senior Convertible Notes into shares of ourcommon stock at a conversion price of $1.35 per share. In addition, for eachmonthly payment under the note, the Senior Investors will be obligated toconvert a portion of the monthly payment into common stock at the applicableconversion price, so long as:

·              The average closingprice of our common stock (for the five trading days immediately preceding thepayment date) is greater than $1.48 per share (which represents 110% of thenote conversion price, based on the initial conversion price of $1.35),

·              Such amount beingconverted does not exceed 25% of the aggregate dollar trading volume for suchimmediately preceding twenty-two trading days, and

·              The shares of commonstock underlying the note are registered under an effective registrationstatement with the Securities and Exchange Commission

The terms of the SeniorConvertible Notes and Senior Warrants prohibit conversion of the notes orexercise of the warrants to the extent that conversion of the notes andexercise of the warrants would result in any holder thereof, together with itsaffiliates, beneficially owning in excess of 4.99% of our outstanding shares ofcommon stock. A holder may waive the 4.99% limitation upon 75 days’ priorwritten notice to us. Also, this limitation does not preclude the holder fromconverting or exercising the note or warrant and selling shares underlying thenote or warrant in stages over time where each stage does not cause the holderand its affiliates to beneficially own shares in excess of the limitationamount.

As security for ourobligations to the Senior Investors, we, along with our wholly-owned subsidiaryPublic Safety Group, Inc. (“PSG”), granted to the Senior Investors ablanket security interest in all of our assets, and we entered into a stockpledge with the Senior Investors for the capital stock in PSG. If an event ofdefault occurs under the Senior Convertible Notes or the other relatedinvestment agreements, 120% of the unpaid principal balance on the SeniorConvertible Notes, plus accrued interest and fees, shall become immediately dueand the Senior Investors shall be entitled to payment of a default interestrate of 1.5% per month on all amounts due under the Senior Convertible Notes.Such events of default include the following:

·              A failure to payinterest and principal payments under the Senior Convertible Notes within threedays of when due;

·              A breach by us ofany material covenant or term or condition of the Senior Convertible Notes orin any of the investment agreements, if not cured within 30 days of suchbreach;

·              A breach by us ofany material representation or warranty made in the Senior Convertible Notes orin any of the investment agreements;

·              If we make anassignment for the benefit of our creditors, or a receiver or trustee isappointed for us, or any form of bankruptcy or insolvency proceeding isinstituted by us, or any involuntary proceeding is instituted against us if notvacated within 60 days;

·              The filing of anymoney judgment or similar final process against us for more than $50,000, whichremains unvacated, unbonded or

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unstayedfor a period of 30 days;

·              If our common stockis suspended for five consecutive days or for five days during any tenconsecutive days from a principal market or pursuant to a Securities andExchange Commission stop order; and

·              A failure by us totimely deliver shares of common stock when due upon conversions of the SeniorConvertible Notes.

As of December 31,2004 the Company was in default of one of its December 1 principalpayments. The Company cured this default on January 5, 2005 and has receiveda waiver from the Senior Investors, thus avoiding any penalties.

Upon an event of default,the Senior Lenders will be entitled to specified remedies, including remediesunder the Uniform Commercial Code.

We have registered withthe Securities and Exchange Commission for resale the shares of common stockthat are issuable upon conversion of the Senior Convertible Notes and uponexercise of the Senior Warrants. If we fail to comply with our registrationobligations, the Senior Investors will be entitled to certain specifiedremedies, including monetary liquidated damages. In particular, for each 30days (or such pro rated number of days) that we are out of compliance with ourregistration obligations, we will be subject to a liquidated damage assessmentof 2% of the original principal amount of the Senior Convertible Notes.

Each Senior Investor hasagreed, pursuant to the Senior Purchase Agreement, that neither it nor any ofits affiliates and investment partners will (and will not cause any otherperson or entity, directly or indirectly or indirectly, to) engage in “shortsales” of our common stock for as long as any Senior Convertible Notes held byit remain outstanding. “Short sales” are contracts for the sale of shares ofstock that the seller does not own, or certificates which are not within theseller’s control, so as to be available for delivery at the time when, underapplicable rules, delivery must be made.

**2005 Notes**

On June 8, 2005, we entered into a SecuritiesPurchase Agreement (the “Senior Purchase Agreement”) with Laurus Master FundLtd (“Laurus”). Under the Senior Purchase Agreement, the Company issued aSecured Convertible Term Note (the “Senior Convertible Note”) in the aggregateprincipal amount of $2,000,000, convertible into Common Stock of the Company incertain circumstances at $1.35 per share, and issued a warrant (the “SeniorWarrant”) to purchase an aggregate of 444,444 shares of the Common Stock at aper share exercise price of $1.55. The aggregate consideration received by theCompany, net of all fees and expenses, for the Senior Convertible Note and theSenior Warrant was approximately $1,841,000. The proceeds from this transactionare to be used for working capital purposes. The Company’s obligations underthe Senior Purchase Agreement and the Senior Convertible Notes are secured by asecurity interest in all or substantially all of the Company’s assets.

Under the terms of the Senior Convertible Note, we arerequired to make monthly payments of accrued interest only beginning on July 1,2005. In addition, the Senior Convertible Note provides for monthly payments ofprincipal in equal 1/32 increments thereof, plusaccrued interest, commencing October 1, 2005. The Senior Convertible Notebears interest at an initial rate equal to the prime rate plus two percent(2%), subject to a six percent (6%) floor. The interest rate on the SeniorConvertible Note is subject to reduction on a month-by-month basis if thefollowing specified conditions are met. If (a) we register the commonstock underlying the Senior Convertible Note and Senior Warrant on aregistration statement declared effective by the Securities and ExchangeCommission and (b) our common stock is trading at a 25% or greater premiumto the note conversion price, then the interest rate will be adjusted downwardby 2.0% for each incremental 25% increase over the note conversion price.Alternatively, if (x) we have not registered such Common stock under aneffective registration statement, but (y) our common stock is trading at a25% or greater premium to the note conversion price, and then the interest ratewill be adjusted downward by 1.0% for each incremental 25% increase over thenote conversion price. In no event shall the interest rate be less than 0%.

For any cash payments we make on the SeniorConvertible Note (e.g., any amounts due that are not converted into commonstock), we are required to pay an amount equal to 102% of the principal amountdue. In addition, we can prepay the note at any time upon payment of an amountequal to110% of the then outstanding principal balance, plus accrued and unpaidinterest.

Laurus has the option at any time to convert any orall of the outstanding principal and accrued and unpaid interest on the SeniorConvertible Note into shares of our common stock at a conversion price of $1.35per share. In addition, for each monthly payment under the note, Laurus will beobligated to convert a portion of the monthly payment into common stock at theapplicable conversion price, so long as:

·      The average closing price of our commonstock (for the five trading days immediately preceding the payment date) isgreater than $1.48 per share (which represents 110% of the note conversionprice, based on the initial conversion price of $1.35),

·      Such amount being converted does notexceed 25% of the aggregate dollar trading volume for such immediatelypreceding twenty-two trading days, and

·      The shares of common stock underlying thenote are registered under an effective registration statement with theSecurities and Exchange Commission.

The terms of the Senior Convertible Note and SeniorWarrant prohibit conversion of the note or exercise of the warrant to theextent that conversion of the note and exercise of the warrant would result inany holder thereof, together with its affiliates, beneficially owning in excessof 4.99% of our outstanding shares of common stock. A holder may waive the4.99% limitation upon 75 days’ prior written notice to us. Also, thislimitation does not preclude the holder from converting or exercising the noteor warrant and selling shares underlying the note or warrant in stages overtimewhere each stage does not cause the holder and its affiliates to beneficiallyown shares in excess of the limitation amount.

As security for our obligations to Laurus, we, alongwith our wholly-owned subsidiary Public Safety Group, Inc. (“PSG”), havegranted to Laurus a blanket security interest in all of our assets, and we haveentered into a stock pledge with Laurus for the capital stock in PSG. If anevent of default occurs under the Senior Convertible Note or the other relatedinvestment agreements, 120% of the unpaid principal balance on the SeniorConvertible Note, plus accrued interest and fees, shall become immediately dueand Laurus shall be entitled to payment of a default interest rate of 1.5% permonth on all amounts due under the Senior Convertible Note. Such events ofdefault include the following:

·      A failure to pay interest and principalpayments under the Senior Convertible Note within three days of when due;

·      A breach by us of any material covenant orterm or condition of the Senior Convertible Note or in any of the investmentagreements, if not cured within 30 days of such breach;

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·      A breach by us of any materialrepresentation or warranty made in the Senior Convertible Note or in any of theinvestment agreements;

·      If we make an assignment for the benefitof our creditors, or a receiver or trustee is appointed for us, or any form ofbankruptcy or insolvency proceeding is instituted by us, or any involuntaryproceeding is instituted against us if not vacated within 60 days;

·      The filing of any money judgment orsimilar final process against us for more than $50,000, which remainsunvacated, unbonded or unstayed for a period of 30 days;

·      If our common stock is suspended for fiveconsecutive days or for five days during any ten consecutive days from aprincipal market or pursuant to a Securities and Exchange Commission stoporder; and

·      A failure by us to timely deliver sharesof common stock when due upon conversions of the Senior Convertible Note.

Upon an event of default, Laurus will be entitled tospecified remedies, including remedies under the Uniform Commercial Code.

We have agreed toregister with the Securities and Exchange Commission for resale the shares ofcommon stock that are issuable upon conversion of the Senior Convertible Noteand upon exercise of the Senior Warrant. Under the registration rightsagreement, we were obligated to file a registration statement with theSecurities and Exchange Commission on or before July 8, 2005, and to usereasonable commercial efforts to have the registration statement declaredeffective not later than September 6, 2005. The resale registrationstatement was initially filed with the Securities and Exchange Commission on July 8,2005 for the shares underlying the Senior Convertible Note and Senior Warrant.If we fail to comply with our registration obligations, Laurus will be entitledto certain specified remedies, including monetary liquidated damages. Inparticular, for each 30 days (or such pro rated number of days) that weare out of compliance with our registration obligations, we will be subject toa liquidated damage assessment of 2% of the original principal amount of theSenior Convertible Note. As of December 31, 2005, this registrationstatement has not been declared effective, therefore, the Company hasapproximately $113,000 reserved for payment of liquidating damages. Thesedamages were limited by a portion that had been waived by Laurus during 2005.

Each Senior Investor hasagreed, pursuant to the Senior Purchase Agreement, that neither it nor any ofits affiliates and investment partners will (and will not cause any otherperson or entity, directly or indirectly, to) engage in “short sales” of ourcommon stock for as long as any Senior Convertible Notes held by it remainoutstanding. “Short sales” are contracts for the sale of shares of stock thatthe seller does not own, or certificates which are not within the seller’scontrol, so as to be available for delivery at the time when, under applicablerules, delivery must be made.

***Subordinated Convertible TermNotes***

**2004 Notes**

On September 29,2004, we entered into a Securities Purchase Agreement (the “SubordinatedPurchase Agreement”) with The Shaar Fund, Ltd. (“Shaar”) and otherexisting shareholders of the Company and accredited investors (collectively,the “Subordinated Investors”) for $4,950,000. Under the Subordinated PurchaseAgreement, the Company issued unsecured convertible term notes (the “SubordinatedConvertible Notes”) in the aggregate principal amount of $4,950,000,convertible into common stock of the Company in certain circumstances at $1.35per share, and issued warrants (the “Subordinated Warrants”) to purchase anaggregate of 1,099,997 shares of our common stock at an exercise price of $1.55per share. The proceeds from this transaction were used in part to finance aportion of the Aether Acquisition and will be used in part for working capitalpurposes.

Under the terms of the SubordinatedConvertible Notes, we are required to make monthly payments of accrued interestonly beginning on November 1, 2004. In addition, the SubordinatedConvertible Notes provide for monthly payments of principal in equal monthlyincrements of $154,688 thereof, plus accrued interest, commencing February 1,2005, which payments may be made in shares of common stock at the option ofeach note holder. The Subordinate Investors converted $135,000 of these notesin 2004 and $1,996,420 in 2005. They also made principal payments of $454,380in 2005. The Subordinated Convertible Notes bear interest at an initial rateequal to the prime rate plus seven and one-half percent (7.5%), subject to aneleven percent (11%) floor.

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We may prepay theSubordinated Convertible Notes at any time upon payment of an amount equal to110% of the then outstanding principal balance, plus accrued and unpaidinterest. Upon any such prepayment, the Senior Convertible Notes must also beprepaid. The Subordinated Investors have the option at any time to convert anyor all of the outstanding principal and accrued and unpaid interest on theSubordinated Convertible Notes into shares of our common stock at a conversionprice of $1.35 per share. During 2004, certain subordinated investors convertedan aggregate principal amount of $135,000 into 100,000 shares of the Company’scommon stock.

The terms of theSubordinated Convertible Notes and Subordinated Warrants prohibit conversion ofthe notes or exercise of the warrants to the extent that conversion of thenotes and exercise of the warrants would result in any holder thereof, togetherwith its affiliates, beneficially owning in excess of 4.99% of our outstandingshares of common stock. A holder may waive the 4.99% limitation upon 75 days’prior written notice to us. Also, this limitation does not preclude the holderfrom converting or exercising the note or warrant and selling shares underlyingthe note or warrant in stages over time where each stage does not cause theholder and its affiliates to beneficially own shares in excess of thelimitation amount.

If an event of defaultoccurs under the Subordinated Convertible Notes or the other related investmentagreements, the unpaid principal balance on the Subordinated Convertible Notes,plus accrued interest, shall, at the noteholder’s option, become immediatelydue and the Subordinated Investors shall be entitled to payment of additionaldefault interest at the rate of 2.0% per annum on all amounts due under theSubordinated Convertible Notes. Such events of default include the following:

·              A failure to payinterest and principal payments under the Subordinated Convertible Notes withinthree days of when due;

·              A breach by us ofany covenant, term or condition in any material respect of the SubordinatedConvertible Notes or in any of the investment agreements, if not cured within30 days of such breach;

·              Any representationor warranty made in the Subordinated Convertible Notes or in any of theinvestment agreements being false or misleading in any material respect;

·              If we make anassignment for the benefit of our creditors, or a receiver or trustee isappointed for us, or any form of bankruptcy or insolvency proceeding isinstituted by us, or any involuntary proceeding is instituted against us;

·              The filing of anymoney judgment or similar final process against us for more than $50,000, whichremains unvacated, unbonded or unstayed for a period of 30 days;

·              If our common stockis suspended for five consecutive days or for five days during any tenconsecutive days from a principal market or pursuant to a Securities andExchange Commission stop order;

·              A failure by us totimely deliver shares of common stock when due upon conversions of theSubordinated Convertible Notes; and

·              A change in our controllingownership.

Upon an event of default,the rights and remedies of the Subordinated Investors will be subordinate tothose of the Senior Investors pursuant to Subordination and IntercreditorAgreement dated as of September 30, 2004 by and among Laurus, asCollateral Agent, Shaar, as Purchaser Agent, Aether Systems, Inc., PSG andthe Company.

We have registered withthe Securities and Exchange Commission for resale the shares of common stockthat are issuable upon conversion of the Subordinated Convertible Notes andupon exercise of the Subordinated Warrants. If we fail to comply with ourregistration obligations, the Subordinated Investors will be entitled tocertain specified remedies, including monetary liquidated damages. Inparticular, for each 30 days (or such pro rated number of days) that we are outof compliance with our registration obligations, we will be subject to aliquidated damage assessment of 2% of the original principal amount of theSubordinated Convertible Notes.

Each Subordinated Investorhas agreed, pursuant to the Subordinated Purchase Agreement, that neither itnor any of its affiliates and investment partners will (and will not cause anyother person or entity, directly or indirectly, to) engage in “short sales” ofour common stock for as long as any Subordinated Convertible Notes held by itremain outstanding.

**2005 Notes**

We entered into aSecurities Purchase Agreement, effective as of May 31, 2005, (the “SubordinatedPurchase Agreement”) with existing shareholders of the Company and otheraccredited investors (collectively, the “Subordinated Investors”). Under theSubordinated Purchase Agreement, the Company issued Convertible Term Notes (the“Subordinated Convertible Notes”) in the aggregate principal amount of$2,794,723,convertible into Common Stock of the Company in certaincircumstances at $1.35 per share, and issued warrants (the “SubordinatedWarrants”) to purchase an aggregate of 828,066 shares of the Common Stock at aper share exercise price of $1.50. The aggregate consideration received by theCompany, net of all fees and expenses, for such Subordinated Convertible Notesand Subordinated Warrants was approximately $2,411,000. The proceeds from thistransaction are to be used for working capital purposes. The Subordinated ConvertibleNotes were issued at a purchase price equal to $900 for each $1,000 ofprincipal amount of the Note.

Certain SubordinatedInvestors purchased additional Subordinated Convertible Notes in the aggregateprincipal amount of $450,000 and received additional Subordinated Warrants topurchase an aggregate of 133,333 shares of Common Stock at a per share exerciseprice of $1.50. The aggregate consideration received by the Company net of allfees and expenses for such Subordinated Convertible Notes and SubordinatedWarrants was $404,500, which was paid by the Subordinated Investors on July 8,2005.

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Under the terms of theSubordinated Convertible Notes, we are required to make quarterly payments ofaccrued interest only beginning on September 1, 2005. In addition, theSubordinated Convertible Notes provide for quarterly payments of principal inequal increments thereof, plus accrued interest, commencing September 1,2006 through May 31, 2008, which payments may be made in shares of commonstock at the option of each note holder. The Subordinated Convertible Notesbear interest at nine percent (9%) per annum. Each Subordinated ConvertibleNote was issued at a purchase price equal to $900 for each $1,000 of principalamount of the Note.

We may prepay the SubordinatedConvertible Notes at any time upon payment of an amount equal to 120% of thethen outstanding principal balance, plus accrued and unpaid interest. Upon anysuch prepayment, the Senior Convertible Note must also be prepaid. TheSubordinated Investors have the option at any time to convert any or all of theoutstanding principal and accrued and unpaid interest on the SubordinatedConvertible Notes into shares of our common stock at a conversion price of$1.35 per share.

The terms of theSubordinated Convertible Notes and Subordinated Warrants prohibit conversion ofthe notes or exercise of the warrants to the extent that conversion of thenotes and exercise of the warrants would result in any holder thereof, togetherwith its affiliates, beneficially owning in excess of 4.99% of our outstandingshares of common stock. A holder may waive the 4.99% limitation upon75 days’ prior written notice to us. Also, this limitation does notpreclude the holder from converting or exercising the note or warrant andselling shares underlying the note or warrant in stages over time where eachstage does not cause the holder and its affiliates to beneficially own sharesin excess of the limitation amount.

If an event of defaultoccurs under the Subordinated Convertible Notes or the other related investmentagreements, the unpaid principal balance on the Subordinated Convertible Notes,plus accrued interest, shall, at the note holder’s option, become immediatelydue and the Subordinated Investors shall be entitled to payment of additionaldefault interest at the rate of 2.0% per annum on all amounts due under theSubordinated Convertible Notes. Such events of default include the following:

·      Failure to pay interest and principalpayments under the Subordinated Convertible Notes within three days of whendue;

·      A breach by us of any covenant, term orcondition in any material respect of the Subordinated Convertible Notes or inany of the investment agreements, if not cured within 30 days of such breach;

·      Any representation or warranty made in theSubordinated Convertible Notes or in any of the investment agreements beingfalse or misleading in any material respect;

·      If we make an assignment for the benefitof our creditors, or a receiver or trustee is appointed for us, or any form ofbankruptcy or insolvency proceeding is instituted by us, or any involuntaryproceeding is instituted against us;

·      The filing of any money judgment orsimilar final process against us for more than $50,000, which remainsunvacated, unbonded or unstayed for a period of 30 days;

·      If our common stock is suspended for fiveconsecutive days or for five days during any ten consecutive days from aprincipal market or pursuant to a Securities and Exchange Commission stoporder;

·      A failure by us to timely deliver sharesof common stock when due upon conversions of the Subordinated ConvertibleNotes; and

·      A change in our controlling ownership.

Upon an event of default,the rights and remedies of the Subordinated Investors will be subordinate tothose of the Senior Investors pursuant to a Subordination and IntercreditorAgreement dated as of September 30, 2004 (as amended, supplemented orotherwise modified from time to time) by and among Laurus, as Collateral Agent,Shaar, as Purchaser Agent, Aether Systems, Inc., PSG and the Company.

We have agreed toregister with the Securities and Exchange Commission for resale the shares ofcommon stock that are issuable upon conversion of the Subordinated ConvertibleNotes and upon exercise of the Subordinated Warrants. Under the registrationrights agreement, we were obligated to file a registration statement with theSecurities and Exchange Commission on or before July 8, 2005, and to usereasonable commercial efforts to have the registration statement declared effectivenot later than September 6, 2005. The resale registration statement wasinitially filed with the Securities and Exchange Commission on July 8,2005 for the shares underlying the Subordinated Convertible Notes andSubordinated Warrants. If we fail to comply with our registration obligations,the Subordinated Investors will be entitled to certain specified remedies,including monetary liquidated damages. In particular, for each 30 days (or suchpro rated number of days) that we are out of compliance with our registrationobligations, we will be subject to a liquidated damage assessment of 2% of theoriginal principal amount of the Subordinated Convertible Notes. As of December 31,2005, this registration statement has not been declared effective, therefore,the Company has approximately $202,000 reserved for payment of liquidatingdamages. These damages were limited by a portion that had been waived by one ofthe Subordinated Investors during 2005.

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Each SubordinatedInvestor has agreed, pursuant to the Subordinated Purchase Agreement, thatneither it nor any of its affiliates and investment partners will (and will notcause any other person or entity, directly or indirectly, to) engage in “shortsales” of our common stock for as long as any Subordinated Convertible Notesheld by it remain outstanding.

**2004 and 2005 Senior and Subordinate Notes**

The Senior Notes’features discussed above; such as a variety of conversion options, a variableinterest rate feature, events of default and a variable liquidated damagesclause are considered embedded derivative financial instruments. These featuresare described below, as follows:

·                  Principal’sconversion option:  The Notes areconvertible at the Holder’s option at any time at the fixed conversion price of$1.35 per share. This conversion feature has been identified as an embeddedderivative and has been bifurcated and recorded on the Company’s balance sheetat its fair value using the Binomial Option Pricing Model;

·                  Monthly PaymentsConversion Option:  Holders have theoption to convert the Notes’ monthly payment at a $1.35 per share conversionprice if the common stock price is higher than 110% of the conversion price($1.49), as long as the amount converted is not higher than 25% of tradingvolume for the last 22 trading days. If the Notes’ monthly payments are notconverted, the payments will be paid in cash at 102% of such amount. Thisconversion feature has been identified as an embedded derivative and has beenbifurcated and recorded on the Company’s balance sheet at its fair value usingbinomial models;

·                  Interest RateAdjustment provision:  For every 25%increase in common stock value above $1.35 per share, the interest will bereduced by 2%. The interest rate may never be reduced below 0%. This conversionfeature has been identified as an embedded derivative and has been bifurcatedand recorded on the Company’s balance sheet at its fair value by measuring theimpact of the derivative on the expected interest payment amount over the lifeof the Note;

·                  Defaultprovision: In the event of default under the terms set forth above, the SeniorLenders will be entitled to specified remedies, including remedies under theUniform Commercial Code; This feature has been identified as an embeddedderivative and has been bifurcated and recorded on the Company’s balance sheetat its fair value;

The Subordinate Notesincludes certain features that are considered embedded derivative financialinstruments, such as a variety of conversion options, a variable interest ratefeature, events of default and a variable liquidated damages clause. Thesefeatures are described below, as follows:

·                  Principal’sconversion option:  The Notes areconvertible at the Holder’s option at any time at the fixed conversion price of$1.35 per share. This conversion feature has been identified as an embeddedderivative and has been bifurcated and recorded on the Company’s balance sheetat its fair value;

·                  Monthly PaymentsConversion Option:  Holders have theoption to convert the Notes’ monthly payment at a $1.35 per share conversionprice if the common stock price is higher than 110% of the conversion price($1.49), as long as the amount converted is not higher than 25% of tradingvolume for the last 22 trading days. If the Notes’ monthly payments are notconverted, the payments will be paid in cash at 102% of such amount. Thisconversion feature has been identified as an embedded derivative and has beenbifurcated and recorded on the Company’s balance sheet at its fair value;

·                  Defaultprovision: In the event of default under the terms set forth above, the unpaidprincipal balance on the Subordinated Convertible Notes, plus accrued interest,shall, at the note holder’s option, become immediately due and the SubordinatedInvestors shall be entitled to payment of additional default interest at therate of 2.0% per annum on all amounts due under the Subordinated ConvertibleNotes. This feature has been identified as an embedded derivative and has beenbifurcated and recorded on the Company’s balance sheet at its fair value;

In conjunction with theSenior Notes, the Company issued warrants to purchase 1,566,666 shares ofcommon stock. In conjunction with the Subordinate Notes, the Company issuedwarrants to purchase 2,061,396 shares of common stock. The Company also issuedwarrants to the Investment Banker to purchase 892,615 shares of common stock inconnection with services rendered related to the 2004 and 2005 notes.

As of September 30, 2005, the Company hadincorrectly calculated certain interest obligations on certain subordinatednotes issued by the Company in September 2004. Accordingly, the Companyhas corrected the error, and as of December 31, 2005 is current withrespect to its obligations under the September 2004 subordinated notes.

The Company entered into an Amendment and Waiver withLaurus, dated as of August 31, 2005, pursuant to which the Company waspermitted to defer the payment of the monthly principal amounts due and payablefor the months of September, October, November and December 2005 underboth (a) the Secured Convertible Term Note in the original principalamount of $5,000,000 issued by the Company to Laurus on September 29, 2004(the “September 2004 Note”), and (b) the Secured Convertible TermNote in the original principal amount of $2,000,000 issued by the Company toLaurus on June 8, 2005 (the “June 2005 Note”), such aggregatedeferred principal amounts being equal to $625,000 and $187,500,respectively. Thedeferred principal amount under the September 2004 Note is now due on September 29,2007, the maturity date of that note, and will be paid at the same time thefinal payments due with respect to that note upon maturity. The deferredprincipal amount under the June 2005 Note is now due on June 7, 2008,the maturity date of that note, and will be paid at the same time the finalpayments due with respect to that note upon maturity. The Company will remainobligated to pay all monthly interest amounts under these notes as they arecurrently due.

Pursuant to this Amendment and Waiver, the Companyissued an aggregate of 612,166 shares of its Common Stock as consideration forthis principal payment deferral. The Company entered into a Registration RightsAgreement dated as of August 31, 2005(the “Registration Rights Agreement”)pursuant to which the Company has agreed to file a registration statement withthe Securities and Exchange Commission (the “SEC”) covering the resale of theseshares of Common Stock on or before August 31, 2006.

The Company also enteredinto Amendment and Waivers, dated as of August 31, 2005, pursuant to whichcertain Subordinated Investors allowed the Company to defer the payment of themonthly principal amounts due and payable for the months of September, October,November and December 2005 under the Convertible Term Notes in theaggregate original principal amount of $2,800,000 issued by the Company to theSubordinated Investors on September 29, 2004 (the “Subordinated Notes”),such aggregate deferred principal amount being equal to $350,004. The deferredprincipal amount under each Subordinated Note is now due on September 29,2007, the maturity date of each such note, and will be paid at the same timethe final payments due with respect to each such note upon maturity. TheCompany will remain obligated to pay all monthly interest amounts under thesenotes as they are currently due.

Pursuant to these Amendment and Waivers, the Companyissued an aggregate of 263,705 shares of its Common Stock to the SubordinatedInvestors as consideration for this principal payment deferral. The Companyentered into the Registration Rights Agreement with each of the SubordinatedInvestors, pursuant to which the Company has agreed to file a registrationstatement with the SEC covering the resale of these shares of Common Stock onor before August 31, 2006.

On July 8, 2005, the Company made a payment of$39,061 to a holder of a senior convertible note issued by the Company on September 29,2004 to fully pay all principal and interest on the Note. In conjunction withthis repayment, the holder surrendered a warrant to purchase 11,111 shares ofthe Company’s $0.0001 par value common stock.

Certain holders of convertible term notes issued bythe Company on September 29, 2004 and May 31, 2005 did not permit theCompany to defer such principal payments, but instead waived certain provisionsof those notes, specifically regarding anti-dilution adjustments of the FixedConversion Price that would otherwise have been triggered as a result of theissuance of the above described shares in connection with the debt deferral. Inconsideration of these waivers, the warrants held by these note holders weremodified to reflect an exercise price of $1.35.

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The accounting treatment of the derivatives andwarrants requires that the Company record the derivatives and the warrant attheir relative fair value as of the inception date of the agreement, and atfair value as of each subsequent balance sheet date. Any change in fair valuewill be recorded as non-operating, non-cash income or expense at each reportingdate. If the fair value of the derivatives and warrants is higher at thesubsequent balance sheet date, the Company will record a non-operating,non-cash charge. If the fair value of the derivatives and warrants is lower atthe subsequent balance sheet date, the Company will record non-operating,non-cash income. As of December 31, 2004 and 2005, respectively, thederivatives were valued at $6,024,677 and $1,011,543 for the 2004 and 2005notes. Conversion related derivatives were valued using the Binomial OptionPricing Model with the following assumptions: dividend yield of 0%; annualvolatility of 83% to 118%; and risk free interest rate of 2.89% to 4.4% as wellas probability analysis related to trading volume restrictions. The remainingderivatives were valued using other binomial models and measuring the impact ofthe derivative on the expected interest payment amount over the life of theNote. The Warrants issued with the 2004 and 2005 debt financings classified asliabilities were valued at $1,483,511 and $2,847,019 using the Black ScholesOption Pricing model with the following assumptions: dividend yield of 0%;annual volatility of 110% and risk-free interest rate of 4.4%, and dividendyield of 0%; annual volatility of 128% and risk-free interest rate of 3.6%, asof December 31, 2005 and 2004, respectively. Both the derivatives andwarrants were classified as long-term liabilities.

At the time of issuance,the initial relative fair value assigned to the embedded derivatives was$3,714,589 and $2,031,414 for the 2004 and 2005 notes, respectively. Theinitial relative fair value assigned to the warrants was $1,912,639 and$1,233,153 for the 2004 and 2005 notes, respectively.

Both the derivatives andthe warrants were recorded as discounts to the Notes and are being amortized tointerest expense over the expected term of the debt, using the effectiveinterest method. At December 31, 2005, the unamortized discount on theNotes was $2,307,679 and $3,396,454 for 2004 and 2005 notes, respectively. Theeffective interest rate on the Notes for the period ended December 31,2005 and 2004 ranged between 77% and 136% based on the frequency of principalpayments as well as actual payments made. At December 31, 2004, theunamortized discount on the Notes was $5,971,662 for the 2004 debt.

**Other Debt**

The key provisions of the Company’s long-term notesand debentures issued prior to 2004 are as follows:

·             **10%Secured Convertible Note Issued in 2001:**During 2001, the Companyhad unsecured short-term notes from Shaar in the aggregate principal amount of$2,770,000. Shaar converted this amount and associated accrued interest of$257,920 together with additional financing of $1,065,000 into a convertiblenote in the principal amount of $4,092,920 (the Convertible Note). During 2003,Shaar converted $475,000 of this note along with accrued interest of $98,465into 764,620 shares of the Company’s common stock at the stipulated per shareconversion price of $0.75 per share. The note is collateralized bysubstantially all of the Company’s assets. During 2004, Shaar first converted$2,063,938 of this note into shares of the Company’s common stock at thestipulated per share conversion price of $0.75 per share. During March 2004,the Company entered into a securities exchange agreement (the Agreement) withShaar. Pursuant to the Agreement, Shaar converted the remaining $1,553,982 ofthis note into shares of the Company’s Series A convertible preferredstock at the stipulated per share conversion price of $100 per share.

In conjunction with the issuance of the ConvertibleNote, the Company issued a warrant to the Shaar to purchase 4,000,000 shares ofcommon stock at $1.00 per share through November 26, 2006. The ConvertibleNote was recorded along with a $1,016,000 discount assigned to the fair valueof the warrant. The value assigned to the warrant was amortized as interestexpense over the twenty-two month life of the Convertible Note. The fair valueassigned to the warrant was estimated on the grant date using the Black-Scholespricing model. The assumptions used to determine the fair value of the grantincluded the following assumptions: risk-free interest rate of 3.5%, expectedlife of three years, stock price volatility of 175%, and expected dividends ofzero.

·             **10%Secured Convertible Notes Issued in 2002:**As part of arecapitalization transaction, the Shaar agreed to provide additional financingin incremental monthly installments during the six-month period commencing March 1,2002, subject to certain conditions. As of December 31, 2002, the Companyhas received $1,080,000 and issued notes payable to Shaar. The notes areconvertible into shares of the Company’s common stock at a conversion price of$0.75 per share. The notes are collateralized by substantially all of theCompany’s assets. Pursuant to the Agreement entered into in March 2004,Shaar converted this note into shares of the Company’s Series Aconvertible preferred stock at the stipulated per share conversion price of$100 per share.

·             **7%Convertible Notes Issued in 2002:**As part of an August 2002bridge note agreement with Shaar, Shaar provided a total of $750,000 ofadditional financing in incremental monthly installments during the four-monthperiod commencing August 2002. The note, as amended, is due October 1,2005 along with accrued interest at 7% per annum. The bridge notes areconvertible at the option of Shaar into shares of the Company’s common stock ata conversion price of $0.75 per share or into shares of the Company’sseries B preferred stock at a conversion price of $100 per share. The noteis collateralized by substantially all of the Company’s assets. Pursuant to theAgreement entered into in March 2004, Shaar converted this note intoshares of the Company’s Series A convertible preferred stock at thestipulated per share conversion price of $100 per share.

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·             **7% Secured Convertible Notes Issued in 2003:**InJanuary 2003, Shaar agreed to provide up to $2,350,000 of new debtfinancing. The agreement was amended in October 2003 to provide for up to$2,500,000 of additional funding. As of December 31, 2003, the Company hadreceived advances totaling $3,852,250. Pursuant to this agreement, Shaar is toprovide the additional monthly borrowings during 2004, subject to certainconditions. The terms of the notes, as amended December 31, 2003, requiredthe principal and accrued interest at 7% to be repaid on October 1, 2005.In the event that the Company completed a private placement of equitysecurities resulting in gross proceeds of at least $5,000,000 on or before June 30,2004 the principal amount and accrued interest due under the note isconvertible, at the option of Shaar, into the securities sold in suchtransaction at a conversion price equal to the sale price of such securities.Upon completion of such an equity transaction, Shaar also has the right torequest repayment of the note. Shaar may, at any time, elect to convert some orall of the notes into shares of the Company’s common stock at a conversionprice of $0.75 per share or into shares of the Company’s series Bpreferred stock at a conversion price of $100 per share. The notes arecollateralized by substantially all of the Company’s assets. The terms of aRegistration Rights Agreement with Shaar, as amended, required the Company tofile a registration statement with the SEC covering the resale of anyshares of common stock issuable upon any conversion of these notes. Thisregistration statement was filed in July 2004.

Duringthe quarter ended March 31, 2004, the Company received the final advancestotaling $1,000,000, pursuant to this note agreement. In March 2004, atthe request of Shaar, the Company issued Thomas J. Colatosti, the chairman ofthe Board, a $375,000 note and Shaar a $2,125,000 note (collectively theInvestors) in exchange for the October 31, 2003, $2,500,000 7% SecuredConvertible Promissory Note due Shaar. The terms of the notes require theprincipal and accrued interest at 7% to be repaid on October 1, 2005. Inthe event that the Company completes a private placement of equity securitiesresulting in gross proceeds of at least $5,000,000 on or before June 30,2004 the principal amount and accrued interest due under the notes areconvertible, at the option of the Investors, into the securities sold in suchtransaction at a conversion price equal to the sale price of such securities.Upon completion of such an equity transaction, the Investors also have theright to request repayment of the note. The Investors may, at any time, electto convert some or all of the notes into shares of the Company’s common stockat a conversion price of $0.75 per share or into shares of the Company’sseries C preferred stock at a conversion price of $100 per share.

Pursuantto the Agreement entered into in March 2004, the Investors converted theremaining $2,352,250 of these notes into shares of the Company’s series Cconvertible preferred stock at the stipulated per share conversion price of$100 per share. During March 2004, Shaar, in a separate transaction,converted $1,777,500 of this note into shares of the Company’s series Cconvertible preferred stock at the stipulated per share conversion price of$100 per share. In March 2004, Shaar, in connection with a securitiespurchase agreement, paid for a portion of their purchased stock and warrants bycanceling $347,500 of this note.

In2005, it was determined that the Convertible Notes contained an embeddedderivative known as a Conversion Price Adjustment Provision which needed to beseparated from the host contract and accounted for separately. The derivativeis known as the Conversion Price Adjustment Provision and is described asfollows:

If,prior to June 30, 2004, the Company completes a private placement ofequity securities of the Company for an aggregate sale price of at least $5million, upon the closing of the transaction, the principal and the accrued interestof the Note, shall, at the option of the holder, either (i) be convertedinto shares of the current financing securities at a conversion price equal tothe price per share at which the current financing securities are issued of (ii) immediatelybe paid in cash.

Theaccounting treatment of the derivative requires that the Company record thederivative at their relative fair value as of the inception date of theagreement, and at fair value as of each subsequent balance sheet date. Anychange in fair value will be recorded as non-operating, non-cash income orexpense at each reporting date. If the fair value of the derivative is higherat the subsequent balance sheet date, the Company will record a non-operating,non-cash charge. If the fair value of the derivatives and warrants is lower atthe subsequent balance sheet date, the Company will record non-operating,non-cash income. As of December 31, 2003, the derivative was valued at$310,603 and was recorded as a liability. As of December 31, 2004 and 2005,the derivative was valued at $0 and $0 because the debt had been retired. Thederivative was valued as of December 31, 2003 using the Binomial OptionPricing Model with the following assumptions: stock price of $.35 to $1.61;exercise price of $.75; annual volatility of 87% to 141%; and risk freeinterest rate of 0.96% to 1.51%. The derivative features are being accountedfor properly as part of the current year restatement.

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On April 28,2005, The Shaar Fund Ltd. loaned $250,000 to the Company. The loan allowed forinterest at 10% per annum and was paid in full in June 2005 in conjunctionwith the Company’s June financing activities.

As of December 31,2003, all existing long-term obligations were amended to provide, among otherthings, that all accrued interest be repaid on October 1, 2005. Inconnection with the above conversions of notes during 2004, Shaar alsoconverted all accrued interest due thereon into shares of the Company’s commonstock and series C convertible preferred stock at their respectivestipulated per share conversion prices of $0.75 and $100 per share.

Theconversion and exercise prices of the Company’s convertible instruments,options and warrants discussed here and elsewhere were determined by individualnegotiation between the Company and the individual security holders orgrantees.

Primarilyall of the Company’s interest expense during 2005 and 2004 related toobligations due Shaar. During 2005 and 2004, interest expense to Shaar wasapproximately $226,000 and $176,000, respectively.

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**NOTEM—SEGMENT INFORMATION**

In the fourth quarter of fiscal year 2005, the Company’sconsolidated operations were divided into three segments: Law, Fire andBiometric. Prior to this segmentation of the business management evaluated thebusiness as one consolidated operation. For presentation and comparabilitypurposes the allocation of costs between segments for prior periods have beenestimated.

The Company evaluates performance and allocatesresources based on revenues and operating income (loss). Operating income(loss) for each segment includes selling, general and administrative expensesdirectly attributable to the segment in addition to those allocated as apercentage based on the segments revenues. The segmentation of operating Incomeas noted above and detailed below reflects how management now evaluates itsbusiness.  Assets for the company are commingled and are related to alloperating segments. Management does not evaluate or identify the operatingassets of the segments separately.

Geographically North American sales accounted forapproximately 100% of the Company’s total sales for fiscal years 2005, 2004 and2003.

Summarized financialinformation concerning our reportable segments is shown in the following table:

|                                                | ** ** | **For the Years Ended December 31,** | ** ** |
|------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                     | ** ** | **2005**                                                      | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                     | ** ** | **Restated**                                                  | ** ** | **Restated** | ** ** | **Restated** | ** ** |
| **Revenue:**                                   | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Law                                            |       | $                                                             | 10,524,938 |   | $ | 4,482,778 |   | $ | — |   |
| Fire                                           |       | 3,221,086                                                     |       | 881,196 |   | — |   |
| Biometrics                                     |       | 480,071                                                       |       | 356,977 |   | 215,481 |   |
| Consolidated Revenue                           |       | 14,226,095                                                    |       | 5,720,951 |   | 215,481 |   |
| **Segment operating income**                   | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Law                                            |       | (3,817,866                                                    | )          | (1,463,095 | ) | — |   |
| Fire                                           |       | (1,555,788                                                    | )          | (590,056 | ) | — |   |
| Biometrics                                     |       | (2,914,528                                                    | )          | (4,384,310 | ) | (3,010,852 | ) |
| Total Segment Operating Income                 |       | (8,288,182                                                    | )          | (6,437,461 | ) | (3,010,852 | ) |
| **Reconciliation to net loss**                 | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest expense                               |       | (4,521,344                                                    | )          | (1,415,535 | ) | (1,909,788 | ) |
| Interest income                                |       | 35,958                                                        |       | 66,824 |   | — |   |
| Derivative and  warrant fair value adjustments |       | 9,154,951                                                     |       | (3,008,419 | ) | 857,545 |   |
| Other expense                                  |       | (54,767                                                       | )          | (55,300 | ) | 4,145 |   |
| **Net  loss**                                  |       | $                                                             | (3,673,384 | ) | $ | (10,849,891 | ) | $ | (4,058,950 | ) |

 

**NOTE N—COMMITMENTS AND CONTINGENCIES**

*Operating Leases*

The Company does not own any real estate but conductsoperations from four leased premises. These non-cancelable operating leasesexpire a various dates through 2009. In addition to base rent, the Company paysfor property taxes, maintenance, insurance and other occupancy expensesaccording to the terms of the individual leases.

In connection with the Company’s acquisition of AMG in2004, the Company entered into a sub-lease with Aether, which requires monthlylease payments in excess of existing market rates. Rent expense is recorded atmarket rate and charged on a straight- line basis through August 31, 2008,the termination date of the lease. The company has accrued a liability toreflect the net present value of the excess of cash payments over rent expensefor the remaining term of the lease.

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Minimum rentalcommitments of non-cancelable operating leases are approximately as follows:

| Year ending December 31, | ** ** |
|-----------------------------------------|------------|
| 2006                                    |       | $ | 1,260,000 |   |
| 2007                                    |       | 1,278,000 |   |
| 2008                                    |       | 866,000 |   |
| 2009                                    |       | 23,000 |   |
|                                    |       |   |   |
|                                    |       | $ | 3,427,000 |   |

 

Rental expense was approximately $753,000, $258,000and $60,000 during 2005, 2004 and 2003, respectively.

*Employment Agreements*

The Company has employment agreements with fiveemployees. These agreements allow the continuation of the employee’s salary inthe event of termination without cause. The agreements also acknowledge theemployee’s eligibility to participate in the Company’s bonus and option plans,the terms of which have not yet been established. Upon completion of one yearof service during 2005, one employee is eligible for options for up to 300,000shares. As of December 31, 2005, 2004 and 2003, the aggregate commitmentunder these agreements is approximately $275,000, $930,000 and $90,000,respectively.

*Legal Proceeding*

Prior to our acquisition of PSG in June 2003, PSGwas named as a defendant in a civil action initiated in the Superior CourtDepartment in Hampden County, Commonwealth of Massachusetts by The Vince Group, Inc.(“TVG”). The case has since been removed to the United States District Courtfor the District of Massachusetts at the request of the Parties. The complaintclaims that PSG is obligated to pay a percentage of certain of its revenues toTVG in consideration for a strategic business introduction allegedly made by anagent of TVG. PSG has denied the allegations and filed an answer in thelitigation, and as of the date of this report the outcome of the litigation ispending. The claim is for an unspecified amount including actual damages,interest, and attorney’s fees. Management believes the claim is without meritand will settle out of court for an amount which will not have a materialadverse affect on our business, financial condition or operating results.

*Accrued Royalties*

From time to time, the Company licenses or sellsproducts which may include technology obtained from third parties under aroyalty agreement. These agreements obligate the company to pay the third partya fixed fee, or in some instances, a percentage of the associated revenue. Thefees are generally due and payable only when software has been installed andaccepted by the customer. For the years ended December 31, 2005 and 2004,royalty expense was approximately $178,000 and $23,000, respectively.

**NOTE O—STOCKHOLDERS’ EQUITY**

*Common Stock*

In August 2004, the Company’s shareholdersapproved amendments to its articles of incorporation which increased the numberof authorized shares of common stock from 60,000,000 to 85,000,000.

During March 2004, the company entered into asecurities purchase agreement with certain institutional and accreditedinvestors pursuant to which the Company issued and sold an aggregate of8,888,928 shares of common stock and warrants to purchase an aggregate of4,444,464 shares of common stock. The investors paid an aggregate purchaseprice of $1.35 for each share of common stock and warrant to purchase 0.5 of ashare of common stock, resulting in gross proceeds of approximately$12,000,000. In connection with the securities purchase agreement, the Investorpaid for a portion of their purchased stock and warrants by canceling $347,500of outstanding debt.

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The Warrants issued in conjunction with the sale ofcommon stock on March 31, 2004, may be exercised at any time prior to June 8,2009. Each Warrant contains anti-dilution protection through March 31,2005, which has resulted in a reduction of the exercise price from $1.755 to$1.35 per share. Fifty percent (50%) of any unexercised portions of theWarrants are callable by the Company if the volume weighted average tradingprice per share of our common stock exceeds $4.3875 per share for ten (10) consecutivetrading days and the Warrants have not been exercised after forty-five(45) days’ prior notice from the Company.

Under the Purchase Agreement, in the event that (i) aninvestor is not permitted to sell its securities hereunder for any reason forfive (5) or more trading days (whether or not consecutive), (ii) anysecurities covered hereunder are not listed on an eligible trading market or (iii) ourcommon stock is not listed or quoted, or is suspended from trading, on aneligible trading market for a period of three (3) trading days (whether ornot consecutive), the Company will be required to pay a cash amount to theinvestors equal to one percent (1%) of the aggregate purchase price paid by theinvestors pursuant to the Purchase Agreement for the first month that suchevent occurs and one percent (1%) for each month thereafter in which such eventremains uncured, in each case prorated for any partial month. If the Companyfails to make any such payment in a timely manner, such payment shall bearinterest at the rate of one percent (1%) per month (prorated for partialmonths) until paid in full.

*Series A 7% ConvertiblePreferred Stock*

On January 1, 2005, BIO-key International, Inc.,a Minnesota corporation (“BIO-key Minnesota”), consummated a merger (the “Reincorporation”)with and into its wholly owned subsidiary, BIO-key International, Inc., aDelaware corporation (“BIO-key Delaware”), in order to reincorporate in theState of Delaware. The Reincorporation was effected pursuant to an Agreementand Plan of Merger dated as of December 30, 2004 (the “Merger Agreement”)by and between BIO-key Minnesota and BIO-key Delaware. The Reincorporation wasrecommended was approved by the board of directors of both BIO-key Minnesotaand BIO-key Delaware, Pursuant to the Merger Agreement, at the effective timeof the Reincorporation: (i) each outstanding share of Common Stock ofBIO-key Minnesota, $0.01 par value per share, was automatically converted intoone share of Common Stock, $0.0001 par value per share, of BIO-key Delaware; (ii) eachoutstanding share of Series C 7% Convertible Preferred Stock of BIO-keyMinnesota, $0.01 par value per share, was automatically converted into oneshare of Series A 7% Convertible Preferred Stock, $0.0001 par value pershare, of BIO-key Delaware, with such Series A 7% Convertible PreferredStock containing substantially identical terms and conditions as the Series C7% Convertible Preferred Stock of BIO-key Minnesota; (iii) each option topurchase shares of BIO-key Minnesota’s Common Stock granted by BIO-keyMinnesota under any warrant, stock option plan or similar plan of BIO-keyMinnesota outstanding immediately before the Reincorporation was, by virtue ofthe Merger Agreement and without any action on the part of the holder thereof,converted into and become an option to purchase, upon the same terms andconditions, the same number of shares of BIO-key Delaware common stock at anexercise price per share equal to the exercise price per share thereunderimmediately before the Reincorporation; and (iv) each warrant, option orstock option plan of BIO-key Minnesota was assumed by, and continues to be, awarrant, option or plan of BIO-key Delaware.

The Series A Preferred Stock accrues dividends of7% payable semi-annually on June 15th, December 15th and on such date that the preferredstockholder elects to convert preferred stock to common stock in additionalshares of its common stock. As of December 31, 2005, cumulative dividendsin arrears were approximately $545,800.

*Series B 9% ConvertiblePreferred Stock (**BIO-key Minnesota)*

The Series B Preferred Stock accrues dividends of9% payable semi-annually on June 15, December 15, and on such datethat the preferred stockholder elects to convert preferred stock to commonstock, in cash, or at the option of the Company, in additional shares of itscommon stock. As of December 31, 2003, cumulative dividends in arrearswere approximately $86,000. The Series B shares are redeemable at theoption of the Company, so long as the Company’s common stock is eligible forquotation on the OTC Bulletin Board and the shares issuable upon conversion aresubject to an effective registration statement. The Series B shares areconvertible into shares of the Company’s common stock at a per share conversionprice equal to the lesser of $0.75 or a 22% discount to the average closingprice of the common stock during the five trading days preceding conversion.The Series B shares have no voting rights.

During March 2004, the Investor converted theremaining 4,180 shares of Series B 9% convertible preferred stock and$107,693 of dividends and accrued interest thereon into 5,257 shares of theCompany’s Series A preferred stock. All of the Company’s Series Apreferred stock is convertible into shares of the Company’s common stock at aconversion price of $.75 per share.

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*Series C 7% Convertible Preferred Stock*

In March 2004, we designated 100,000 shares ofpreferred stock as Series C Convertible Preferred Stock (the “Series CShares”), of which 62,182 are issued and outstanding at December 31, 2004.The Series C Shares accrue a cumulative annual dividend of 7% on the $100face amount of such shares payable in shares of common stock on June 15and December 15 each year, and on such date that the preferred stockholderelects to convert preferred stock to common stock. As of December 31, 2004,cumulative dividends in arrears were approximately $308,900. In the event of aliquidation, dissolution or winding up of the Company, the Series C Shareshave a liquidation preference of $100 per share plus all accrued and unpaiddividends thereon prior to any payment or distribution to holders of our commonstock. The Series C Shares are convertible into common stock at aconversion price of $.75 per share. The conversion price is subject toproportional adjustment in the event of stock splits, stock dividends orreclassifications. Subject to certain exceptions, in the event we issueadditional shares of common stock at a purchase price less than the conversionprice of the Series C Shares, the conversion price shall be lowered tosuch lesser price. In the event that the average closing bid price of ourcommon stock is less than $1.00 per share for thirty (30) consecutivetrading days at any time after March 3, 2007, we will be required toredeem the Series C Shares by payment of $100 per share plus all accruedand unpaid dividends due thereon.

We are required to obtain the consent of the holdersof a majority of the Series C Shares in order to, among other things,issue any shares of preferred stock that are equal to or have a preference overthe Series C shares or issue any shares of preferred stock, rights,options, warrants, or any other securities convertible into common stock of theCompany, other than those issued to employees of the Company in the ordinarycourse of their employment or to consultants or other persons providingservices to the Company so long as such issuances do not exceed the conversionrights for more than 500,000 shares of common stock. We are also required toobtain such consent in order to, among other things, complete a sale or otherdisposition of any material assets, complete an acquisition of a materialamount of assets, engage in a merger, reorganization or consolidation, or incuror guaranty any indebtedness in excess of $50,000.

*Warrants*

The Company has issuedwarrants to certain creditors, investors, investment bankers and consultants. Asummary of warrant activity is as follows:
| ** **                                     | ** ** | **Outstanding** | ** ** | **Price per  share** | ** **   | **Expiration  date** | ** ** | **Exercisable at  December 31,** | ** ** |
|------------------------------------------------|------------|-----------------|------------|---------------------------|--------------|----------------------|------------|--------------------------------------------|------------|
| **Balance,  December 31, 2002**           |       | 5,857,682       |       |                      |         |                 |       | 5,723,682                                  |       |
|                                           |       |            |       |                      |         |                 |       |                                       |       |
| Granted to  consultants                        |       | 200,000         |       | $                         | 0.49         |                 | 2006       |                                       | 200,000    |   |
| Expired                                        |       | (663,000        | )          | $                         | 0.86 - $7.50 |                 | —     |                                       | (529,000   | ) |
|                                           |       |            |       |                      |         |                 |       |                                       |       |
| **Balance,  December 31, 2003**           |       | 5,394,682       |       |                      |         |                 |       | 5,394,682                                  |       |
|                                           |       |            |       |                      |         |                 |       |                                       |       |
| Sold in  connection with private placement     |       | 4,444,464       |       | $                         | 1.35         |                 | 2009       |                                       | 4,444,464  |   |
| Sold in  connection with convertible notes     |       | 2,222,219       |       | $                         | 1.55         |                 | 2009       |                                       | 2,222,219  |   |
| Granted to  consultants and Investment bankers |       | 1,214,667       |       | $                         | 0.97 - $1.35 |                 | 2009       |                                       | 1,114,667  |   |
| Exercised                                      |       | (3,000          | )          | $                         | 0.65         |                 | —     |                                       | (3,000     | ) |
| Repurchased                                    |       | (567,000        | )          | $                         | 0.38 - $1.00 |                 | —     |                                       | (567,000   | ) |
| Expired or  cancelled                          |       | (561,932        | )          | $                         | 0.45 - $3.00 |                 | —     |                                       | (561,932   | ) |
|                                           |       |            |       |                      |         |                 |       |                                       |       |
| **Balance,  December 31, 2004**           |       | 12,144,100      |       |                      |         |                 |       | 12,044,100                                 |       |
|                                           |       |            |       |                      |         |                 |       |                                       |       |
| Sold in  connection with convertible notes     |       | 1,425,843       |       | $                         | 0.90 - $1.55 |                 | 2010       |                                       | 1,425,843  |   |
| Granted to  consultants and Investment bankers |       | 271,948         |       | $                         | 1.35         |                 | 2010       |                                       | 271,948    |   |
| Exercised                                      |       | (525,000        | )          | $                         | 1.00 - $1.35 |                 | —     |                                       | (525,000   | ) |
| Expired or  cancelled                          |       | (128,611        | )          | $                         | 0.90 - $1.31 |                 | —     |                                       | (128,611   | ) |
| Vested during  the year                        |       | —          |       | $                         | 0.97 - $1.35 |                 | —     |                                       | 75,000     |   |
| ** **                                     | ** ** | ** **      | ** ** | ** **                | ** **   | ** **           | ** ** | ** **                                 | ** ** |
| **Balance, December 31, 2005**            |       | 13,188,280      |       |                      |         |                 |       | 13,163,280                                 |       |

 

97

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The estimated fair value of the warrants grantedduring 2005, 2004 and 2003 was $1,467,302, $2,466,839 and $67,000,respectively. The estimated fair value of the warrants granted to consultantsand investment bankers was $234,148 and $534,201 of the $1,467,302 and$2,466,839 for the years 2005 and 2004, respectively. The fair value ofwarrants is estimated as of the grant date using the Black-Scholes pricingmodel utilizing the same assumptions described in the Stock-Based Compensationfootnote. The estimated fair value of warrants granted for goods and servicesis being amortized to expense over the terms of the consulting agreements.

**NOTE P—STOCK-BASED COMPENSATION**

*1996 Stock Option Plan*

During 1996, the Board of Directors and stockholdersof the Company adopted the 1996 Stock Option Plan (the 1996 Plan). Under the1996 Plan, 750,000 shares of common stock are reserved for issuance toemployees, officers, directors, and consultants of the Company at exerciseprices which may not be below 100% of fair market value for incentive stockoptions and 50% for all others. The term of stock options granted may notexceed ten years. Options issued under the Plan vest pursuant to the terms ofstock option agreements with the recipients. In the event of a change incontrol, as defined, all options outstanding vest immediately. The Planterminates in May 2005.

*1999 Stock Option Plan*

During 1999, the Board of Directors of the Companyadopted the 1999 Stock Option Plan (the 1999 Plan). The 1999 Plan was notpresented to stockholders for approval and thus incentive stock options are notavailable under the plan. Under the 1999 Plan, 2,000,000 shares of common stockare reserved for issuance to employees, officers, directors, and consultants ofthe Company at exercise prices which may not be below 85% of fair market value.The term of nonstatutory stock options granted may not exceed ten years.Options issued under the Plan vest pursuant to the terms of stock optionagreements with the recipients. In the event of a change in control, asdefined, all options outstanding vest immediately. The 1999 Plan terminates in August 2009.

*2004 Stock Option Plan*

On October 12, 2004, the Board of Directors of theCompany approved the 2004 Stock Option Plan (the 2004 Plan). The 2004 Plan hasnot yet been presented to stockholders for approval and thus incentive stockoptions are not available under this plan. Under the terms of this plan,4,000,000 shares of common stock are reserved for issuance to employees,officers, directors, and consultants of the Company at exercise prices whichmay not be below 85% of fair market value. The term of stock options grantedmay not exceed ten years. Options issued under the Plan vest pursuant to theterms of stock option agreements with the recipients. In the event of a changein control, as defined, all options outstanding vest immediately. The Planterminates in October 2014.

*Non-Plan Stock Options*

Periodically, the Company has granted options outsideof the 1996, 1999, and 2004 Plans to various employees and consultants. In theevent of change in control, as defined, certain of the non-plan optionsoutstanding vest immediately.

98

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*Summary of Option Information*

Information summarizingoption activity is as follows:
| ** **                                               | ** ** | **Number of Options** | ** ** | ** **         | ** ** | ** **         | ** ** |
|----------------------------------------------------------|------------|---------------------------------|------------|--------------------|------------|--------------------|------------|
| ** **                                               | ** ** | **1996 Plan**              | ** ** | **1999 Plan** | ** ** | **2004 Plan** | ** ** | **Non Plan** | ** ** | **Total** | ** ** | **Range of  exercise price** | ** ** | **Weighted  average  exercise price** | ** ** |
| Balance, as of  December 31, 2002         |       | 390,380                         |       | 1,836,669          |       | —             |       | 1,963,000 |   | 4,190,049 |   | 0.19-6.42 |   | 0.77 |   |
|                                                     |       |                            |       |               |       |               |       |   |   |   |   |   |   |   |   |
| Granted                                                  |       | 130,000                         |       | 150,000            |       | —             |       | 2,460,000 |   | 2,740,000 |   | 0.20-1.32 |   | 0.89 |   |
| Exercised                                                |       | —                          |       | (193,743           | )          | —             |       | (114,581 | ) | (308,324 | ) | 0.20 |   | 0.20 |   |
| Expired or  cancelled                                    |       | (33,000                         | )          | (616,257           | )          | —             |       | (1,040,419 | ) | (1,689,676 | ) | 0.19-3.00 |   | 1.04 |   |
| Balance, as of  December 31, 2003         |       | 487,380                         |       | 1,176,669          |       | —             |       | 3,268,000 |   | 4,932,049 |   | 0.19-6.42 |   | 0.79 |   |
|                                                     |       |                            |       |               |       |               |       |   |   |   |   |   |   |   |   |
| Granted                                                  |       | —                          |       | —             |       | 1,960,000          |       | 930,000 |   | 2,890,000 |   | 0.93-1.62 |   | 1.14 |   |
| Exercised                                                |       | (251,000                        | )          | —             |       | —             |       | — |   | (251,000 | ) | 0.38 |   | 0.38 |   |
| Expired or  cancelled                                    |       | (5,000                          | )          | —             |       | —             |       | (40,000 | ) | (45,000 | ) | 0.50-3.22 |   | 0.80 |   |
| Balance, as of  December 31, 2004         |       | 231,380                         |       | 1,176,669          |       | 1,960,000          |       | 4,158,000 |   | 7,526,049 |   | 0.19-6.42 |   | 0.94 |   |
|                                                     |       |                            |       |               |       |               |       |   |   |   |   |   |   |   |   |
| Granted                                                  |       | 18,018                          |       | —             |       | 831,000            |       | 700,000 |   | 1,549,018 |   | 0.38-1.34 |   | 0.90 |   |
| Exercised                                                |       | (96,668                         | )          | (97,000            | )          | —             |       | (60,000 | ) | (253,668 | ) | 0.38-0.91 |   | 0.77 |   |
| Expired or  cancelled                                    |       | (2,730                          | )          | (17,544            | )          | (738,140           | )          | (1,715,150 | ) | (2,473,564 | ) | 0.35-1.62 |   | 1.00 |   |
| Balance, as of  December 31, 2005         |       | 150,000                         |       | 1,062,125          |       | 2,052,860          |       | 3,082,850 |   | 6,347,835 |   |   |   |   |   |
|                                                     |       |                            |       |               |       |               |       |   |   |   |   |   |   |   |   |
| **Available for future grants,  December 31, 2005** | ** ** | **—**                      | ** ** | **647,132**        | ** ** | **1,947,140**      | ** ** | **—** | ** ** | **2,594,272** | ** ** | ** ** | ** ** | ** ** | ** ** |

 

Additional informationregarding outstanding options as of December 31, 2005 is as follows:

| Shares under outstanding options | ** ** | **Shares exercisable under  outstanding options** | ** ** |
|-------------------------------------------------|------------|------------------------------------------------------------------|------------|
| **Range of  exercise prices**         | ** ** | **Number of  shares**                                       | ** ** | **Weighted  average  exercise  price** | ** ** | **Weighted  average  remaining  life (in  years)** | ** ** | **Number  exercisable** | ** ** | **Weighted  average  exercise  price** | ** ** |
|                                                 | $          | 0.19                                                             |       |   | 60,000 |   | $ | 0.19 |   | 2.65 |   | 60,000 |   | $ | 0.19 |   |
|                                            | 0.29-0.40  |                                                             |       | 837,456 |   | 0.33 |   | 2.47 |   | 822,046 |   | 0.33 |   |
|                                                 | 0.46-0.69  |                                                             |       | 1,808,000 |   | 0.55 |   | 2.99 |   | 1,303,332 |   | 0.53 |   |
|                                            | 0.86-1.05  |                                                             |       | 646,519 |   | 0.97 |   | 5.47 |   | 396,519 |   | 0.95 |   |
|                                                 | 1.10-1.62  |                                                             |       | 2,947,860 |   | 1.22 |   | 5.90 |   | 2,324,520 |   | 1.20 |   |
|                                            | 6.42       |                                                             |       | 48,000 |   | 6.42 |   | 2.12 |   | 48,000 |   | 6.42 |   |
|                                                 |            |                                                                  |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The weighted average fair value of options granted toemployees and directors during 2005, 2004 and 2003 were $0.85, $0.68, and $0.62per share, respectively. The fair value of each option grant is estimated as ofthe date of the grant using the Black-Scholes option-pricing model utilizingthe same assumptions presented in the proforma compensation disclosure sectionbelow.

Non-Plan options were granted to consultants during2005 and 2004 totaling 700,000 and 45,000 shares, respectively. Six hundredthousand of the options issued in 2005 vest ratably over a three-year periodcommencing in November 2005. The remaining 100,000 shares issued in 2005vest ratably over a two-year period commencing in November 2005. Theoptions issued in 2004 vest annually over a three-year period commencing in July 2005.The estimated fair value of these Non-Plan options granted to consultants in2005 and 2004 were approximately $443,000 and $27,000 respectively.

In February and March 2006,1,798,000 Nonqualified Stock Options were granted to eligible employees

99

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**NOTEQ—INCOME TAXES**

Deferred taxes are due to income tax credits and netoperating loss carryforwards and to the temporary differences between thecarrying values of certain assets and liabilities for financial reporting andincome tax purposes.

Significant components ofdeferred taxes are as follows at December 31:

|                                         | ** ** | **2005**     | ** ** | **2004**     | ** ** | **2003**     | ** ** |
|-----------------------------------------|------------|--------------|------------|--------------|------------|--------------|------------|
| ** **                              | ** ** | **Restated** | ** ** | **Restated** | ** ** | **Restated** | ** ** |
| **Current asset:**                      | ** ** | ** **   | ** ** | ** **   | ** ** | ** **   | ** ** |
| Accrued  compensation                   |       | $            | 37,000     |         | $          | 59,000       |       | $ | 20,000 |   |
| Accounts  receivable allowance          |       | 63,000       |       | 29,000       |       | —       |       |
| **Non-current asset:**                  |       | —       |       |         |       |         |       |
| Basis  differences in fixed assets      |       | 14,000       |       | 12,000       |       | (11,000      | )          |
| Basis differences  in intangible assets |       | (145,000     | )          | 39,000       |       | —       |       |
| Accrued interest  and other             |       | 269,000      |       | 89,000       |       | 407,000      |       |
| Income tax  credits                     |       | 856,000      |       | 217,000      |       | 166,000      |       |
| Net operating  loss carryforwards       |       | 16,782,000   |       | 11,796,000   |       | 9,070,000    |       |
| Valuation  allowances                   |       | (17,876,000  | )          | (12,241,000  | )          | (9,652,000   | )          |
|                                    |       | $            | —     |         | $          | —       |       | $ | — |   |

 

As of December 31, 2005 the Company has federaland state net operating loss carryforwards of approximately $47,122,000 and$16,491,000 respectively, subject to expiration between 2011 and 2025.

These net operating loss carryforwards are subject tothe limitations under Section 382 of the Internal Revenue Code due tochanges in the equity ownership of the Company.

A valuation allowance equal to the full amount of thedeferred tax assets has been recorded due to the uncertainty of realization ofthe deferred tax assets due to operating loss history of the Company. Thevaluation allowance could be reduced or eliminated based on future earnings andfuture estimates of taxable income. Similarly, income tax benefits related tostock options exercised have not been recognized in the financial statements.

A reconciliation of theeffective income tax rate on operations reflected in the Statements ofOperations to the US Federal statutory income tax rate is presented below.

|                                                           | ** ** | **2005**     | ** ** | **2004**     | ** ** | **2003**     | ** ** |
|-----------------------------------------------------------|------------|--------------|------------|--------------|------------|--------------|------------|
| ** **                                                | ** ** | **Restated** | ** ** | **Restated** | ** ** | **Restated** | ** ** |
| US Federal  statutory income tax rate                     |       | 34.0         | %          | 34.0         | %          | 34.0         | %          |
|                                                      |       |         |       |         |       |         |       |
| Federal income  tax provision (benefit) at statutory rate |       | $            | (1,249,000 | )            | $          | (3,689,000   | )          | $ | (1,380,000 | ) |
| Derivative and  warrant valuation adjustments             |       | (3,113,000   | )          | 1,023,000    |       | —       |       |
| Other                                                     |       | (1,273,000   | )          | 77,000       |       | 55,000       |       |
| Change in  valuation allowance                            |       | 5,635,000    |       | 2,589,000    |       | 1,325,000    |       |
|                                                      |       |         |       |         |       |         |       |
| Provision  (benefit) for income taxes                     |       | $            | —     |         | $          | —       |       | $ | — |   |
| Effective rate on  operations                             |       | 0.0          | %          | 0.0          | %          | 0.0          | %          |

 

100

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**NOTER—FAIR VALUES OF FINANCIAL INSTRUMENTS**

The Company’s derivativefinancial instruments consist of embedded derivatives related to the $7,050,000Senior Secured Convertible Term Note and the $8,194,723 Subordinate UnsecuredConvertible Term Note (“Notes’’). These embedded derivatives include certainconversion features and variable interest features. The Company also issuedwarrants to purchase shares of the Company’s Common stock as part of the debtfinancing. The accounting treatment of derivatives and the warrants requiresthat the Company record the derivatives and the warrants as a liability attheir relative fair values as of the inception date of the agreement, and atfair value as of each subsequent balance sheet date. Any change in fair valuewill be recorded as non-operating, non-cash income or expense at each reportingdate. If the fair value of the derivatives or the warrant is higher at thesubsequent balance sheet date, the Company will record a non-operating,non-cash charge. If the fair value of the derivatives or warrant is lower atthe subsequent balance sheet date, the Company will record non-operating,non-cash income. As of December 31, 2005, the derivatives and warrantsclassified as liabilities were valued at $1,011,543 and $1,483,511respectively. Conversion related derivatives were valued at each quarter endusing the Binomial Option Pricing Model with the following assumptions:dividend yield of 0%; annual volatility ranging from 141% to 87%; and risk freeinterest rate ranging from .96% to 1.51% as well as probability analysisrelated to subsequent financing. In accordance with EITF 00-19, thederivatives are classified as long-term liabilities due to the possiblemonetary penalties associated with conversion features embedded within the debtinstruments.

101

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**NOTE S—SUPPLEMENTARY DISCLOSURES OFCASH FLOW INFORMATION**
| ** **                                                                                                                                             | ** ** | **Years ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                                             | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                                                                             | ** ** | **Restated**                                | ** ** | **Restated** | ** ** | ** ** | ** ** |
| **Cash paid for:**                                                                                                                                     | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest                                                                                                                                               |       | 1,267,713                                   |       | 181,934 |   | — |   |
| **Noncash Financing Activities:**                                                                                                                      | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Conversion of convertible debentures and notes,  bridge notes and accrued interest into common stock                                                   |       | 890,003                                     |       | 2,547,644 |   | 1,573,466 |   |
|                                                                                                                                                   |       |                                        |       |   |   |   |   |
| Issuance of Series C preferred stock in  exchange for Series B Preferred stock and cumulative dividends in  arrears, thereon                 |       | —                                      |       | 525,668 |   | — |   |
| Issuance of Series C preferred stock in  exchange for debt                                                                                        |       | —                                      |       | 8,702,463 |   | — |   |
| Issuance of common stock in exchange for options and  warrants                                                                                         |       | —                                      |       | 99,222 |   | — |   |
| Issuance of common stock in conjunction with PSG  acquisition                                                                                          |       | —                                      |       | 3,608,940 |   | — |   |
| Issuance of common stock and warrants in exchange  for services                                                                                        |       | —                                      |       | 99,400 |   | — |   |
| Trade receivables assumed by prior Shareholders of  AMG                                                                                                |       | —                                      |       | 54,552 |   | — |   |
| Offering costs                                                                                                                                         |       | —                                      |       | 131,211 |   | — |   |
| Conversion of short-term notes and penalties into  long-term notes                                                                                     |       | —                                      |       | — |   | 9,300,170 |   |
| Issuance of common stock in exchange for  Series A, Series B and Series C preferred stock and cumulative  dividends in arrears, thereon |       | 121,819                                     |       | 94,383 |   | 244,919 |   |
| Securities transferred from held-to-maturity to  available-for-sale                                                                                    |       | —                                      |       | 1,000,000 |   | — |   |
| Cashless exercise of options and warrants                                                                                                              |       | 164,075                                     |       | — |   | — |   |
| Goodwill allocation adjustment                                                                                                                         |       | 633,959                                     |       | — |   | — |   |
| Issuance of warrants in exchange for financing fees                                                                                                    |       | 234,150                                     |       | 534,201 |   | — |   |
| Issuance of common stock for financing fees related  to payment deferral                                                                               |       | 788,284                                     |       | — |   | — |   |
| Issuance of warrants in conjunction with convertible  debt financing                                                                                   |       | 1,233,153                                   |       | 1,912,639 |   | — |   |
| Origination of embedded derivatives with debt  financing                                                                                               |       | 2,031,414                                   |       | 3,714,589 |   | — |   |
| Origination of  debt discounts with debt financing                                                                                                     |       | 690,609                                     |       | 941,160 |   | — |   |

 

**NOTE T—PROFIT SHARING PLAN**

The Company hasestablished a savings plan under section 401(k) of the InternalRevenue Code. All employees of the Company, after completing one day of serviceare eligible to enroll in the 401(k) plan. Participating employees mayelect to defer a portion of their salary on a pre-tax basis up to the limits asprovided by the IRS Code. The Company is not required to match employeecontributions but may do so at its discretion. The Company made nocontributions during the three years ended December 31, 2005.

102

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**NOTE U—EARNINGS PER SHARE “EPS”**

The Company’s basic EPS is calculated using netearnings and the weighted-average number of shares outstanding during thereporting period. Diluted EPS includes the effect from potential issuance ofcommon stock, such as stock issuable pursuant to the exercise of stock optionsand warrants and the assumed conversion of convertible notes and preferredstock.

The reconciliation of the numerators and denominatorsof the basic and diluted EPS calculations was as follows for the followingfiscal years ended December 31:
| ** **                                                    | ** ** | **2005**     | ** ** | **2004**     | ** ** | **2003**     | ** ** |
|---------------------------------------------------------------|------------|--------------|------------|--------------|------------|--------------|------------|
| ** **                                                    | ** ** | **Restated** | ** ** | **Restated** | ** ** | **Restated** | ** ** |
|                                                          |       |         |       |         |       |         |       |
| **Numerator:**                                                | ** ** | ** **   | ** ** | ** **   | ** ** | ** **   | ** ** |
|                                                          |       |         |       |         |       |         |       |
| Net loss                                                      |       | (3,673,384   | )          | (10,849,891  | )          | (4,058,950   | )          |
|                                                          |       |         |       |         |       |         |       |
| Dividends accumulated on cumulative preferred stock           |       | (313,517     | )          | (385,355     | )          | (136,755     | )          |
| Loss available to common shareholders (basic eps)             |       | (3,986,901   | )          | (11,235,246  | )          | (4,195,705   | )          |
|                                                          |       |         |       |         |       |         |       |
| Adjustment for interest expense and debt conversion  features |       | (2,036,945   | )          | —       |       | —       |       |
| Net earnings, adjusted (diluted eps)                          |       | (6,023,846   | )          | (11,235,246  | )          | (4,195,705   | )          |
|                                                          |       |         |       |         |       |         |       |
| **Denominator:**                                              | ** ** | ** **   | ** ** | ** **   | ** ** | ** **   | ** ** |
| Weighted-average shares used to compute basic EPS             |       | 44,787,807   |       | 34,806,201   |       | 17,543,586   |       |
| Effect of  dilutive securities:                               |       |         |       |         |       |         |       |
| Convertible notes                                             |       | 7,258,496    |       | —       |       | —       |       |
| Weighted-average shares used to compute diluted EPS           |       | 52,046,303   |       | 34,806,201   |       | 17,543,586   |       |
|                                                          |       |         |       |         |       |         |       |
| **Earnings per share**                                        | ** ** | ** **   | ** ** | ** **   | ** ** | ** **   | ** ** |
| Basic                                                         |       | $            | (0.09      | )            | $          | (0.32        | )          | $ | (0.24 | ) |
| Diluted                                                       |       | $            | (0.12      | )            | $          | (0.32        | )          | $ | (0.24 | ) |

 

The following table summarizes the potential weightedaverage shares of common stock that were excluded from the diluted per sharecalculation, because the effect of including these potential shares wasanti-dilutive.

|                              | ** ** | **Years ended December 31,** | ** ** |
|------------------------------|------------|---------------------------------------------|------------|
| ** **                   | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
|                         |       |                                        |       |   |   |   |   |
| Preferred Stock              |       | 5,971,755                                   |       | 5,556,376 |   | 1,876,500 |   |
| Convertible Debt             |       | —                                      |       | 2,926,942 |   | 2,185,653 |   |
| Stock Options                |       | 1,456,349                                   |       | 2,205,895 |   | 1,164,967 |   |
| Warrants                     |       | 188,009                                     |       | 1,034,070 |   | 155,533 |   |
|                         |       |                                        |       |   |   |   |   |
| Potentially dilutive  shares |       | 7,616,113                                   |       | 11,723,283 |   | 5,382,653 |   |

 

Items excluded from the diluted per share calculationbecause the exercise price was greater than the average market price of thecommon shares:

103

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|               | ** ** | **Years ended December 31,** | ** ** |
|---------------|------------|---------------------------------------------|------------|
| ** **    | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **    | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Stock options |       | 4,024,544                                   |       | 218,014 |   | 1,876,742 |   |
| Warrants      |       | 8,565,442                                   |       | 4,365,829 |   | 4,767,932 |   |
|          |       |                                        |       |   |   |   |   |
| Total         |       | 12,589,986                                  |       | 4,583,843 |   | 6,644,674 |   |

 

Had the 2006 Financing taken place prior to theyear-ended December 31, 2005, potential common shares would have beenincreased by 1,428,571 shares. These shares would have been anti-dilutive andwould have been excluded from the EPS calculation.

**NOTE V—RECLASSIFICATIONS**

Certain amounts in the2004 and 2003 financial statements have been reclassified to conform to the 2005presentation. These reclassifications had no effect on the previously reportednet loss or stockholders’ equity (deficit).

**NOTE W—EVENTS OCCURRING SUBSEQUENT TODECEMBER 31, 2005**

Effective as of January 23,2006, BIO-key International, Inc. (the “Company”) entered into anAmendment and Waiver (the “Secured Notes Amendment and Waiver”) with Laurus inconnection with the Secured Convertible Notes (the “Secured Notes”) currentlyheld by Laurus.

Under the Secured NotesAmendment and Waiver, the Secured Notes issued by the Company to Laurus on September 29,2004 in the aggregate principal amount of $5,000,000 (the “September 2004Note”) and on June 7, 2005 in the aggregate principal amount of $2,000,000(the “June 2005 Note”) were amended as follows: (i) the maturity dateof the September 2004 Note was extended to January 1, 2008, (ii) thematurity date of the June 2005 Note was extended to December 1, 2008,and (iii) the fixed conversion price under each of the Secured Notes wasreset from $1.35 to $0.85 per share. In addition, the exercise price of allwarrants to purchase Common Stock of the Company held by Laurus was reset to$1.00 per share.

The Company also issued150,000 shares (the “Newly Issued Shares”) of the Company’s Common Stock toLaurus in connection with the Secured Notes Amendment and Waiver. TheCompany granted Laurus registration rights with respect to these shares. Inconnection with the issuance of the Newly Issued Shares, Laurus agreed to waivethe provisions of the Secured Notes regarding any adjustment of the fixedconversion price that would otherwise be triggered as a result of the issuanceof the Newly Issued Shares and certain other securities which have a conversionprice of $0.70 per share.

Effective as of January 23,2006, the Company also entered into an Amendment and Waiver (the “SubordinatedNotes Amendment and Waiver”) with certain holders (“the “Subordinated NoteHolders”) of its Subordinated Convertible Promissory Notes (the “SubordinatedNotes”).

Under the SubordinatedNotes Amendment and Waiver, the Subordinated Notes issued by the Company on September 29,2004 in the aggregate principal amount of $5,288,221 (the “September 2004Notes”) and on May 31, 2005 in the aggregate principal amount of$3,244,723 (the “May 2005 Notes”) were amended as follows: (i) thematurity dates were extended from September 29, 2007 and May 31,2008, respectively, to January 1, 2009; (ii) the interest rate wasfixed at fifteen percent (15%); (iii) all principal amounts are due at thematurity date and shall be paid in shares of Common Stock priced at $0.70 pershare if the average closing price of the Common Stock for the thirty (30)trading days immediately preceding the maturity date is greater than $1.10; (iv) interestshall be paid, at the Company’s election, in cash or shares of Common Stock,with the Common Stock priced at the average closing price of the Common Stockfor the ten (10) trading days immediately preceding the repayment date;and (v) the currently applicable fixed conversion price was amended to$0.70 per share. In addition, the exercise price of all warrants to purchaseCommon Stock held by the Subordinated Note Holders that currently have anexercise price greater than $1.00 per share was reset to $1.00 per share.

The Company also enteredinto a Securities Purchase Agreement (the “Securities Purchase Agreement”),effective as of January 23,2006, with The Shaar Fund, Ltd., Longview Fund,L.P. and Longview Special Finance (collectively, the “Purchasers”).

Under the SecuritiesPurchase Agreement, the Company issued to the Purchasers Convertible Term Notes(the “Convertible Notes”) in the aggregate principal amount of$1,000,000. The Convertible Notes are convertible into shares of the Series BPreferred Stock of the Company, which shares are convertible into shares of theCommon Stock of the Company at an initial fixed conversion price of $0.70 pershare.

In connection with thePurchasers’ purchase of the Notes, the Company also issued warrants to thePurchasers (the “Warrants”) to purchase up to an aggregate of 500,000 shares ofthe Company’s Common Stock(subject to adjustment as set forth therein) at a pershare exercise price of $1.00 per share. The proceeds from this transactionwill be used for general working capital purposes.

The Company entered into an Amendment No. 1 toSubordinated Secured Promissory Note, dated as of January 23, 2006 (the “AetherNote Amendment”), with Aether Systems, Inc. (“Aether”). Pursuant to theAether Note Amendment, the Subordinated Secured Promissory Note issued by theCompany to Aether on September 30,2004 in the aggregate maximum principalamount of $6,884,588 (the “Aether Note”),was amended to increase such aggregatemaximum principal amount to $7,884,588. The Aether Note evidences a contingentreimbursement obligation of the Company to Aether and a surety fee payable bythe Company to Aether, in each case with respect to a letter of creditmaintained by Aether for the Company’s benefit in connection with the Company’sacquisition of the Mobile Government Division of Aether on September 30,2004. The Company’s obligations under the Aether Note remain secured by asecurity interest granted to Aether in all or substantially all of the Company’sassets subordinate to the security interest of Laurus pursuant to the SecuredNotes.

On February 7, 2006,BIO-key International, Inc. (the “Company”) entered into a CompensationAgreement (the “Agreement”) with Thomas J. Colatosti (“Mr. Colatosti”),the current Chairman of the Board of Directors and Co-Chief Executive Officerof the Company. Pursuant to the Agreement, Mr. Colatosti will provideservices to the Company and its subsidiaries and affiliates for the year endingDecember 31, 2006 at a rate of $14,500 per month.

In February 2006,the Company’s shareholders approved amendments to articles of incorporationwhich increased the number of authorized shares of common stock from 85,000,000to 170,000,000.

On March 28,2006, the Company entered into a two-year employment agreement with Michael W.DePasquale to serve as the Co-Chief Executive Officer of the Company at anannual base salary of $250,000 subject to adjustment by the Board of Directorsas well as $1,000 per month in lieu of participating in the Company’s medicalplan. In addition to the Base Salary and Stock Options, a “Discretionary Bonus”may be awarded to Mr. DePasquale on the basis of merit performance on anannual basis in the sole discretion of the Board of Directors. The employmentagreement also provides for the grant of options to purchase up to 400,000shares of Company common stock payable at the discretion of the Board ofDirectors.

The employment agreementcontains standard and customary confidentiality, non-solicitation and “workmade for hire” provisions as well as a covenant not to compete which prohibits Mr. DePasqualefrom doing business with any current or prospective customer of the Company orengaging in a business competitive with that of the Company during the term ofhis employment and for the one year period thereafter. The Company mayterminate the agreement at any time with or without cause. In the event oftermination without cause, Mr. DePasquale shall continue to be paid histhen current base salary for the greater of six months from the date of suchtermination or the number of months remaining until the end of the term of theemployment agreement.

As of May 19, 2006, the Company was delinquentwith respect to some interest obligations on certain subordinated notes issuedin September 2004 and May 2005. Due to certain cross defaultprovisions contained in both the senior and subordinated notes, all outstandingdebt is considered to be in default. Accordingly, the Company has reclassifiedapproximately $8,849,000 of principal from long-term to current liabilities asof March 31, 2006 and approximately $9,734,000 of principal from long-termto current liabilities as of December 31, 2005. All of the relateddiscount and embedded derivatives associated with the debt has also beenreclassed to current.

104

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**NOTE X—Results by Quarter (Unaudited)**

Thefirst set of tables below presents unaudited quarterly financial informationfor 2005, 2004 and 2003. The amounts presented have been restated from thosepreviously reported on Form 10-Q for the applicable periods and inour 2004 annual report on Form 10-K. The second set of tables belowsets forth, for each of the quarters and for each of the interim balance sheetdates presented, the amounts of the restatement adjustments and areconciliation from previously reported amounts to the restated amounts.

Therestatement adjustments are attributable to the same matters that are discussedin depth in Note B, Restatement of Previously Issued Financial Statements, andwe refer you to that discussion. The third set of tables below summarizes, foreach of the quarters and for each of the interim balance sheet dates presented,the impact of each category of adjustment on previous reported revenue; netloss from continuing operations and earnings per share; and assets, liabilitiesand stockholders’ equity.

Certainof the previously reported amounts have been reclassified to conform to the2005 presentation. These reclassifications had no effect on the previouslyreported net loss or stockholders’ equity (deficit).

105

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**Resultsby Quarter(Unaudited)**
| ** **                                                            | ** ** | **Three Months Ended  March 31,** | ** ** | **Three Months Ended  June 30,** | ** ** |
|-----------------------------------------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                                            | ** ** | **2005**                                         | ** ** | **2004**                                        | ** ** | **2003** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                            | ** ** | **(Restated)**                                   | ** ** | **(Restated)**                                  | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
|                                                                  |       |                                             |       |                                            |       |   |   |   |   |   |   |   |   |
| **Revenues**                                                          | ** ** | ** **                                       | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Services                                                              |       | $                                                | 3,059,854  |                                            | $          | 27,800 |   | $ | — |   | $ | 2,761,887 |   | $ | 103,439 |   | $ | 2,715 |   |
| License fees and other                                                |       | 879,737                                          |       | 248,871                                         |       | 27,504 |   | 923,665 |   | 322,895 |   | 10,305 |   |
|                                                                  |       | 3,939,591                                        |       | 276,671                                         |       | 27,504 |   | 3,685,552 |   | 426,334 |   | 13,020 |   |
| **Costs  and other expenses**                                         | ** ** | ** **                                       | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Services                                                              |       | 835,565                                          |       | —                                          |       | — |   | 1,034,127 |   | — |   | 715 |   |
| Cost of license fees and other                                        |       | 327,857                                          |       | 5,778                                           |       | 2,393 |   | 205,385 |   | 94,889 |   | 2,589 |   |
| Selling, general and administrative                                   |       | 2,846,623                                        |       | 815,703                                         |       | 568,499 |   | 3,125,471 |   | 1,343,942 |   | 468,947 |   |
| Research, development and engineering                                 |       | 2,075,070                                        |       | 262,761                                         |       | 221,107 |   | 1,670,471 |   | 351,814 |   | 253,770 |   |
|                                                                  |       |                                             |       |                                            |       |   |   |   |   |   |   |   |   |
|                                                                  |       | 6,085,115                                        |       | 1,084,242                                       |       | 791,999 |   | 6,035,454 |   | 1,790,645 |   | 726,021 |   |
| **Operating  loss**                                                   |       | (2,145,524                                       | )          | (807,571                                        | )          | (764,495 | ) | (2,349,902 | ) | (1,364,311 | ) | (713,001 | ) |
| **Other  income (deductions)**                                        | ** ** | ** **                                       | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest income                                                       |       | 26,062                                           |       | —                                          |       | — |   | 2,988 |   | — |   | — |   |
| Interest expense                                                      |       | (834,916                                         | )          | (367,044                                        | )          | (410,964 | ) | (552,093 | ) | (852 | ) | (484,733 | ) |
| Derivative and warrant fair value adjustments                         |       | 3,576,881                                        |       | 323,128                                         |       | (119,247 | ) | 1,373,367 |   | — |   | 27,359 |   |
| Gain on sale of marketable securities                                 |       | (20,000                                          | )          | —                                          |       | — |   | — |   | — |   | — |   |
| Other income (expense)                                                |       | —                                           |       | 2,348                                           |       | 554 |   | (532 | ) | 14,175 |   | 426 |   |
| Total other income (deductions)                                       |       | 2,748,027                                        |       | (41,568                                         | )          | (529,657 | ) | 823,730 |   | 13,323 |   | (456,948 | ) |
| **NET  INCOME (LOSS)**                                                |       | $                                                | 602,503    |                                            | $          | (849,139 | ) | $ | (1,294,152 | ) | $ | (1,526,172 | ) | $ | (1,350,988 | ) | $ | (1,169,949 | ) |
|                                                                  |       |                                             |       |                                            |       |   |   |   |   |   |   |   |   |
| **Basic  Earnings (Loss) per Share:**                                 | ** ** | ** **                                       | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                           | * *   | * *                                         | * *   | * *                                        | * *   | * * | * * | * * | * * | * * | * * | * * | * * |
| Net Income (loss)                                                     |       | $                                                | 602,503    |                                            | $          | (849,139 | ) | $ | (1,294,152 | ) | $ | (1,526,172 | ) | $ | (1,350,988 | ) | $ | (1,169,949 | ) |
|                                                                  |       |                                             |       |                                            |       |   |   |   |   |   |   |   |   |
| Convertible preferred stock dividends and accretion                   |       | (89,185                                          | )          | (11,103                                         | )          | — |   | (79,701 | ) | (127,765 | ) | — |   |
|                                                                  |       |                                             |       |                                            |       |   |   |   |   |   |   |   |   |
| Net Income (loss) attributable to common shareholders                 |       | $                                                | 513,318    |                                            | $          | (860,242 | ) | $ | (1,294,152 | ) | $ | (1,605,873 | ) | $ | (1,478,753 | ) | $ | (1,169,949 | ) |
|                                                                  |       |                                             |       |                                            |       |   |   |   |   |   |   |   |   |
| *Denominator*                                                         | * *   | * *                                         | * *   | * *                                        | * *   | * * | * * | * * | * * | * * | * * | * * | * * |
| Weighted average common shares outstanding                            |       | 42,662,253                                       |       | 23,845,247                                      |       | 14,377,406 |   | 44,663,981 |   | 37,693,849 |   | 14,886,809 |   |
|                                                                  |       |                                             |       |                                            |       |   |   |   |   |   |   |   |   |
| ***Basic  Earnings (Loss) per Shar****e*                              |       | $                                                | 0.01       |                                            | $          | (0.04 | ) | $ | (0.09 | ) | $ | (0.04 | ) | $ | (0.04 | ) | $ | (0.08 | ) |
|                                                                  |       |                                             |       |                                            |       |   |   |   |   |   |   |   |   |
| **Diluted  Loss per Share:**                                          | ** ** | ** **                                       | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                           | * *   | * *                                         | * *   | * *                                        | * *   | * * | * * | * * | * * | * * | * * | * * | * * |
| Net income (loss) attributable to common shareholders                 |       | $                                                | 513,318    |                                            | $          | (860,242 | ) | $ | (1,294,152 | ) | $ | (1,605,873 | ) | $ | (1,478,753 | ) | $ | (1,169,949 | ) |
|                                                                  |       |                                             |       |                                            |       |   |   |   |   |   |   |   |   |
| Effect of Dilutive Securities: Convertible Debentures                 |       | (2,141,436                                       | )          | —                                          |       | — |   | (467,709 | ) | — |   | — |   |
|                                                                  |       |                                             |       |                                            |       |   |   |   |   |   |   |   |   |
| Net loss attributable to common shareholders and  assumed conversions |       | $                                                | (1,628,118 | )                                               | $          | (860,242 | ) | $ | (1,294,152 | ) | $ | (2,073,582 | ) | $ | (1,478,753 | ) | $ | (1,169,949 | ) |
|                                                                  |       |                                             |       |                                            |       |   |   |   |   |   |   |   |   |
| *Denominator*                                                         | * *   | * *                                         | * *   | * *                                        | * *   | * * | * * | * * | * * | * * | * * | * * | * * |
| Weighted average shares outstanding                                   |       | 42,662,253                                       |       | 23,845,247                                      |       | 14,377,406 |   | 44,663,981 |   | 37,693,849 |   | 14,886,809 |   |
|                                                                  |       |                                             |       |                                            |       |   |   |   |   |   |   |   |   |
| Effect of Dilutive Securities:                                        |       |                                             |       |                                            |       |   |   |   |   |   |   |   |   |
| Convertible Debentures                                                |       | 6,092,739                                        |       | —                                          |       | — |   | 6,094,636 |   | — |   | — |   |
|                                                                  |       |                                             |       |                                            |       |   |   |   |   |   |   |   |   |
| Diluted weighted average common shares and common  equivalents        |       | 48,754,992                                       |       | 23,845,247                                      |       | 14,377,406 |   | 50,758,617 |   | 37,693,849 |   | 14,886,809 |   |
|                                                                  |       |                                             |       |                                            |       |   |   |   |   |   |   |   |   |
| ***Diluted  Loss per Share***                                         |       | $                                                | (0.03      | )                                               | $          | (0.04 | ) | $ | (0.09 | ) | $ | (0.04 | ) | $ | (0.04 | ) | $ | (0.08 | ) |

 

106

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**Resultsby Quarter (Continued)(Unaudited)**
| ** **                                                            | ** ** | **Three Months Ended  September 30,** | ** ** | **Three Months Ended  December 31,** | ** ** |
|-----------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                            | ** ** | **2005**                                             | ** ** | **2004**                                            | ** ** | **2003** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                            | ** ** | **(Restated)**                                       | ** ** | **(Restated)**                                      | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
|                                                                  |       |                                                 |       |                                                |       |   |   |   |   |   |   |   |   |
| **Revenues**                                                          | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Services                                                              |       | $                                                    | 2,496,883  |                                                | $          | 10,640 |   | $ | 5,000 |   | $ | 2,543,025 |   | $ | 3,209,527 |   | $ | 2,979 |   |
| License fees and other                                                |       | 735,588                                              |       | 254,763                                             |       | 141,987 |   | 825,456 |   | 1,543,016 |   | 24,991 |   |
|                                                                  |       | 3,232,471                                            |       | 265,403                                             |       | 146,987 |   | 3,368,481 |   | 4,752,543 |   | 27,970 |   |
| **Costs  and other expenses**                                         | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Services                                                              |       | 503,843                                              |       | —                                              |       | — |   | 532,607 |   | 1,174,324 |   | 979 |   |
| Cost of license fees and other                                        |       | 125,633                                              |       | 25,465                                              |       | 2,641 |   | 278,616 |   | 763,764 |   | 79,764 |   |
| Selling, general and administrative                                   |       | 2,836,875                                            |       | 1,636,260                                           |       | 511,297 |   | 3,015,640 |   | 3,318,383 |   | 551,179 |   |
| Research, development and engineering                                 |       | 1,799,845                                            |       | 452,545                                             |       | 246,523 |   | 1,300,649 |   | 1,912,784 |   | 315,930 |   |
|                                                                  |       | 5,266,196                                            |       | 2,114,270                                           |       | 760,461 |   | 5,127,512 |   | 7,169,255 |   | 947,852 |   |
| **Operating  loss**                                                   |       | (2,033,725                                           | )          | (1,848,867                                          | )          | (613,474 | ) | (1,759,031 | ) | (2,416,712 | ) | (919,882 | ) |
| **Other  income (deductions)**                                        | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest income                                                       |       | 6,908                                                |       | —                                              |       | — |   | — |   | 66,824 |   | — |   |
| Interest income (expense)                                             |       | (1,605,771                                           | )          | 82,937                                              |       | (546,195 | ) | (1,528,564 | ) | (1,130,576 | ) | (467,896 | ) |
| Derivative and warrant fair value adjustments                         |       | 3,210,057                                            |       | 517,591                                             |       | 71,799 |   | 994,646 |   | (3,849,138 | ) | 877,634 |   |
| Gain on sale of marketable securities                                 |       | —                                               |       | 33,125                                              |       | — |   | — |   | (33,125 | ) | — |   |
| Other income (expense)                                                |       | (24,816                                              | )          | 9,855                                               |       | 1,766 |   | (9,420 | ) | (81,678 | ) | 1,399 |   |
| Total other income (deductions)                                       |       | 1,586,378                                            |       | 643,508                                             |       | (472,630 | ) | (543,338 | ) | (5,027,693 | ) | 411,137 |   |
| **NET LOSS**                                                          |       | $                                                    | (447,347   | )                                                   | $          | (1,205,359 | ) | $ | (1,086,104 | ) | $ | (2,302,369 | ) | $ | (7,444,405 | ) | $ | (508,745 | ) |
|                                                                  |       |                                                 |       |                                                |       |   |   |   |   |   |   |   |   |
| **Basic  Loss per Share:**                                            | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                           | * *   | * *                                             | * *   | * *                                            | * *   | * * | * * | * * | * * | * * | * * | * * | * * |
| Net loss                                                              |       | $                                                    | (447,347   | )                                                   | $          | (1,205,359 | ) | $ | (1,086,104 | ) | $ | (2,302,369 | ) | $ | (7,444,405 | ) | $ | (508,745 | ) |
|                                                                  |       |                                                 |       |                                                |       |   |   |   |   |   |   |   |   |
| Convertible preferred stock dividends and accretion                   |       | (72,632                                              | )          | (126,801                                            | )          | — |   | (71,999 | ) | (119,686 | ) | (136,755 | ) |
|                                                                  |       |                                                 |       |                                                |       |   |   |   |   |   |   |   |   |
| Net loss attributable to common shareholders                          |       | $                                                    | (519,979   | )                                                   | $          | (1,332,160 | ) | $ | (1,086,104 | ) | $ | (2,374,368 | ) | $ | (7,564,091 | ) | $ | (645,500 | ) |
|                                                                  |       |                                                 |       |                                                |       |   |   |   |   |   |   |   |   |
| *Denominator*                                                         | * *   | * *                                             | * *   | * *                                            | * *   | * * | * * | * * | * * | * * | * * | * * | * * |
| Weighted average common shares outstanding                            |       | 45,476,802                                           |       | 38,624,196                                          |       | 16,389,475 |   | 46,306,589 |   | 39,270,676 |   | 19,117,761 |   |
|                                                                  |       |                                                 |       |                                                |       |   |   |   |   |   |   |   |   |
| ***Basic  Loss per Share***                                           |       | $                                                    | (0.01      | )                                                   | $          | (0.03 | ) | $ | (0.07 | ) | $ | (0.05 | ) | $ | (0.19 | ) | $ | (0.03 | ) |
|                                                                  |       |                                                 |       |                                                |       |   |   |   |   |   |   |   |   |
| **Diluted  Loss per Share:**                                          | ** ** | ** **                                           | ** ** | ** **                                          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                           | * *   | * *                                             | * *   | * *                                            | * *   | * * | * * | * * | * * | * * | * * | * * | * * |
| Net loss attributable to common shareholders                          |       | $                                                    | (519,979   | )                                                   | $          | (1,332,160 | ) | $ | (1,086,104 | ) | $ | (2,374,368 | ) | $ | (7,564,091 | ) | $ | (645,500 | ) |
|                                                                  |       |                                                 |       |                                                |       |   |   |   |   |   |   |   |   |
| Effect of Dilutive Securities: Convertible Debentures                 |       | (356,879                                             | )          | (458,318                                            | )          | — |   | — |   | — |   | — |   |
|                                                                  |       |                                                 |       |                                                |       |   |   |   |   |   |   |   |   |
| Net loss attributable to common shareholders and  assumed conversions |       | $                                                    | (876,858   | )                                                   | $          | (1,790,478 | ) | $ | (1,086,104 | ) | $ | (2,374,368 | ) | $ | (7,564,091 | ) | $ | (645,500 | ) |
|                                                                  |       |                                                 |       |                                                |       |   |   |   |   |   |   |   |   |
| *Denominator*                                                         | * *   | * *                                             | * *   | * *                                            | * *   | * * | * * | * * | * * | * * | * * | * * | * * |
| Weighted average shares outstanding                                   |       | 45,476,802                                           |       | 38,624,196                                          |       | 16,389,475 |   | 46,306,589 |   | 39,270,676 |   | 19,117,761 |   |
|                                                                  |       |                                                 |       |                                                |       |   |   |   |   |   |   |   |   |
| Effect of Dilutive Securities: Convertible Debentures                 |       | 8,384,793                                            |       | 73,751                                              |       | — |   | — |   | — |   | — |   |
|                                                                  |       |                                                 |       |                                                |       |   |   |   |   |   |   |   |   |
| Diluted weighted average common shares and common  equivalents        |       | 53,861,595                                           |       | 38,697,947                                          |       | 16,389,475 |   | 46,306,589 |   | 39,270,676 |   | 19,117,761 |   |
|                                                                  |       |                                                 |       |                                                |       |   |   |   |   |   |   |   |   |
| ***Diluted  Loss per Share***                                         |       | $                                                    | (0.02      | )                                                   | $          | (0.05 | ) | $ | (0.07 | ) | $ | (0.05 | ) | $ | (0.19 | ) | $ | (0.03 | ) |

 

107

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**Resultsby Quarter (Continued)(Unaudited)**
| ** **                                                                                                                                                                                                | ** ** | **March 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|
| ** **                                                                                                                                                                                                | ** ** | **2005**           | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                                                                                                                                | ** ** | **(Restated)**     | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
| **ASSETS:**                                                                                                                                                                                               | ** ** | ** **         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash and cash  equivalents                                                                                                                                                                                |       | $                  | 1,370,585  |   | $ | 478,419 |   | $ | 339,838 |   |
| Receivables                                                                                                                                                                                               |       |               |       |   |   |   |   |
| Billed, less allowance for doubtful receivables of  $209,102, $4,000 and $0, respectively                                                                                                                 |       | 2,431,498          |       | 461,256 |   | 11,195 |   |
| Unbilled                                                                                                                                                                                                  |       | 605,523            |       | — |   | — |   |
| Escrow                                                                                                                                                                                                    |       | —             |       | 11,248,803 |   | — |   |
| Due from selling  stockholders and other                                                                                                                                                                  |       | 28,793             |       | 153,988 |   | — |   |
| Costs and  earnings in excess of billings on uncompleted contracts                                                                                                                                        |       | 6,040,927          |       | — |   | — |   |
| Inventory                                                                                                                                                                                                 |       | 29,599             |       | 59,624 |   | — |   |
| Prepaid expenses                                                                                                                                                                                          |       | 208,222            |       | 34,404 |   | 52,366 |   |
| Total current assets                                                                                                                                                                                      |       | 10,715,147         |       | 12,436,494 |   | 403,399 |   |
| Equipment and  leasehold improvements, net                                                                                                                                                                |       | 658,859            |       | 75,866 |   | — |   |
| Costs and  earnings in excess of billings on uncompleted contracts                                                                                                                                        |       | 657,000            |       | — |   | — |   |
| Deposits                                                                                                                                                                                                  |       | 2,258,191          |       | — |   | — |   |
| Intangible  assets—less accumulated amortization                                                                                                                                                     |       | 3,883,614          |       | — |   | — |   |
| Deferred  financing costs, net                                                                                                                                                                            |       | 821,036            |       | — |   | — |   |
| Other                                                                                                                                                                                                     |       | —             |       | 4,827,747 |   | 123,962 |   |
| Goodwill                                                                                                                                                                                                  |       | 11,331,311         |       | — |   | — |   |
| Total non-current assets                                                                                                                                                                                  |       | 19,610,011         |       | 4,903,613 |   | 123,962 |   |
| **TOTAL  ASSETS**                                                                                                                                                                                         |       | $                  | 30,325,158 |   | $ | 17,340,107 |   | $ | 527,361 |   |
| **LIABILITIES:**                                                                                                                                                                                          | ** ** | ** **         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Current  maturities of long-term obligations                                                                                                                                                              |       | $                  | 2,391,742  |   | $ | — |   | $ | 6,645,832 |   |
| Note payable                                                                                                                                                                                              |       | —             |       | 400,000 |   | — |   |
| Advances from  stockholders                                                                                                                                                                               |       | —             |       | 60,958 |   | — |   |
| Accounts payable                                                                                                                                                                                          |       | 1,133,684          |       | 540,862 |   | 245,687 |   |
| Billings in  excess of costs and earnings on uncompleted contracts                                                                                                                                        |       | 1,404,165          |       | — |   | — |   |
| Accrued  liabilities                                                                                                                                                                                      |       | 5,404,872          |       | 118,480 |   | 732,175 |   |
| Deferred rent                                                                                                                                                                                             |       | 405,605            |       | — |   | — |   |
| Deferred revenue                                                                                                                                                                                          |       | 3,535,164          |       | 119,657 |   | — |   |
| Total current liabilities                                                                                                                                                                                 |       | 14,275,232         |       | 1,239,957 |   | 7,623,694 |   |
| Long-term  obligations, net of discount and current maturities                                                                                                                                            |       | 6,023,273          |       | 375,000 |   | 1,218,866 |   |
| Deferred rent                                                                                                                                                                                             |       | 1,205,468          |       | — |   | — |   |
| Deferred revenue                                                                                                                                                                                          |       | 53,317             |       | 58,301 |   | — |   |
| Total non-current liabilities                                                                                                                                                                             |       | 7,282,058          |       | 433,301 |   | 1,218,866 |   |
| **TOTAL  LIABILITIES**                                                                                                                                                                                    |       | 21,557,290         |       | 1,673,258 |   | 8,842,560 |   |
| **STOCKHOLDERS’ EQUITY (DEFICIT):**                                                                                                                                                                  | ** ** | ** **         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Preferred stock  — authorized, 5,000,000 shares of $.0001 par value (liquidation preference of  $100 per share)                                                                                      |       |               |       |   |   |   |   |
| Series A 7% Convertible; issued and outstanding  51,182 shares of $.0001 par value                                                                                                                   |       | 5                  |       | — |   | — |   |
| Series B 9% Convertible; issued and  outstanding, 18,430 shares                                                                                                                                      |       | —             |       | — |   | 184 |   |
| Series C 7% Convertible; issued and  outstanding, 88,532 shares                                                                                                                                      |       | —             |       | 885 |   | — |   |
| Common stock -  authorized, 85,000,000 shares; issued and outstanding; 44,344,251 shares of  $.0001 par value in 2005, 35,889,649 and 14,377,406 shares of $.01 par value  in 2004 and 2003, respectively |       | 4,434              |       | 358,897 |   | 143,774 |   |
| Additional  paid-in capital                                                                                                                                                                               |       | 47,189,619         |       | 44,173,027 |   | 16,440,399 |   |
| Accumulated  deficit                                                                                                                                                                                      |       | (38,426,190        | )          | (28,865,960 | ) | (24,899,556 | ) |
| **TOTAL  STOCKHOLDERS’ EQUITY (DEFICIT)**                                                                                                                                                            |       | 8,767,868          |       | 15,666,849 |   | (8,315,199 | ) |
| **TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY (DEFICIT)**                                                                                                                                            |       | $                  | 30,325,158 |   | $ | 17,340,107 |   | $ | 527,361 |   |

 

108

----

**Resultsby Quarter (Continued)(Unaudited)**
| ** **                                                                                                                                                                                                | ** ** | **June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|
| ** **                                                                                                                                                                                                | ** ** | **2005**          | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                                                                                                                                | ** ** | **(Restated)**    | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
| **ASSETS:**                                                                                                                                                                                               | ** ** | ** **        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash and cash  equivalents                                                                                                                                                                                |       | $                 | 1,972,453  |   | $ | 3,837,147 |   | $ | 254,766 |   |
| Receivables                                                                                                                                                                                               |       |              |       |   |   |   |   |
| Billed, less allowance for doubtful receivables of  $166,853 and $6,000 and $0, respectively                                                                                                              |       | 1,812,413         |       | 775,755 |   | 7,428 |   |
| Unbilled                                                                                                                                                                                                  |       | 676,682           |       | — |   | — |   |
| Escrow                                                                                                                                                                                                    |       | —            |       | 50,000 |   |   |   |
| Due from selling  stockholders and other                                                                                                                                                                  |       | 28,342            |       | 154,515 |   | — |   |
| Costs and  earnings in excess of billings on uncompleted contracts                                                                                                                                        |       | 6,724,902         |       | — |   | — |   |
| Inventory                                                                                                                                                                                                 |       | 31,301            |       | 36,910 |   | — |   |
| Prepaid expenses                                                                                                                                                                                          |       | 476,899           |       | 71,697 |   | 93,529 |   |
| Total current assets                                                                                                                                                                                      |       | 11,722,992        |       | 4,926,024 |   | 355,723 |   |
| Equipment and  leasehold improvements, net                                                                                                                                                                |       | 649,468           |       | 127,536 |   | — |   |
| Marketable debt  securities                                                                                                                                                                               |       | —            |       | 5,887,500 |   | — |   |
| Deposits                                                                                                                                                                                                  |       | 2,260,065         |       | — |   | — |   |
| Deferred  offering costs                                                                                                                                                                                  |       | —            |       | — |   | — |   |
| Intangible  assets—less accumulated amortization                                                                                                                                                     |       | 3,689,285         |       | 4,593,692 |   | — |   |
| Deferred  financing costs                                                                                                                                                                                 |       | 1,166,929         |       | — |   | — |   |
| Other                                                                                                                                                                                                     |       | —            |       | 115,377 |   | 130,066 |   |
| Goodwill                                                                                                                                                                                                  |       | 11,139,046        |       | — |   | — |   |
| Total non-current assets                                                                                                                                                                                  |       | 18,904,793        |       | 10,724,105 |   | 130,066 |   |
| **TOTAL  ASSETS**                                                                                                                                                                                         |       | $                 | 30,627,785 |   | $ | 15,650,129 |   | $ | 485,789 |   |
| **LIABILITIES:**                                                                                                                                                                                          | ** ** | ** **        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Current  maturities of long-term obligations                                                                                                                                                              |       | $                 | 2,186,946  |   | $ | — |   | $ | 8,730,708 |   |
| Advances from  stockholders                                                                                                                                                                               |       | —            |       | 22,944 |   | — |   |
| Accounts payable                                                                                                                                                                                          |       | 971,333           |       | 574,783 |   | 332,384 |   |
| Billings in  excess of costs and earnings on uncompleted contracts                                                                                                                                        |       | 1,152,126         |       | — |   | — |   |
| Accrued  liabilities                                                                                                                                                                                      |       | 5,107,407         |       | 266,994 |   | 907,846 |   |
| Deferred rent                                                                                                                                                                                             |       | 417,895           |       | — |   | — |   |
| Deferred revenue                                                                                                                                                                                          |       | 3,050,907         |       | 226,235 |   | — |   |
| Total current liabilities                                                                                                                                                                                 |       | 12,886,614        |       | 1,090,956 |   | 9,970,938 |   |
| Long-term  obligations, net of discount and current maturities                                                                                                                                            |       | 8,595,645         |       | — |   | — |   |
| Deferred rent                                                                                                                                                                                             |       | 1,096,271         |       | — |   | — |   |
| Deferred revenue                                                                                                                                                                                          |       | 53,317            |       | — |   | — |   |
| Total non-current liabilities                                                                                                                                                                             |       | 9,745,233         |       | — |   | — |   |
| **TOTAL  LIABILITIES**                                                                                                                                                                                    |       | 22,631,847        |       | 1,090,956 |   | 9,970,938 |   |
| **STOCKHOLDERS’ EQUITY (DEFICIT):**                                                                                                                                                                  | ** ** | ** **        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Preferred stock  — authorized, 5,000,000 shares of $.0001 par value (liquidation preference of  $100 per share)                                                                                      |       |              |       |   |   |   |   |
| Series A 7% Convertible; issued and outstanding  47,557 shares of $.0001 par value                                                                                                                   |       | 5                 |       | — |   | — |   |
| Series B 9% Convertible; issued and  outstanding, 14,630 shares of $.01 par value                                                                                                                    |       | —            |       | — |   | 146 |   |
| Series C 7% Convertible; issued and  outstanding, 75,682 shares of $.01 par value                                                                                                                    |       | —            |       | 757 |   | — |   |
| Common stock -  authorized, 85,000,000 shares; issued and outstanding; 44,952,217 shares of  $.0001 par value in 2005, 38,430,820 and 15,861,519 shares of $.01 par value  in 2004 and 2003, respectively |       | 4,495             |       | 384,308 |   | 158,615 |   |
| Additional  paid-in capital                                                                                                                                                                               |       | 47,974,795        |       | 44,408,954 |   | 16,480,472 |   |
| Accumulated  deficit                                                                                                                                                                                      |       | (39,983,356       | )          | (30,234,846 | ) | (26,124,382 | ) |
| **TOTAL  STOCKHOLDERS’ EQUITY (DEFICIT)**                                                                                                                                                            |       | 7,995,939         |       | 14,559,173 |   | (9,485,149 | ) |
| **TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY (DEFICIT)**                                                                                                                                            |       | $                 | 30,627,785 |   | $ | 15,650,129 |   | $ | 485,789 |   |

 

109

----

**Resultsby Quarter (Continued)(Unaudited)**
| ** **                                                                                                                                                                                                | ** ** | **September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                                                | ** ** | **2005**               | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                                                                                                                                | ** ** | **(Restated)**         | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
| **ASSETS:**                                                                                                                                                                                               | ** ** | ** **             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash and cash  equivalents                                                                                                                                                                                |       | $                      | 1,497,188  |   | $ | 2,971,569 |   | $ | 58,774 |   |
| Receivables                                                                                                                                                                                               |       |                   |       |   |   |   |   |
| Billed, less allowance for doubtful receivables of  $134,292, $1,014,161 and $0, respectively                                                                                                             |       | 2,980,298              |       | 3,156,808 |   | 147,378 |   |
| Unbilled                                                                                                                                                                                                  |       | 122,662                |       | — |   | — |   |
| Due from selling  stockholders and other                                                                                                                                                                  |       | —                 |       | 164,714 |   | — |   |
| Costs and  earnings in excess of billings on uncompleted contracts                                                                                                                                        |       | 5,243,350              |       | 6,619,726 |   | — |   |
| Inventory                                                                                                                                                                                                 |       | 3,465                  |       | 76,985 |   | — |   |
| Prepaid expenses                                                                                                                                                                                          |       | 207,718                |       | 388,923 |   | 118,183 |   |
| Total current assets                                                                                                                                                                                      |       | 10,054,681             |       | 13,378,725 |   | 324,335 |   |
| Equipment and  leasehold improvements, net                                                                                                                                                                |       | 609,375                |       | 578,225 |   | 38,573 |   |
| Marketable debt  securities                                                                                                                                                                               |       | —                 |       | 1,000,000 |   | — |   |
| Deposits                                                                                                                                                                                                  |       | 1,757,037              |       | 2,769,691 |   | — |   |
| Intangible  assets—less accumulated amortization                                                                                                                                                     |       | 3,508,529              |       | 16,268,614 |   | — |   |
| Deferred  financing costs, net                                                                                                                                                                            |       | 1,813,499              |       | 1,056,201 |   | — |   |
| Other                                                                                                                                                                                                     |       | —                 |       | 194,665 |   | 144,703 |   |
| Goodwill                                                                                                                                                                                                  |       | 11,388,760             |       | — |   | — |   |
| Total non-current assets                                                                                                                                                                                  |       | 19,077,200             |       | 21,867,396 |   | 183,276 |   |
| **TOTAL  ASSETS**                                                                                                                                                                                         |       | $                      | 29,131,881 |   | $ | 35,246,121 |   | $ | 507,611 |   |
| **LIABILITIES:**                                                                                                                                                                                          | ** ** | ** **             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Current  maturities of long-term obligations                                                                                                                                                              |       | $                      | 1,067,966  |   | $ | 1,082,280 |   | $ | 9,625,287 |   |
| Advances from  stockholders                                                                                                                                                                               |       | —                 |       | 17,931 |   | 38,532 |   |
| Accounts payable                                                                                                                                                                                          |       | 964,987                |       | 1,744,600 |   | 219,918 |   |
| Billings in  excess of costs and earnings on uncompleted contracts                                                                                                                                        |       | 61,402                 |       | — |   | — |   |
| Accrued  liabilities                                                                                                                                                                                      |       | 5,175,101              |       | 4,434,162 |   | 1,109,126 |   |
| Deferred rent                                                                                                                                                                                             |       | 430,558                |       | 441,732 |   | — |   |
| Deferred revenue                                                                                                                                                                                          |       | 4,152,152              |       | 4,755,277 |   | 10,000 |   |
| Total current liabilities                                                                                                                                                                                 |       | 11,852,166             |       | 12,475,982 |   | 11,002,863 |   |
| Long-term  obligations, net of discount and current maturities                                                                                                                                            |       | 7,370,462              |       | 7,241,180 |   | — |   |
| Deferred rent                                                                                                                                                                                             |       | 983,765                |       | 1,636,098 |   | — |   |
| Deferred revenue                                                                                                                                                                                          |       | 570,136                |       | 59,707 |   | — |   |
| Total non-current liabilities                                                                                                                                                                             |       | 8,924,363              |       | 8,936,985 |   | — |   |
| **TOTAL  LIABILITIES**                                                                                                                                                                                    |       | 20,776,529             |       | 21,412,967 |   | 11,002,863 |   |
| **STOCKHOLDERS’  EQUITY (DEFICIT):**                                                                                                                                                                 | ** ** | ** **             | ** ** | ** ** | ** ** | ** ** | ** ** |
| Preferred stock —  authorized, 5,000,000 shares of $.0001 par value (liquidation preference of  $100 per share)                                                                                      |       |                   |       |   |   |   |   |
| Series A 7% Convertible; issued and outstanding  44,557 shares of $.0001 par value                                                                                                                   |       | 4                      |       | — |   | — |   |
| Series B 9% Convertible; issued and  outstanding, 11,930                                                                                                                                             |       | —                 |       | — |   | 119 |   |
| Series C 7% Convertible; issued and  outstanding, 73,682 shares of .01 par value                                                                                                                     |       | —                 |       | 737 |   | — |   |
| Common stock -  authorized, 85,000,000 shares; issued and outstanding; 46,306,588 shares of  $.0001 par value in 2005, 38,962,281 and 17,020,776 shares of $.01 par value  in 2004 and 2003, respectively |       | 4,630                  |       | 389,623 |   | 170,208 |   |
| Additional  paid-in capital                                                                                                                                                                               |       | 48,810,298             |       | 44,891,088 |   | 16,590,140 |   |
| Accumulated  deficit                                                                                                                                                                                      |       | (40,459,580            | )          | (31,448,294 | ) | (27,255,719 | ) |
| **TOTAL  STOCKHOLDERS’ EQUITY (DEFICIT)**                                                                                                                                                            |       | 8,355,352              |       | 13,833,154 |   | (10,495,252 | ) |
| **TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY (DEFICIT)**                                                                                                                                            |       | $                      | 29,131,881 |   | $ | 35,246,121 |   | $ | 507,611 |   |

 

110

----

**Resultsby Quarter (Continued)(Unaudited)**
| ** **                                                                            | ** ** | **Three Months Ended March 31,** | ** ** |
|---------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                            | ** ** | **2005**                                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                            | ** ** | **(Restated)**                                       | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
|                                                                                  |       |                                                 |       |   |   |   |   |
| **CASH FLOW FROM OPERATING  ACTIVITIES:**                                             |       |                                                 |       |   |   |   |   |
| Net Income (Loss)                                                                     |       | $                                                    | 602,503    |   | $ | (849,139 | ) | $ | (1,294,152 | ) |
| **Adjustments  to reconcile net loss to cash used in operating activities:**          |       |                                                 |       |   |   |   |   |
| Derivative and warrant fair value adjustments                                         |       | (3,576,881                                           | )          | (323,128 | ) | 119,247 |   |
| Depreciation                                                                          |       | 58,590                                               |       | 6,995 |   | — |   |
| Amortization                                                                          |       |                                                 |       |   |   |   |   |
| Deferred financing costs                                                              |       | 7,311                                                |       | — |   | — |   |
| Intangible assets                                                                     |       | 215,682                                              |       | — |   | — |   |
| Discounts on convertible debt related to warrants  and beneficial conversion features |       | 463,202                                              |       | — |   | 258,165 |   |
| Allowance for doubtful receivables                                                    |       | 19,790                                               |       | 2,000 |   | — |   |
| Gain on sale of marketable debt securities                                            |       | —                                               |       | — |   | — |   |
| Write down of deferred offering costs                                                 |       | —                                               |       | 81,900 |   | — |   |
| Non-cash interest                                                                     |       | —                                               |       | 230,424 |   | — |   |
| Deferred rent                                                                         |       | (94,057                                              | )          | — |   | — |   |
| Options and warrants issued for services and other                                    |       | —                                               |       | — |   | 156,000 |   |
| Loss on sale of investment                                                            |       | 20,000                                               |       | — |   | — |   |
| **Change  in assets and liabilities:**                                                |       |                                                 |       |   |   |   |   |
| Accounts receivable trade                                                             |       | (655,593                                             | )          | (299,077 | ) | 56,803 |   |
| Costs and earnings in excess of billings on  uncompleted contracts                    |       | 92,235                                               |       | — |   | — |   |
| Inventories                                                                           |       | —                                               |       | 6,233 |   | — |   |
| Prepaid expenses and other                                                            |       | (18,195                                              | )          | 131,525 |   | (1,469 | ) |
| Accounts payable                                                                      |       | (238,721                                             | )          | (124,191 | ) | (109,007 | ) |
| Billings in excess of costs and earnings on  uncompleted contracts                    |       | 1,054,043                                            |       | — |   | — |   |
| Accrued liabilities                                                                   |       | 776,864                                              |       | 98,244 |   | 159,474 |   |
| Deferred revenue                                                                      |       | 350,922                                              |       | 83,280 |   | — |   |
| Net cash used in operating activities                                                 |       | (922,305                                             | )          | (954,934 | ) | (654,939 | ) |
| **CASH FLOWS FROM INVESTING  ACTIVITIES:**                                            |       |                                                 |       |   |   |   |   |
| Acquisition of PSG                                                                    |       | —                                               |       | (498,937 | ) | — |   |
| Capital expenditures                                                                  |       | (73,348                                              | )          | (17,399 | ) | — |   |
| Purchases of marketable debt securities                                               |       | —                                               |       | (50,000 | ) | — |   |
| Proceeds from sale of marketable debt securities                                      |       | 980,000                                              |       | — |   | — |   |
| Deposits                                                                              |       | 502,943                                              |       | — |   | — |   |
| Proceeds from sale of trademark                                                       |       | 50,000                                               |       | — |   | — |   |
| Other                                                                                 |       | —                                               |       | (6,869 | ) | (1,971 | ) |
| Net cash provided by (used in) investing activities                                   |       | 1,459,595                                            |       | (573,205 | ) | (1,971 | ) |
| **CASH FLOW FROM FINANCING  ACTIVITIES:**                                             |       |                                                 |       |   |   |   |   |
| Net advance from (to) stockholders                                                    |       | (12,753                                              | )          | (6,232 | ) | — |   |
| Issuance of long-term obligations                                                     |       | —                                               |       | 1,000,000 |   | 980,000 |   |
| Repayment of long term obligations                                                    |       | (738,346                                             | )          | — |   | — |   |
| Exercise of warrants                                                                  |       | 528,164                                              |       | — |   | — |   |
| Net refund of offering costs                                                          |       | 100,000                                              |       | — |   | — |   |
| Net cash provided by (used in) financing activities                                   |       | (122,935                                             | )          | 993,768 |   | 980,000 |   |
| **NET  INCREASE (DECREASE) IN CASH**                                                  |       | 414,355                                              |       | (534,371 | ) | 323,090 |   |
| **CASH  AND CASH EQUIVALENTS, BEGINNING OF PERIOD**                                   |       | 956,230                                              |       | 1,012,790 |   | 16,748 |   |
| **CASH AND CASH EQUIVALENTS, END  OF PERIOD**                                         |       | $                                                    | 1,370,585  |   | $ | 478,419 |   | $ | 339,838 |   |

 

111

----

**Resultsby Quarter (Continued)(Unaudited)**
| ** **                                                                            | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                            | ** ** | **2005**                                          | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                            | ** ** | **(Restated)**                                    | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
|                                                                                  |       |                                              |       |   |   |   |   |
| **CASH FLOW FROM OPERATING  ACTIVITIES:**                                             | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net loss                                                                              |       | $                                                 | (923,669   | ) | $ | (2,200,127 | ) | $ | (2,464,101 | ) |
| **Adjustments  to reconcile net loss to cash used in operating activities:**          | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Derivative and warrant fair value adjustments                                         |       | (4,950,248                                        | )          | (323,128 | ) | 91,888 |   |
| Depreciation                                                                          |       | 115,618                                           |       | 17,015 |   | — |   |
| Amortization                                                                          |       |                                              |       |   |   |   |   |
| Deferred financing costs                                                              |       | 14,622                                            |       | — |   | — |   |
| Intangible assets                                                                     |       | 441,012                                           |       | 108,329 |   | — |   |
| Discounts on convertible debt related to warrants  and beneficial conversion features |       | 617,728                                           |       | 230,424 |   | 578,534 |   |
| Allowance for doubtful receivables                                                    |       | 36,865                                            |       | 4,000 |   | — |   |
| Loss on sale of investment                                                            |       | 20,000                                            |       | — |   | — |   |
| Deferred rent                                                                         |       | (190,964                                          | )          | — |   | — |   |
| Options and warrants issued for services and other                                    |       | 529,968                                           |       | — |   | 156,000 |   |
|                                                                                  |       |                                              |       |   |   |   |   |
| **Change in assets and liabilities:**                                                 | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Accounts receivable trade                                                             |       | (86,981                                           | )          | (560,293 | ) | 60,570 |   |
| Costs and earnings in excess of billings on  uncompleted contracts                    |       | 65,260                                            |       | — |   | — |   |
| Inventories                                                                           |       | (1,702                                            | )          | 28,947 |   | — |   |
| Prepaid expenses and other                                                            |       | (356,571                                          | )          | 155,351 |   | (42,633 | ) |
| Accounts payable                                                                      |       | (411,986                                          | )          | (90,270 | ) | (22,310 | ) |
| Billings in excess of costs and earnings on  uncompleted contracts                    |       | 802,004                                           |       | — |   | — |   |
| Accrued liabilities                                                                   |       | 659,932                                           |       | 246,758 |   | 335,145 |   |
| Deferred revenue                                                                      |       | (133,335                                          | )          | 75,747 |   | — |   |
| Net cash used in operating activities                                                 |       | (3,752,447                                        | )          | (2,307,247 | ) | (1,306,907 | ) |
| **CASH FLOWS FROM INVESTING  ACTIVITIES:**                                            | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Acquisition of PSG                                                                    |       | —                                            |       | (498,937 | ) | — |   |
| Deposits                                                                              |       | 501,069                                           |       | — |   | — |   |
| Capital expenditures                                                                  |       | (120,985                                          | )          | (79,089 | ) | — |   |
| Purchases of marketable debt securities                                               |       | 980,000                                           |       | (5,887,500 | ) | — |   |
| Proceeds from sale of trademark                                                       |       | 50,000                                            |       | — |   | — |   |
| Subscription                                                                          |       | —                                            |       | (50,000 | ) | — |   |
| Other                                                                                 |       | (21,353                                           | )          | (25,739 | ) | (8,075 | ) |
| Net cash provided by (used in) investing activities                                   |       | 1,388,731                                         |       | (6,541,265 | ) | (8,075 | ) |
| **CASH FLOW FROM FINANCING  ACTIVITIES:**                                             | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net advance from (to) stockholders                                                    |       | (12,753                                           | )          | (44,246 | ) | — |   |
| Issuance of convertible bridge notes                                                  |       | 250,000                                           |       | — |   | — |   |
| Repayment of convertible bridge notes                                                 |       | (250,000                                          | )          | — |   | — |   |
| Issuance of long-term obligations                                                     |       | 4,515,249                                         |       | 1,000,000 |   | 1,553,000 |   |
| Repayment of long term obligations                                                    |       | (1,404,568                                        | )          | (400,000 | ) | — |   |
| Financing costs                                                                       |       | (347,315                                          | )          | — |   | — |   |
| Sale of common stock                                                                  |       | —                                            |       | 11,248,803 |   | — |   |
| Exercise of warrants                                                                  |       | 538,788                                           |       | — |   | — |   |
| Repurchase of warrants and other                                                      |       | —                                            |       | (100,000 | ) | — |   |
| Net refund of offering costs                                                          |       | 90,538                                            |       | — |   | — |   |
| Other                                                                                 |       | —                                            |       | (31,688 | ) | — |   |
| Net cash provided by financing activities                                             |       | 3,379,939                                         |       | 11,672,869 |   | 1,553,000 |   |
| **NET  INCREASE IN CASH**                                                             |       | 1,016,223                                         |       | 2,824,357 |   | 238,018 |   |
| **CASH  AND CASH EQUIVALENTS, BEGINNING OF PERIOD**                                   |       | 956,230                                           |       | 1,012,790 |   | 16,748 |   |
| **CASH AND CASH EQUIVALENTS, END  OF PERIOD**                                         |       | $                                                 | 1,972,453  |   | $ | 3,837,147 |   | $ | 254,766 |   |

 

112

----

**Resultsby Quarter (Continued)(Unaudited)**
| ** **                                                                            | ** ** | **Nine Months Ended September 30,** | ** ** |
|---------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                            | ** ** | **2005**                                                | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                            | ** ** | **(Restated)**                                          | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
|                                                                                  |       |                                                    |       |   |   |   |   |
| **CASH FLOW FROM OPERATING  ACTIVITIES:**                                             | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net loss                                                                              |       | $                                                       | (1,371,016 | ) | $ | (3,405,486 | ) | $ | (3,550,205 | ) |
| **Adjustments  to reconcile net income (loss) to cash used in operating activities:** | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Derivative and warrant fair value adjustments                                         |       | (8,160,305                                              | )          | (840,719 | ) | 20,089 |   |
| Depreciation                                                                          |       | 179,642                                                 |       | 31,617 |   | 38,819 |   |
| Amortization                                                                          |       |                                                    |       |   |   |   |   |
| Deferred financing costs                                                              |       | 29,621                                                  |       | — |   | — |   |
| Intangible assets                                                                     |       | 1,474,979                                               |       | 216,658 |   | — |   |
| Discounts on convertible debt related to warrants  and beneficial conversion features |       | 1,067,927                                               |       | 230,424 |   | 945,662 |   |
| Allowance for doubtful receivables                                                    |       | 22,440                                                  |       | 106,000 |   | — |   |
| Gain on sale of marketable debt securities                                            |       | 20,000                                                  |       | (33,125 | ) | — |   |
| Deferred rent                                                                         |       | (290,807                                                | )          | — |   | — |   |
| Options and warrants issued for services and other                                    |       | 542,758                                                 |       | 24,850 |   | 156,000 |   |
| **Change in assets and  liabilities:**                                                | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Accounts receivable trade                                                             |       | (862,889                                                | )          | (113,351 | ) | (79,380 | ) |
| Costs and earnings in excess of billings on  uncompleted contracts                    |       | 1,546,812                                               |       | — |   | — |   |
| Inventories                                                                           |       | 26,134                                                  |       | 35,559 |   | — |   |
| Prepaid expenses and other                                                            |       | (221,842                                                | )          | 125,343 |   | 8,714 |   |
| Accounts payable                                                                      |       | (418,332                                                | )          | 23,091 |   | (134,776 | ) |
| Billings in excess of costs and earnings on  uncompleted contracts                    |       | 24,173                                                  |       | — |   | — |   |
| Accrued liabilities                                                                   |       | 683,989                                                 |       | 137,355 |   | 536,425 |   |
| Deferred revenue                                                                      |       | 1,174,224                                               |       | 70,598 |   | 10,000 |   |
| Net cash used in operating activities                                                 |       | (4,532,492                                              | )          | (3,391,186 | ) | (2,048,652 | ) |
| **CASH FLOWS FROM INVESTING  ACTIVITIES:**                                            | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Acquisition of PSG                                                                    |       | —                                                  |       | (498,937 | ) | — |   |
| Acquisition of AMG                                                                    |       | —                                                  |       | (10,089,560 | ) | — |   |
| Proceeds from sale of trademarks                                                      |       | 50,000                                                  |       | — |   | — |   |
| Capital expenditures                                                                  |       | (144,916                                                | )          | (163,022 | ) | (77,392 | ) |
| Purchases of marketable debt securities                                               |       | —                                                  |       | (5,887,500 | ) | — |   |
| Proceeds from sale of marketable debt securities                                      |       | 980,000                                                 |       | 4,920,625 |   | — |   |
| Deposits                                                                              |       | 1,004,097                                               |       | (2,769,140 | ) | — |   |
| Other                                                                                 |       | (56,610                                                 | )          | (126,358 | ) | (22,712 | ) |
| Net cash provided by (used in) investing activities                                   |       | 1,832,571                                               |       | (14,613,892 | ) | (100,104 | ) |
| **CASH FLOW FROM FINANCING  ACTIVITIES:**                                             | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net advance from (to) stockholders                                                    |       | (12,753                                                 | )          | (49,259 | ) | 38,532 |   |
| Issuance of convertible bridge notes                                                  |       | 250,000                                                 |       | — |   | — |   |
| Repayment of convertible notes                                                        |       | (250,000                                                | )          | — |   | — |   |
| Issuance of long-term obligations                                                     |       | 4,920,251                                               |       | 9,841,051 |   | 2,152,250 |   |
| Repayment of long term obligations                                                    |       | (1,894,148                                              | )          | (400,000 | ) | — |   |
| Financing costs                                                                       |       | (374,614                                                | )          | (522,000 | ) | — |   |
| Net refund of offering costs                                                          |       | 100,000                                                 |       | — |   | — |   |
| Exercise of warrants                                                                  |       | 558,787                                                 |       | 1,950 |   | — |   |
| Sale of common stock                                                                  |       | —                                                  |       | 11,248,803 |   | — |   |
| Repurchase of warrants and other                                                      |       | —                                                  |       | (125,000 | ) | — |   |
| Offering costs                                                                        |       | (56,644                                                 | )          | (31,688 | ) | — |   |
| Net cash provided by financing activities                                             |       | 3,240,879                                               |       | 19,963,857 |   | 2,190,782 |   |
| **NET  INCREASE IN CASH**                                                             |       | 540,958                                                 |       | 1,958,779 |   | 42,026 |   |
| **CASH  AND CASH EQUIVALENTS, BEGINNING OF PERIOD**                                   |       | 956,230                                                 |       | 1,012,790 |   | 16,748 |   |
| **CASH AND CASH EQUIVALENTS, END  OF PERIOD**                                         |       | $                                                       | 1,497,188  |   | $ | 2,971,569 |   | $ | 58,774 |   |

 

113

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The following tables set forth, for each of thequarters and for each of the interim balance sheet dates presented, the amountsof the restatement adjustments and reconciliation from previously reportedamounts to restated amounts.
| ** **                                                                     | ** ** | **Three Months Ended March 31, 2005 (Unaudited)** | ** ** |
|--------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------|------------|
| ** **                                                                     | ** ** | **As Previously**                                                          | ** ** | **Effect of** | ** ** | **As** | ** ** |
| ** **                                                                     | ** ** | **Reported**                                                                    | ** ** | **Restatement** | ** ** | **Restated** | ** ** |
| **Revenues**                                                                   | ** ** | ** **                                                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Services                                                                       |       | $                                                                               | 3,059,854  |   | $ | — |   | $ | 3,059,854 |   |
| License fees and other                                                         |       | 840,537                                                                         |       | 39,200 |   | 879,737 |   |
|                                                                           |       | 3,900,391                                                                       |       | 39,200 |   | 3,939,591 |   |
| **Costs and other expenses**                                                   | ** ** | ** **                                                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cost of services                                                               |       | 835,565                                                                         |       | — |   | 835,565 |   |
| Cost of license fees and other                                                 |       | 327,857                                                                         |       | — |   | 327,857 |   |
| Selling, general and administrative                                            |       | 2,846,623                                                                       |       | — |   | 2,846,623 |   |
| Research, development and engineering                                          |       | 2,075,070                                                                       |       | — |   | 2,075,070 |   |
|                                                                           |       | 6,085,115                                                                       |       | — |   | 6,085,115 |   |
| **Operating  loss**                                                            |       | (2,184,724                                                                      | )          | 39,200 |   | (2,145,524 | ) |
| **Other income (deductions)**                                                  | ** ** | ** **                                                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest income                                                                |       | 26,062                                                                          |       | — |   | 26,062 |   |
| Interest expense                                                               |       | (505,055                                                                        | )          | (329,861 | ) | (834,916 | ) |
| Derivative and warrant fair value adjustments                                  |       | —                                                                          |       | 3,576,881 |   | 3,576,881 |   |
| Gain on sale of marketable securities                                          |       | (20,000                                                                         | )          | — |   | (20,000 | ) |
| Total other income (deductions)                                                |       | (498,993                                                                        | )          | 3,247,020 |   | 2,748,027 |   |
| **NET  INCOME (LOSS)**                                                         |       | $                                                                               | (2,683,717 | ) | $ | 3,286,220 |   | $ | 602,503 |   |
|                                                                           |       |                                                                            |       |   |   |   |   |
| **Basic Earnings (Loss) per  Share:**                                          | ** ** | ** **                                                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                                    | * *   | * *                                                                        | * *   | * * | * * | * * | * * |
| Net income (loss)                                                              |       | $                                                                               | (2,683,717 | ) | $ | 3,286,220 |   | $ | 602,503 |   |
|                                                                           |       |                                                                            |       |   |   |   |   |
| Convertible preferred stock dividends and accretion                            |       | (10,692                                                                         | )          | (78,493 | ) | (89,185 | ) |
|                                                                           |       |                                                                            |       |   |   |   |   |
| Net income (loss) attributable to common  shareholders                         |       | $                                                                               | (2,694,409 | ) | $ | 3,207,727 |   | $ | 513,318 |   |
|                                                                           |       |                                                                            |       |   |   |   |   |
| *Denominator*                                                                  | * *   | * *                                                                        | * *   | * * | * * | * * | * * |
| Weighted average common shares outstanding                                     |       | 42,662,253                                                                      |       | 42,662,253 |   | 42,662,253 |   |
|                                                                           |       |                                                                            |       |   |   |   |   |
| ***Basic  Earnings (Loss) per Share***                                         |       | $                                                                               | (0.06      | ) | $ | (0.07 | ) | $ | 0.01 |   |
|                                                                           |       |                                                                            |       |   |   |   |   |
| **Diluted Earnings (Loss) per  Share:**                                        | ** ** | ** **                                                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                                    | * *   | * *                                                                        | * *   | * * | * * | * * | * * |
| Net income (loss) attributable to common  shareholders                         |       | $                                                                               | (2,694,409 | ) | $ | 3,207,727 |   | $ | 513,318 |   |
|                                                                           |       |                                                                            |       |   |   |   |   |
| Effect of  Dilutive Securities:                                                |       |                                                                            |       |   |   |   |   |
| Convertible Debentures                                                         |       | —                                                                          |       | (2,141,436 | ) | (2,141,436 | ) |
|                                                                           |       |                                                                            |       |   |   |   |   |
| Net income (loss) attributable to common shareholders  and assumed conversions |       | $                                                                               | (2,694,409 | ) | $ | 1,066,291 |   | $ | (1,628118 | ) |
|                                                                           |       |                                                                            |       |   |   |   |   |
| *Denominator*                                                                  | * *   | * *                                                                        | * *   | * * | * * | * * | * * |
| Weighted average shares outstanding                                            |       | 42,662,253                                                                      |       | 42,662,253 |   | 42,662,253 |   |
|                                                                           |       |                                                                            |       |   |   |   |   |
| Effect of  Dilutive Securities:                                                |       |                                                                            |       |   |   |   |   |
| Convertible Debentures                                                         |       | —                                                                          |       | 6,092,739 |   | 6,092,739 |   |
|                                                                           |       |                                                                            |       |   |   |   |   |
| Diluted weighted average common shares and common  equivalents outstanding     |       | 42,662,253                                                                      |       | 48,754,992 |   | 48,754,992 |   |
|                                                                           |       |                                                                            |       |   |   |   |   |
| ***Diluted  Earnings (Loss) per Share***                                       |       | $                                                                               | (0.06      | ) | $ | 0.02 |   | $ | (0.03 | ) |

 

114

----

 
| ** **                                                                     | ** ** | **Three Months Ended June 30, 2005 (Unaudited)** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------|------------|
| ** **                                                                     | ** ** | **As Previously**                                                         | ** ** | **Effect of** | ** ** | **As** | ** ** |
| ** **                                                                     | ** ** | **Reported**                                                                   | ** ** | **Restatement** | ** ** | **Restated** | ** ** |
| **Revenues**                                                                   | ** ** | ** **                                                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Services                                                                       |       | $                                                                              | 2,761,887  |   | $ | — |   | $ | 2,761,887 |   |
| License fees and other                                                         |       | 902,645                                                                        |       | 21,020 |   | 923,665 |   |
|                                                                           |       | 3,664,532                                                                      |       | 21,020 |   | 3,685,552 |   |
| **Costs and other expenses**                                                   | ** ** | ** **                                                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cost of services                                                               |       | 1,034,127                                                                      |       | — |   | 1,034,127 |   |
| Cost of license fees and other                                                 |       | 205,385                                                                        |       | — |   | 205,385 |   |
| Selling, general and administrative                                            |       | 3,125,471                                                                      |       | — |   | 3,125,471 |   |
| Research, development and engineering                                          |       | 1,670,471                                                                      |       | — |   | 1,670,471 |   |
|                                                                           |       | 6,035,454                                                                      |       | — |   | 6,035,454 |   |
| **Operating  loss**                                                            |       | (2,370,922                                                                     | )          | 21,020 |   | (2,349,902 | ) |
| **Other income (deductions)**                                                  | ** ** | ** **                                                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest income                                                                |       | 2,988                                                                          |       | — |   | 2,988 |   |
| Interest expense                                                               |       | (575,760                                                                       | )          | 23,667 |   | (552,093 | ) |
| Derivative and warrant fair value adjustments                                  |       | —                                                                         |       | 1,373,367 |   | 1,373,367 |   |
| Other expense                                                                  |       | (532                                                                           | )          | — |   | (532 | ) |
| Total other income (deductions)                                                |       | (573,304                                                                       | )          | 1,397,034 |   | 823,730 |   |
| **NET  INCOME (LOSS)**                                                         |       | $                                                                              | (2,944,226 | ) | $ | 1,418,054 |   | $ | (1,526,172 | ) |
|                                                                           |       |                                                                           |       |   |   |   |   |
| **Basic Earnings (Loss) per  Share:**                                          | ** ** | ** **                                                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                                    | * *   | * *                                                                       | * *   | * * | * * | * * | * * |
| Net income (loss)                                                              |       | $                                                                              | (2,944,226 | ) | $ | 1,418,054 |   | $ | (1,526,172 | ) |
|                                                                           |       |                                                                           |       |   |   |   |   |
| Convertible preferred stock dividends and accretion                            |       | (176,600                                                                       | )          | 96,899 |   | (79,701 | ) |
|                                                                           |       |                                                                           |       |   |   |   |   |
| Net income (loss) attributable to common  shareholders                         |       | $                                                                              | (3,120,826 | ) | $ | 1,514,953 |   | $ | (1,605,873 | ) |
|                                                                           |       |                                                                           |       |   |   |   |   |
| *Denominator*                                                                  | * *   | * *                                                                       | * *   | * * | * * | * * | * * |
| Weighted average common shares outstanding                                     |       | 44,663,981                                                                     |       | 44,663,981 |   | 44,663,981 |   |
|                                                                           |       |                                                                           |       |   |   |   |   |
| ***Basic  Earnings (Loss) per Share***                                         |       | $                                                                              | (0.07      | ) | $ | 0.03 |   | $ | (0.04 | ) |
|                                                                           |       |                                                                           |       |   |   |   |   |
| **Diluted Earnings (Loss) per  Share:**                                        | ** ** | ** **                                                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                                    | * *   | * *                                                                       | * *   | * * | * * | * * | * * |
| Net income (loss) attributable to common  shareholders                         |       | $                                                                              | (3,120,826 | ) | $ | 1,514,953 |   | $ | (1,605,873 | ) |
|                                                                           |       |                                                                           |       |   |   |   |   |
| Effect of  Dilutive Securities:                                                |       |                                                                           |       |   |   |   |   |
| Convertible Debentures                                                         |       | —                                                                         |       | (467,709 | ) | (467,709 | ) |
|                                                                           |       |                                                                           |       |   |   |   |   |
| Net income (loss) attributable to common  shareholders and assumed conversions |       | $                                                                              | (3,120,826 | ) | $ | 1,047,244 |   | $ | (2,073,582 | ) |
|                                                                           |       |                                                                           |       |   |   |   |   |
| *Denominator*                                                                  | * *   | * *                                                                       | * *   | * * | * * | * * | * * |
| Weighted average shares outstanding                                            |       | 44,663,981                                                                     |       | 44,663,981 |   | 44,663,981 |   |
|                                                                           |       |                                                                           |       |   |   |   |   |
| Effect of  Dilutive Securities:                                                |       |                                                                           |       |   |   |   |   |
| Convertible Debentures                                                         |       | —                                                                         |       | 6,094,636 |   | 6,094,636 |   |
|                                                                           |       |                                                                           |       |   |   |   |   |
| Diluted weighted average common shares and common  equivalents outstanding     |       | 44,683,981                                                                     |       | 50,758,617 |   | 50,758,617 |   |
|                                                                           |       |                                                                           |       |   |   |   |   |
| ***Diluted  Earnings (Loss) per Share***                                       |       | $                                                                              | (0.07      | ) | $ | 0.02 |   | $ | (0.04 | ) |

 

115

----

 
| ** **                                                                     | ** ** | **Three Months Ended September 30, 2005 (Unaudited)** | ** ** |
|--------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------|------------|
| ** **                                                                     | ** ** | **As Previously**                                                              | ** ** | **Effect of** | ** ** | **As** | ** ** |
| ** **                                                                     | ** ** | **Reported**                                                                        | ** ** | **Restatement** | ** ** | **Restated** | ** ** |
| **Revenues**                                                                   | ** ** | ** **                                                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Services                                                                       |       | $                                                                                   | 2,496,883  |   | $ | — |   | $ | 2,496,883 |   |
| License fees and other                                                         |       | 705,718                                                                             |       | 29,870 |   | 735,588 |   |
|                                                                           |       | 3,202,601                                                                           |       | 29,870 |   | 3,232,471 |   |
| **Costs and other expenses**                                                   | ** ** | ** **                                                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cost of services                                                               |       | 503,843                                                                             |       | — |   | 503,843 |   |
| Cost of license fees and other                                                 |       | 125,633                                                                             |       | — |   | 125,633 |   |
| Selling, general and administrative                                            |       | 2,868,875                                                                           |       | (32,000 | ) | 2,836,875 |   |
| Research, development and engineering                                          |       | 1,799,845                                                                           |       | — |   | 1,799,845 |   |
|                                                                           |       | 5,298,196                                                                           |       | (32,000 | ) | 5,266,196 |   |
| **Operating  loss**                                                            |       | (2,095,595                                                                          | )          | 61,870 |   | (2,033,725 | ) |
| **Other income (deductions)**                                                  | ** ** | ** **                                                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest income                                                                |       | 6,908                                                                               |       | — |   | 6,908 |   |
| Interest expense                                                               |       | (844,038                                                                            | )          | (761,733 | ) | (1,605,771 | ) |
| Derivative and warrant fair value adjustments                                  |       | —                                                                              |       | 3,210,057 |   | 3,210,057 |   |
| Other expense                                                                  |       | (24,816                                                                             | )          | — |   | (24,816 | ) |
| Total other income (deductions)                                                |       | (861,946                                                                            | )          | 2,448,324 |   | 1,586,378 |   |
| **NET  INCOME (LOSS)**                                                         |       | $                                                                                   | (2,957,541 | ) | $ | 2,510,194 |   | $ | (447,347 | ) |
|                                                                           |       |                                                                                |       |   |   |   |   |
| **Basic Earnings (Loss) per  Share:**                                          | ** ** | ** **                                                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                                    | * *   | * *                                                                            | * *   | * * | * * | * * | * * |
| Net income (loss)                                                              |       | $                                                                                   | (2,957,541 | ) | $ | 2,510,194 |   | $ | (447,347 | ) |
|                                                                           |       |                                                                                |       |   |   |   |   |
| Convertible preferred stock dividends and accretion                            |       | (1,500                                                                              | )          | (71,132 | ) | (72,632 | ) |
|                                                                           |       |                                                                                |       |   |   |   |   |
| Net income (loss) attributable to common  shareholders                         |       | $                                                                                   | (2,959,041 | ) | $ | 2,439,062 |   | $ | (519,979 | ) |
|                                                                           |       |                                                                                |       |   |   |   |   |
| *Denominator*                                                                  | * *   | * *                                                                            | * *   | * * | * * | * * | * * |
| Weighted average common shares outstanding                                     |       | 45,476,802                                                                          |       | 45,476,802 |   | 45,476,802 |   |
|                                                                           |       |                                                                                |       |   |   |   |   |
| ***Basic  Earnings (Loss) per Share***                                         |       | $                                                                                   | (0.07      | ) | $ | 0.05 |   | $ | (0.01 | ) |
|                                                                           |       |                                                                                |       |   |   |   |   |
| **Diluted Earnings (Loss) per  Share:**                                        | ** ** | ** **                                                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                                    | * *   | * *                                                                            | * *   | * * | * * | * * | * * |
| Net income (loss) attributable to common  shareholders                         |       | $                                                                                   | (2,959,041 | ) | $ | 2,439,062 |   | $ | (519,979 | ) |
|                                                                           |       |                                                                                |       |   |   |   |   |
| Effect of  Dilutive Securities:                                                |       |                                                                                |       |   |   |   |   |
| Convertible Debentures                                                         |       | —                                                                              |       | (356,879 | ) | (356,879 | ) |
|                                                                           |       |                                                                                |       |   |   |   |   |
| Net income (loss) attributable to common  shareholders and assumed conversions |       | $                                                                                   | (2,959,041 | ) | $ | 2,082,183 |   | $ | (876,858 | ) |
|                                                                           |       |                                                                                |       |   |   |   |   |
| *Denominator*                                                                  | * *   | * *                                                                            | * *   | * * | * * | * * | * * |
| Weighted average shares outstanding                                            |       | 45,476,802                                                                          |       | 45,476,802 |   | 45,476,802 |   |
|                                                                           |       |                                                                                |       |   |   |   |   |
| Effect of  Dilutive Securities:                                                |       |                                                                                |       |   |   |   |   |
| Convertible Debentures                                                         |       | —                                                                              |       | 8,384,793 |   | 8,384,793 |   |
|                                                                           |       |                                                                                |       |   |   |   |   |
| Diluted weighted average common shares and common  equivalents outstanding     |       | 45,476,802                                                                          |       | 53,861,595 |   | 53,861,595 |   |
|                                                                           |       |                                                                                |       |   |   |   |   |
| ***Diluted  Earnings (Loss) per Share***                                       |       | $                                                                                   | (0.07      | ) | $ | 0.04 |   | $ | (0.02 | ) |

 

116

----

 
| ** **                                                                     | ** ** | **Three Months Ended December 31, 2005 (Unaudited)** | ** ** |
|--------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------|------------|
| ** **                                                                     | ** ** | **As Previously**                                                             | ** ** | **Effect of** | ** ** | **As** | ** ** |
| ** **                                                                     | ** ** | **Reported**                                                                       | ** ** | **Restatement** | ** ** | **Restated** | ** ** |
| **Revenues**                                                                   | ** ** | ** **                                                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Services                                                                       |       | $                                                                                  | 2,543,025  |   | $ | — |   | $ | 2,543,025 |   |
| License fees and other                                                         |       | 825,456                                                                            |       | — |   | 825,456 |   |
|                                                                           |       | 3,368,481                                                                          |       | — |   | 3,368,481 |   |
| **Costs and other expenses**                                                   | ** ** | ** **                                                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cost of services                                                               |       | 532,607                                                                            |       | — |   | 532,607 |   |
| Cost of license fees and other                                                 |       | 278,616                                                                            |       | — |   | 278,616 |   |
| Selling, general and administrative                                            |       | 3,015,640                                                                          |       | — |   | 3,015,640 |   |
| Research, development and engineering                                          |       | 1,300,649                                                                          |       | — |   | 1,300,649 |   |
|                                                                           |       | 5,127,512                                                                          |       | — |   | 5,127,512 |   |
| **Operating  loss**                                                            |       | (1,759,031                                                                         | )          | — |   | (1,759,031 | ) |
| **Other income (deductions)**                                                  | ** ** | ** **                                                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest expense                                                               |       | (2,161,639                                                                         | )          | 633,075 |   | (1,528,564 | ) |
| Derivative and warrant fair value adjustments                                  |       | 1,457,294                                                                          |       | (462,648 | ) | 994,646 |   |
| Other expense                                                                  |       | (9,420                                                                             | )          | — |   | (9,420 | ) |
| Total other income (deductions)                                                |       | (713,765                                                                           | )          | 170,427 |   | (543,338 | ) |
| **NET  INCOME (LOSS)**                                                         |       | $                                                                                  | (2,472,796 | ) | $ | 170,427 |   | $ | (2,302,369 | ) |
|                                                                           |       |                                                                               |       |   |   |   |   |
| **Basic Earnings (Loss) per  Share:**                                          | ** ** | ** **                                                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                                    | * *   | * *                                                                           | * *   | * * | * * | * * | * * |
| Net income (loss)                                                              |       | $                                                                                  | (2,472,796 | ) | $ | 170,427 |   | $ | (2,302,369 | ) |
|                                                                           |       |                                                                               |       |   |   |   |   |
| Convertible preferred stock dividends and accretion                            |       | (71,999                                                                            | )          |   |   | (71,999 | ) |
|                                                                           |       |                                                                               |       |   |   |   |   |
| Net income (loss) attributable to common  shareholders                         |       | $                                                                                  | (2,544,795 | ) | $ | 170,427 |   | $ | (2,374,368 | ) |
|                                                                           |       |                                                                               |       |   |   |   |   |
| *Denominator*                                                                  | * *   | * *                                                                           | * *   | * * | * * | * * | * * |
| Weighted average common shares outstanding                                     |       | 46,306,589                                                                         |       | 46,306,589 |   | 46,306,589 |   |
|                                                                           |       |                                                                               |       |   |   |   |   |
| ***Basic  Earnings (Loss) per Share***                                         |       | $                                                                                  | (0.05      | ) | $ | 0.01 |   | $ | (0.05 | ) |
|                                                                           |       |                                                                               |       |   |   |   |   |
| **Diluted Earnings (Loss) per  Share:**                                        | ** ** | ** **                                                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                                    | * *   | * *                                                                           | * *   | * * | * * | * * | * * |
| Net income (loss) attributable to common  shareholders                         |       | $                                                                                  | (2,544,795 | ) | $ | 170,427 |   | $ | (2,374,368 | ) |
|                                                                           |       |                                                                               |       |   |   |   |   |
| Effect of  Dilutive Securities:                                                |       |                                                                               |       |   |   |   |   |
| Convertible Debentures                                                         |       | —                                                                             |       | — |   | — |   |
|                                                                           |       |                                                                               |       |   |   |   |   |
| Net income (loss) attributable to common  shareholders and assumed conversions |       | $                                                                                  | (2,544,795 | ) | $ | 170,427 |   | $ | (2,374,368 | )) |
|                                                                           |       |                                                                               |       |   |   |   |   |
| *Denominator*                                                                  | * *   | * *                                                                           | * *   | * * | * * | * * | * * |
| Weighted average shares outstanding                                            |       | 46,306,589                                                                         |       | — |   | 46,306,589 |   |
|                                                                           |       |                                                                               |       |   |   |   |   |
| Effect of  Dilutive Securities:                                                |       |                                                                               |       |   |   |   |   |
| Convertible Debentures                                                         |       | —                                                                             |       | — |   | — |   |
|                                                                           |       |                                                                               |       |   |   |   |   |
| Diluted weighted average common shares and common  equivalents outstanding     |       | 46,306,589                                                                         |       | 46,306,589 |   | 46,306,589 |   |
|                                                                           |       |                                                                               |       |   |   |   |   |
| ***Diluted  Earnings (Loss) per Share***                                       |       | $                                                                                  | (0.05      | ) | $ | 0.01 |   | $ | (0.05 | ) |

 

117

----

 
| ** **                                                                     | ** ** | **Three Months Ended March 31, 2004 (Unaudited)** | ** ** |
|--------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------|------------|
| ** **                                                                     | ** ** | **As Previously  Reported**                                                | ** ** | **Effect of  Restatement** | ** ** | **As  Restated** | ** ** |
| **Revenues**                                                                   | ** ** | ** **                                                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Services                                                                       |       | $                                                                               | 27,800     |   | $ | — |   | $ | 27,800 |   |
| License fees and other                                                         |       | 284,086                                                                         |       | (35,215 | ) | 248,871 |   |
|                                                                           |       | 311,886                                                                         |       | (35,215 | ) | 276,671 |   |
| **Costs and other expenses**                                                   | ** ** | ** **                                                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cost of services                                                               |       | —                                                                          |       | — |   | — |   |
| Cost of license fees and other                                                 |       | 5,778                                                                           |       | — |   | 5,778 |   |
| Selling, general and administrative                                            |       | 820,953                                                                         |       | (5,250 | ) | 815,703 |   |
| Research, development and engineering                                          |       | 262,761                                                                         |       | — |   | 262,761 |   |
|                                                                           |       | 1,089,492                                                                       |       | (5,250 | ) | 1,084,242 |   |
| **Operating  loss**                                                            |       | (777,606                                                                        | )          | (29,965 | ) | (807,571 | ) |
| **Other income (deductions)**                                                  | ** ** | ** **                                                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest expense                                                               |       | (136,620                                                                        | )          | (230,424 | ) | (367,044 | ) |
| Derivative and warrant fair value adjustments                                  |       |                                                                            |       | 323,128 |   | 323,128 |   |
| Other income                                                                   |       | 2,348                                                                           |       | — |   | 2,348 |   |
| Total other income (deductions)                                                |       | (134,272                                                                        | )          | 92,704 |   | (41,568 | ) |
| **NET  INCOME (LOSS)**                                                         |       | $                                                                               | (911,878   | ) | $ | 62,739 |   | $ | (849,139 | ) |
|                                                                           |       |                                                                            |       |   |   |   |   |
| **Basic Earnings per Share:**                                                  | ** ** | ** **                                                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                                    | * *   | * *                                                                        | * *   | * * | * * | * * | * * |
| Net income (loss)                                                              |       | $                                                                               | (911,878   | ) | $ | 62,739 |   | $ | (849,139 | ) |
|                                                                           |       |                                                                            |       |   |   |   |   |
| Convertible preferred stock dividends and accretion                            |       | (13,348                                                                         | )          | 2,245 |   | (11,103 | ) |
|                                                                           |       |                                                                            |       |   |   |   |   |
| Net income (loss) attributable to common  shareholders                         |       | $                                                                               | (925,226   | ) | $ | 64,984 |   | $ | (860,242 | ) |
|                                                                           |       |                                                                            |       |   |   |   |   |
| *Denominator*                                                                  | * *   | * *                                                                        | * *   | * * | * * | * * | * * |
| Weighted average common shares outstanding                                     |       | 23,845,247                                                                      |       | 23,845,247 |   | 23,845,247 |   |
|                                                                           |       |                                                                            |       |   |   |   |   |
| ***Basic  Earnings (Loss) per Share***                                         |       | $                                                                               | (0.04      | ) | $ | 0.00 |   | $ | (0.04 | ) |
|                                                                           |       |                                                                            |       |   |   |   |   |
| **Diluted Earnings per Share:**                                                | ** ** | ** **                                                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                                    | * *   | * *                                                                        | * *   | * * | * * | * * | * * |
| Net income (loss) attributable to common  shareholders                         |       | $                                                                               | (925,226   | ) | $ | 64,984 |   | $ | (860,242 | ) |
|                                                                           |       |                                                                            |       |   |   |   |   |
| Effect of  Dilutive Securities:                                                |       |                                                                            |       |   |   |   |   |
| Convertible Debentures                                                         |       | —                                                                          |       | — |   | — |   |
|                                                                           |       |                                                                            |       |   |   |   |   |
| Net income (loss) attributable to common  shareholders and assumed conversions |       | $                                                                               | (925,226   | ) | $ | 64,984 |   | $ | (860,242 | ) |
|                                                                           |       |                                                                            |       |   |   |   |   |
| *Denominator*                                                                  | * *   | * *                                                                        | * *   | * * | * * | * * | * * |
| Weighted average shares outstanding                                            |       | 23,845,247                                                                      |       | 23,845,247 |   | 23,845,247 |   |
|                                                                           |       |                                                                            |       |   |   |   |   |
| Effect of  Dilutive Securities:                                                |       |                                                                            |       |   |   |   |   |
| Convertible Debentures                                                         |       | —                                                                          |       | — |   | — |   |
|                                                                           |       |                                                                            |       |   |   |   |   |
| Diluted weighted average common shares and common  equivalents outstanding     |       | 23,845,247                                                                      |       | 23,845,247 |   | 23,845,247 |   |
|                                                                           |       |                                                                            |       |   |   |   |   |
| ***Diluted  Earnings (Loss) per Share***                                       |       | $                                                                               | (0.04      | ) | $ | 0.00 |   | $ | (0.04 | ) |

 

118

----

 
| ** **                                                                  | ** ** | **Three Months Ended June 30, 2004 (Unaudited)** | ** ** |
|-----------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------|------------|
| ** **                                                                  | ** ** | **As Previously  Reported**                                               | ** ** | **Effect of  Restatement** | ** ** | **As  Restated** | ** ** |
| **Revenues**                                                                | ** ** | ** **                                                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Services                                                                    |       | $                                                                              | 103,439    |   | $ | — |   | $ | 103,439 |   |
| License fees and other                                                      |       | 415,675                                                                        |       | (92,780 | ) | 322,895 |   |
|                                                                        |       | 519,114                                                                        |       | (92,780 | ) | 426,334 |   |
| **Costs  and other expenses**                                               | ** ** | ** **                                                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cost of services                                                            |       | —                                                                         |       | — |   | — |   |
| Cost of license fees and other                                              |       | 94,889                                                                         |       | — |   | 94,889 |   |
| Selling, general and administrative                                         |       | 1,346,442                                                                      |       | (2,500 | ) | 1,343,942 |   |
| Research, development and engineering                                       |       | 351,814                                                                        |       | — |   | 351,814 |   |
|                                                                        |       | 1,793,145                                                                      |       | (2,500 | ) | 1,790,645 |   |
| **Operating  loss**                                                         |       | (1,274,031                                                                     | )          | (90,280 | ) | (1,364,311 | ) |
| **Other  income (deductions)**                                              | ** ** | ** **                                                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest expense                                                            |       | (852                                                                           | )          | — |   | (852 | ) |
| Other income                                                                |       | 14,175                                                                         |       | — |   | 14,175 |   |
| Total other income (deductions)                                             |       | 13,323                                                                         |       | — |   | 13,323 |   |
| **NET  LOSS**                                                               |       | $                                                                              | (1,260,708 | ) | $ | (90,280 | ) | $ | (1,350,988 | ) |
|                                                                        |       |                                                                           |       |   |   |   |   |
| **Basic  Loss per Share:**                                                  | ** ** | ** **                                                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                                 | * *   | * *                                                                       | * *   | * * | * * | * * | * * |
| Net loss                                                                    |       | $                                                                              | (1,260,708 | ) | $ | (90,280 | ) | $ | (1,350,988 | ) |
|                                                                        |       |                                                                           |       |   |   |   |   |
| Convertible preferred stock dividends and accretion                         |       | (153,150                                                                       | )          | 25,385 |   | (127,765 | ) |
|                                                                        |       |                                                                           |       |   |   |   |   |
| Net loss attributable to common shareholders                                |       | $                                                                              | (1,413,858 | ) | $ | (64,895 | ) | $ | (1,478,753 | ) |
|                                                                        |       |                                                                           |       |   |   |   |   |
| *Denominator*                                                               | * *   | * *                                                                       | * *   | * * | * * | * * | * * |
| Weighted average common shares outstanding                                  |       | 37,693,849                                                                     |       | 37,693,849 |   | 37,693,849 |   |
|                                                                        |       |                                                                           |       |   |   |   |   |
| ***Basic  Loss per Share***                                                 |       | $                                                                              | (0.04      | ) | $ | (0.00 | ) | $ | (0.04 | ) |
|                                                                        |       |                                                                           |       |   |   |   |   |
| **Diluted  Loss per Share:**                                                | ** ** | ** **                                                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                                 | * *   | * *                                                                       | * *   | * * | * * | * * | * * |
| Net loss attributable to common shareholders                                |       | $                                                                              | (1,413,858 | ) | $ | (64,895 | ) | $ | (1,478,753 | ) |
|                                                                        |       |                                                                           |       |   |   |   |   |
| Effect of Dilutive Securities:                                              |       |                                                                           |       |   |   |   |   |
| Convertible Debentures                                                      |       | —                                                                         |       | — |   | — |   |
|                                                                        |       |                                                                           |       |   |   |   |   |
| Net loss attributable to common shareholders and  assumed conversions  |       | $                                                                              | (1,413,858 | ) | $ | (64,895 | ) | $ | (1,478,753 | ) |
|                                                                        |       |                                                                           |       |   |   |   |   |
| *Denominator*                                                               | * *   | * *                                                                       | * *   | * * | * * | * * | * * |
| Weighted average shares outstanding                                         |       | 37,693,849                                                                     |       | 37,693,849 |   | 37,693,849 |   |
|                                                                        |       |                                                                           |       |   |   |   |   |
| Effect of Dilutive Securities:                                              |       |                                                                           |       |   |   |   |   |
| Convertible Debentures                                                      |       | —                                                                         |       | — |   | — |   |
|                                                                        |       |                                                                           |       |   |   |   |   |
| Diluted weighted average common shares and common  equivalents outstanding  |       | 37,693,849                                                                     |       | 37,693,849 |   | 37,693,849 |   |
|                                                                        |       |                                                                           |       |   |   |   |   |
| ***Diluted  Loss per Share***                                               |       | $                                                                              | (0.04      | ) | $ | (0.00 | ) | $ | (0.04 | ) |

 

119

----

 
| ** **                                                                     | ** ** | **Three Months Ended September 30, 2004 (Unaudited)** | ** ** |
|--------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------|------------|
| ** **                                                                     | ** ** | **As Previously  Reported**                                                    | ** ** | **Effect of  Restatement** | ** ** | **As  Restated** | ** ** |
| **Revenues**                                                                   | ** ** | ** **                                                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Services                                                                       |       | $                                                                                   | 10,640     |   | $ | — |   | $ | 10,640 |   |
| License fees and other                                                         |       | 298,178                                                                             |       | (43,415 | ) | 254,763 |   |
|                                                                           |       | 308,818                                                                             |       | (43,415 | ) | 265,403 |   |
| **Costs and other expenses**                                                   | ** ** | ** **                                                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cost of services                                                               |       | —                                                                              |       | — |   | — |   |
| Cost of license fees and other                                                 |       | 25,465                                                                              |       | — |   | 25,465 |   |
| Selling, general and administrative                                            |       | 1,733,260                                                                           |       | (97,000 | ) | 1,636,260 |   |
| Research, development and engineering                                          |       | 452,545                                                                             |       | — |   | 452,545 |   |
|                                                                           |       | 2,211,270                                                                           |       | (97,000 | ) | 2,114,270 |   |
| **Operating  loss**                                                            |       | (1,902,452                                                                          | )          | 53,585 |   | (1,848,867 | ) |
| **Other income (deductions)**                                                  | ** ** | ** **                                                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest income (expense)                                                      |       | (692                                                                                | )          | 83,629 |   | 82,937 |   |
| Derivative and warrant fair value adjustments                                  |       | —                                                                              |       | 517,591 |   | 517,591 |   |
| Gain on sale of marketable securities                                          |       | 33,125                                                                              |       | — |   | 33,125 |   |
| Other income                                                                   |       | 9,855                                                                               |       | — |   | 9,855 |   |
| Total other income (deductions)                                                |       | 42,288                                                                              |       | 601,220 |   | 643,508 |   |
| **NET  INCOME (LOSS)**                                                         |       | $                                                                                   | (1,860,164 | ) | $ | 654,805 |   | $ | (1,205,359 | ) |
|                                                                           |       |                                                                                |       |   |   |   |   |
| **Basic Earnings (Loss) per  Share:**                                          | ** ** | ** **                                                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                                    | * *   | * *                                                                            | * *   | * * | * * | * * | * * |
| Net income (loss)                                                              |       | $                                                                                   | (1,860,164 | ) | $ | 654,805 |   | $ | (1,205,359 | ) |
|                                                                           |       |                                                                                |       |   |   |   |   |
| Convertible preferred stock dividends and accretion                            |       | (4,044                                                                              | )          | (122,757 | ) | (126,801 | ) |
|                                                                           |       |                                                                                |       |   |   |   |   |
| Net income (loss) attributable to common  shareholders                         |       | $                                                                                   | (1,864,208 | ) | $ | 532,048 |   | $ | (1,332,160 | ) |
|                                                                           |       |                                                                                |       |   |   |   |   |
| *Denominator*                                                                  | * *   | * *                                                                            | * *   | * * | * * | * * | * * |
| Weighted average common shares outstanding                                     |       | 38,624,196                                                                          |       | 38,624,196 |   | 38,624,196 |   |
|                                                                           |       |                                                                                |       |   |   |   |   |
| ***Basic  Earnings (Loss) per Share***                                         |       | $                                                                                   | (0.05      | ) | $ | 0.01 |   | $ | (0.03 | ) |
|                                                                           |       |                                                                                |       |   |   |   |   |
| **Diluted Earnings (Loss) per  Share:**                                        | ** ** | ** **                                                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                                    | * *   | * *                                                                            | * *   | * * | * * | * * | * * |
| Net income (loss) attributable to common  shareholders                         |       | $                                                                                   | (1,864,208 | ) | $ | 532,048 |   | $ | (1,332,160 | ) |
|                                                                           |       |                                                                                |       |   |   |   |   |
| Effect of  Dilutive Securities:                                                |       |                                                                                |       |   |   |   |   |
| Convertible Debentures                                                         |       | —                                                                              |       | (458,318 | ) | (458,318 | ) |
|                                                                           |       |                                                                                |       |   |   |   |   |
| Net income (loss) attributable to common  shareholders and assumed conversions |       | $                                                                                   | (1,864,208 | ) | $ | 73,730 |   | $ | (1,790,478 | ) |
|                                                                           |       |                                                                                |       |   |   |   |   |
| *Denominator*                                                                  | * *   | * *                                                                            | * *   | * * | * * | * * | * * |
| Weighted average shares outstanding                                            |       | 38,624,196                                                                          |       | 38,624,196 |   | 38,624,196 |   |
|                                                                           |       |                                                                                |       |   |   |   |   |
| Effect of Dilutive  Securities:                                                |       |                                                                                |       |   |   |   |   |
| Convertible Debentures                                                         |       | —                                                                              |       | 73,751 |   | 73,751 |   |
|                                                                           |       |                                                                                |       |   |   |   |   |
| Diluted weighted average common shares and common  equivalents outstanding     |       | 38,624,196                                                                          |       | 38,697,947 |   | 38,697,947 |   |
|                                                                           |       |                                                                                |       |   |   |   |   |
| ***Diluted  Earnings (Loss) per Share***                                       |       | $                                                                                   | (0.05      | ) | $ | 0.00 |   | $ | (0.05 | ) |

 

120

----

 
| ** **                                                                 | ** ** | **Three Months Ended December 30, 2004 (Unaudited)** | ** ** |
|----------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------|------------|
| ** **                                                                 | ** ** | **As Previously  Reported**                                                   | ** ** | **Effect of  Restatement** | ** ** | **As  Restated** | ** ** |
| **Revenues**                                                               | ** ** | ** **                                                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Services                                                                   |       | $                                                                                  | 3,209,527  |   | $ | — |   | $ | 3,209,527 |   |
| License fees and other                                                     |       | 1,208,886                                                                          |       | 334,130 |   | 1,543,016 |   |
|                                                                       |       | 4,418,413                                                                          |       | 334,130 |   | 4,752,543 |   |
| **Costs  and other expenses**                                              | ** ** | ** **                                                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cost of services                                                           |       | 1,174,324                                                                          |       | — |   | 1,174,324 |   |
| Cost of license fees and other                                             |       | 763,764                                                                            |       | — |   | 763,764 |   |
| Selling, general and administrative                                        |       | 3,195,433                                                                          |       | 122,950 |   | 3,318,383 |   |
| Research, development and engineering                                      |       | 1,912,784                                                                          |       | — |   | 1,912,784 |   |
|                                                                       |       | 7,046,305                                                                          |       | 122,950 |   | 7,169,255 |   |
| **Operating  loss**                                                        |       | (2,627,892                                                                         | )          | 211,180 |   | (2,416,712 | ) |
| **Other  income (deductions)**                                             | ** ** | ** **                                                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest income                                                            |       | 66,824                                                                             |       | — |   | 66,824 |   |
| Interest expense                                                           |       | (528,844                                                                           | )          | (601,732 | ) | (1,130,576 | ) |
| Derivative and warrant fair value adjustments                              |       | —                                                                             |       | (3,849,138 | ) | (3,849,138 | ) |
| Loss on sale of marketable securities                                      |       | (33,125                                                                            | )          | — |   | (33,125 | ) |
| Other expense                                                              |       | (81,678                                                                            | )          | — |   | (81,678 | ) |
| Total other income (deductions)                                            |       | (576,823                                                                           | )          | (4,450,870 | ) | (5,027,693 | ) |
| **NET LOSS**                                                               |       | $                                                                                  | (3,204,715 | ) | $ | (4,239,690 | ) | $ | (7,444,405 | ) |
|                                                                       |       |                                                                               |       |   |   |   |   |
| **Basic  Loss per Share:**                                                 | ** ** | ** **                                                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                                | * *   | * *                                                                           | * *   | * * | * * | * * | * * |
| Net loss                                                                   |       | $                                                                                  | (3,204,715 | ) | $ | (4,239,690 | ) | $ | (7,444,405 | ) |
|                                                                       |       |                                                                               |       |   |   |   |   |
| Convertible preferred stock dividends and accretion                        |       | (243,698                                                                           | )          | 124,012 |   | (119,686 | ) |
|                                                                       |       |                                                                               |       |   |   |   |   |
| Net loss attributable to common shareholders                               |       | $                                                                                  | (3,448,413 | ) | $ | (4,115,678 | ) | $ | (7,324,719 | ) |
|                                                                       |       |                                                                               |       |   |   |   |   |
| *Denominator*                                                              | * *   | * *                                                                           | * *   | * * | * * | * * | * * |
| Weighted average common shares outstanding                                 |       | 39,270,676                                                                         |       | 39,270,676 |   | 39,270,676 |   |
|                                                                       |       |                                                                               |       |   |   |   |   |
| ***Basic  Loss Per Share***                                                |       | $                                                                                  | (0.09      | ) | $ | (0.10 | ) | $ | (0.19 | ) |
|                                                                       |       |                                                                               |       |   |   |   |   |
| **Diluted  Loss per Share:**                                               | ** ** | ** **                                                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                                | * *   | * *                                                                           | * *   | * * | * * | * * | * * |
| Net loss attributable to common shareholders                               |       | $                                                                                  | (3,448,413 | ) | $ | (4,115,678 | ) | $ | (7,324,719 | ) |
|                                                                       |       |                                                                               |       |   |   |   |   |
| Effect of Dilutive Securities:                                             |       |                                                                               |       |   |   |   |   |
| Convertible Debentures                                                     |       | —                                                                             |       | — |   | — |   |
|                                                                       |       |                                                                               |       |   |   |   |   |
| Net loss attributable to common shareholders and  assumed conversions      |       | $                                                                                  | (3,448,413 | ) | $ | (4,115,678 | ) | $ | (7,324,719 | ) |
|                                                                       |       |                                                                               |       |   |   |   |   |
| *Denominator*                                                              | * *   | * *                                                                           | * *   | * * | * * | * * | * * |
| Weighted average shares outstanding                                        |       | 39,270,676                                                                         |       | 39,270,676 |   | 39,270,676 |   |
|                                                                       |       |                                                                               |       |   |   |   |   |
| Effect of Dilutive Securities:                                             |       |                                                                               |       |   |   |   |   |
| Convertible Debentures                                                     |       | —                                                                             |       | — |   | — |   |
|                                                                       |       |                                                                               |       |   |   |   |   |
| Diluted weighted average common shares and common  equivalents outstanding |       | 39,270,676                                                                         |       | 39,270,676 |   | 39,270,676 |   |
|                                                                       |       |                                                                               |       |   |   |   |   |
| ***Diluted  Loss per Share***                                              |       | $                                                                                  | (0.09      | ) | $ | (0.10 | ) | $ | (0.19 | ) |

 

121

----

 
| ** **                                                                  | ** ** | **Three Months Ended March 31, 2003 (Unaudited)** | ** ** |
|-----------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------|------------|
| ** **                                                                  | ** ** | **As Previously  Reported**                                                | ** ** | **Effect of  Restatement** | ** ** | **As  Restated** | ** ** |
| **Revenues**                                                                | ** ** | ** **                                                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| License fees and other                                                      |       | $                                                                               | 27,504     |   | $ | — |   | $ | 27,504 |   |
|                                                                        |       | 27,504                                                                          |       | — |   | 27,504 |   |
| **Costs and other expenses**                                                | ** ** | ** **                                                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cost of license fees and other                                              |       | 2,393                                                                           |       | — |   | 2,393 |   |
| Selling, general and administrative                                         |       | 568,499                                                                         |       | — |   | 568,499 |   |
| Research, development and engineering                                       |       | 221,107                                                                         |       | — |   | 221,107 |   |
|                                                                        |       | 791,999                                                                         |       | — |   | 791,999 |   |
| **Operating  loss**                                                         |       | (764,495                                                                        | )          | — |   | (764,495 | ) |
| **Other income (deductions)**                                               | ** ** | ** **                                                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest expense                                                            |       | (291,345                                                                        | )          | (119,619 | ) | (410,964 | ) |
| Derivative and warrant fair value adjustments                               |       |                                                                            |       | (119,247 | ) | (119,247 | ) |
| Other expense                                                               |       | 554                                                                             |       | — |   | 554 |   |
| Total other income (deductions)                                             |       | (290,791                                                                        | )          | (238,866 | ) | (529,657 | ) |
| **NET  LOSS**                                                               |       | $                                                                               | (1,055,286 | ) | $ | (238,866 | ) | $ | (1,294,152 | ) |
|                                                                        |       |                                                                            |       |   |   |   |   |
| **Basic Loss per Share:**                                                   | ** ** | ** **                                                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                                 | * *   | * *                                                                        | * *   | * * | * * | * * | * * |
| Net loss                                                                    |       | $                                                                               | (1,055,286 | ) | $ | (238,866 | ) | $ | (1,294,152 | ) |
|                                                                        |       |                                                                            |       |   |   |   |   |
| Convertible preferred stock dividends and accretion                         |       | —                                                                          |       | — |   | — |   |
|                                                                        |       |                                                                            |       |   |   |   |   |
| Net loss attributable to common shareholders                                |       | $                                                                               | (1,055,286 | ) | $ | (238,866 | ) | $ | (1,294,152 | ) |
|                                                                        |       |                                                                            |       |   |   |   |   |
| *Denominator*                                                               | * *   | * *                                                                        | * *   | * * | * * | * * | * * |
| Weighted average common shares outstanding                                  |       | 14,377,406                                                                      |       | 14,377,406 |   | 14,377,406 |   |
|                                                                        |       |                                                                            |       |   |   |   |   |
| ***Basic  Loss per Share***                                                 |       | $                                                                               | (0.07      | ) | $ | (0.02 | ) | $ | (0.09 | ) |
|                                                                        |       |                                                                            |       |   |   |   |   |
| **Diluted Loss per Share:**                                                 | ** ** | ** **                                                                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                                 | * *   | * *                                                                        | * *   | * * | * * | * * | * * |
| Net loss attributable to common shareholders                                |       | $                                                                               | (1,055,286 | ) | $ | (238,866 | ) | $ | (1,294,152 | ) |
|                                                                        |       |                                                                            |       |   |   |   |   |
| Effect of  Dilutive Securities:                                             |       |                                                                            |       |   |   |   |   |
| Convertible Debentures                                                      |       | —                                                                          |       | — |   | — |   |
|                                                                        |       |                                                                            |       |   |   |   |   |
| Net loss attributable to common shareholders and assumed  conversions  |       | $                                                                               | (1,055,286 | ) | $ | (238,866 | ) | $ | (1,294,152 | ) |
|                                                                        |       |                                                                            |       |   |   |   |   |
| *Denominator*                                                               | * *   | * *                                                                        | * *   | * * | * * | * * | * * |
| Weighted average shares outstanding                                         |       | 14,377,406                                                                      |       | 14,377,406 |   | 14,377,406 |   |
|                                                                        |       |                                                                            |       |   |   |   |   |
| Effect of  Dilutive Securities:                                             |       |                                                                            |       |   |   |   |   |
| Convertible Debentures                                                      |       | —                                                                          |       | — |   | — |   |
|                                                                        |       |                                                                            |       |   |   |   |   |
| Diluted weighted average common shares and common  equivalents outstanding  |       | 14,377,406                                                                      |       | 14,377,406 |   | 14,377,406 |   |
|                                                                        |       |                                                                            |       |   |   |   |   |
| ***Diluted  Loss per Share***                                               |       | $                                                                               | (0.07      | ) | $ | (0.02 | ) | $ | (0.09 | ) |

 

122

----

 
| ** **                                                                  | ** ** | **Three Months Ended June 30, 2003 (Unaudited)** | ** ** |
|-----------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------|------------|
| ** **                                                                  | ** ** | **As Previously  Reported**                                               | ** ** | **Effect of  Restatement** | ** ** | **As  Restated** | ** ** |
| **Revenues**                                                                | ** ** | ** **                                                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Services                                                                    |       | $                                                                              | 2,715      |   | $ | — |   | $ | 2,715 |   |
| License fees and other                                                      |       | 10,305                                                                         |       | — |   | 10,305 |   |
|                                                                        |       | 13,020                                                                         |       | — |   | 13,020 |   |
| **Costs and other expenses**                                                | ** ** | ** **                                                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cost of services                                                            |       | 715                                                                            |       | — |   | 715 |   |
| Cost of license fees and other                                              |       | 2,589                                                                          |       | — |   | 2,589 |   |
| Selling, general and administrative                                         |       | 468,947                                                                        |       | — |   | 468,947 |   |
| Research, development and engineering                                       |       | 253,770                                                                        |       | — |   | 253,770 |   |
|                                                                        |       | 726,021                                                                        |       | — |   | 726,021 |   |
| **Operating  loss**                                                         |       | (713,001                                                                       | )          | — |   | (713,001 | ) |
| **Other income (deductions)**                                               | ** ** | ** **                                                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest income                                                             |       | —                                                                         |       | — |   | — |   |
| Interest expense                                                            |       | (302,910                                                                       | )          | (181,823 | ) | (484,733 | ) |
| Derivative and warrant fair value adjustments                               |       | —                                                                         |       | 27,359 |   | 27,359 |   |
| Gain on sale of marketable securities                                       |       | —                                                                         |       | — |   | — |   |
| Other income                                                                |       | 426                                                                            |       | — |   | 426 |   |
| Total other income (deductions)                                             |       | (302,484                                                                       | )          | (154,464 | ) | (456,948 | ) |
| **NET  LOSS**                                                               |       | $                                                                              | (1,015,485 | ) | $ | (154,464 | ) | $ | (1,169,949 | ) |
|                                                                        |       |                                                                           |       |   |   |   |   |
| **Basic Loss per Share:**                                                   | ** ** | ** **                                                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                                 | * *   | * *                                                                       | * *   | * * | * * | * * | * * |
| Net loss                                                                    |       | $                                                                              | (1,015,485 | ) | $ | (154,464 | ) | $ | (1,169,949 | ) |
|                                                                        |       |                                                                           |       |   |   |   |   |
| Convertible preferred stock dividends and accretion                         |       | —                                                                         |       | — |   | — |   |
|                                                                        |       |                                                                           |       |   |   |   |   |
| Net loss attributable to common shareholders                                |       | $                                                                              | (1,015,485 | ) | $ | (154,464 | ) | $ | (1,169,949 | ) |
|                                                                        |       |                                                                           |       |   |   |   |   |
| *Denominator*                                                               | * *   | * *                                                                       | * *   | * * | * * | * * | * * |
| Weighted average common shares outstanding                                  |       | 14,886,809                                                                     |       | 14,886,809 |   | 14,886,809 |   |
|                                                                        |       |                                                                           |       |   |   |   |   |
| ***Basic  Loss per Share***                                                 |       | $                                                                              | (0.07      | ) | $ | (0.01 | ) | $ | (0.08 | ) |
|                                                                        |       |                                                                           |       |   |   |   |   |
| **Diluted Loss per Share:**                                                 | ** ** | ** **                                                                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                                 | * *   | * *                                                                       | * *   | * * | * * | * * | * * |
| Net loss attributable to common shareholders                                |       | $                                                                              | (1,015,485 | ) | $ | (154,464 | ) | $ | (1,169,949 | ) |
|                                                                        |       |                                                                           |       |   |   |   |   |
| Effect of  Dilutive Securities:                                             |       |                                                                           |       |   |   |   |   |
| Convertible Debentures                                                      |       | —                                                                         |       | — |   | — |   |
|                                                                        |       |                                                                           |       |   |   |   |   |
| Net loss attributable to common shareholders and  assumed conversions  |       | $                                                                              | (1,015,485 | ) | $ | (154,464 | ) | $ | (1,169,949 | ) |
|                                                                        |       |                                                                           |       |   |   |   |   |
| *Denominator*                                                               | * *   | * *                                                                       | * *   | * * | * * | * * | * * |
| Weighted average shares outstanding                                         |       | 14,886,809                                                                     |       | 14,886,809 |   | 14,886,809 |   |
|                                                                        |       |                                                                           |       |   |   |   |   |
| Effect of Dilutive  Securities:                                             |       |                                                                           |       |   |   |   |   |
| Convertible Debentures                                                      |       | —                                                                         |       | — |   | — |   |
|                                                                        |       |                                                                           |       |   |   |   |   |
| Diluted weighted average common shares and common  equivalents outstanding  |       | 14,886,809                                                                     |       | 14,886,809 |   | 14,886,809 |   |
|                                                                        |       |                                                                           |       |   |   |   |   |
| ***Diluted  Loss per Share***                                               |       | $                                                                              | (0.07      | ) | $ | (0.01 | ) | $ | (0.08 | ) |

 

123

----

 
| ** **                                                                 | ** ** | **Three Months Ended September 30, 2003 (Unaudited)** | ** ** |
|----------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------|------------|
| ** **                                                                 | ** ** | **As PreviouslyReported**                                                      | ** ** | **Effect ofRestatement** | ** ** | **As  Restated** | ** ** |
| ** **                                                                 | ** ** | ** **                                                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Revenues**                                                               | ** ** | ** **                                                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Services                                                                   |       | $                                                                                   | 5,000      |   | $ | — |   | $ | 5,000 |   |
| License fees and other                                                     |       | 141,987                                                                             |       | — |   | 141,987 |   |
|                                                                       |       | 146,987                                                                             |       | — |   | 146,987 |   |
| **Costs  and other expenses**                                              | ** ** | ** **                                                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cost of license fees and other                                             |       | 2,641                                                                               |       | — |   | 2,641 |   |
| Selling, general and administrative                                        |       | 511,297                                                                             |       | — |   | 511,297 |   |
| Research, development and engineering                                      |       | 246,523                                                                             |       | — |   | 246,523 |   |
|                                                                       |       | 760,461                                                                             |       | — |   | 760,461 |   |
| **Operating  loss**                                                        |       | (613,474                                                                            | )          | — |   | (613,474 | ) |
| **Other  income (deductions)**                                             | ** ** | ** **                                                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest expense                                                           |       | (317,609                                                                            | )          | (228,586 | ) | (546,195 | ) |
| Derivative and warrant fair value adjustment                               |       | —                                                                              |       | 71,799 |   | 71,799 |   |
| Other income                                                               |       | 1,766                                                                               |       | — |   | 1,766 |   |
| Total other income (deductions)                                            |       | (315,843                                                                            | )          | (156,787 | ) | (472,630 | ) |
| **NET LOSS**                                                               |       | $                                                                                   | (929,317   | ) | $ | (156,787 | ) | $ | (1,086,104 | ) |
|                                                                       |       |                                                                                |       |   |   |   |   |
| **Basic  Loss per Share:**                                                 | ** ** | ** **                                                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                                | * *   | * *                                                                            | * *   | * * | * * | * * | * * |
| Net loss                                                                   |       | $                                                                                   | (929,317   | ) | $ | (156,787 | ) | $ | (1,086,104 | ) |
|                                                                       |       |                                                                                |       |   |   |   |   |
| Convertible preferred stock dividends and accretion                        |       | —                                                                              |       | — |   | — |   |
|                                                                       |       |                                                                                |       |   |   |   |   |
| Net loss attributable to common shareholders                               |       | $                                                                                   | (929,317   | ) | $ | (156,787 | ) | $ | (1,086,104 | ) |
|                                                                       |       |                                                                                |       |   |   |   |   |
| *Denominator*                                                              | * *   | * *                                                                            | * *   | * * | * * | * * | * * |
| Weighted average common shares outstanding                                 |       | 16,389,475                                                                          |       | 16,389,475 |   | 16,389,475 |   |
|                                                                       |       |                                                                                |       |   |   |   |   |
| ***Basic  Loss per Share***                                                |       | $                                                                                   | (0.06      | ) | $ | (0.01 | ) | $ | (0.07 | ) |
|                                                                       |       |                                                                                |       |   |   |   |   |
| **Diluted  Loss per Share:**                                               | ** ** | ** **                                                                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                                | * *   | * *                                                                            | * *   | * * | * * | * * | * * |
| Net loss attributable to common shareholders                               |       | $                                                                                   | (929,317   | ) | $ | (156,787 | ) | $ | (1,086,104 | ) |
|                                                                       |       |                                                                                |       |   |   |   |   |
| Effect of Dilutive Securities:                                             |       |                                                                                |       |   |   |   |   |
| Convertible Debentures                                                     |       | —                                                                              |       | — |   | — |   |
|                                                                       |       |                                                                                |       |   |   |   |   |
| Net loss attributable to common shareholders and  assumed conversions      |       | $                                                                                   | (929,317   | ) | $ | (156,787 | ) | $ | (1,086,104 | ) |
|                                                                       |       |                                                                                |       |   |   |   |   |
| *Denominator*                                                              | * *   | * *                                                                            | * *   | * * | * * | * * | * * |
| Weighted average shares outstanding                                        |       | 16,389,475                                                                          |       | 16,389,475 |   | 16,389,475 |   |
|                                                                       |       |                                                                                |       |   |   |   |   |
| Effect of Dilutive Securities:                                             |       |                                                                                |       |   |   |   |   |
| Convertible Debentures                                                     |       | —                                                                              |       | — |   | — |   |
|                                                                       |       |                                                                                |       |   |   |   |   |
| Diluted weighted average common shares and common  equivalents outstanding |       | 16,389,475                                                                          |       | 16,389,475 |   | 16,389,475 |   |
|                                                                       |       |                                                                                |       |   |   |   |   |
| ***Diluted  Loss per Share***                                              |       | $                                                                                   | (0.06      | ) | $ | (0.01 | ) | $ | (0.07 | ) |

 

124

----

 
| ** **                                                                     | ** ** | **Three Months Ended December 31, 2003 (Unaudited)** | ** ** |
|--------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------|------------|
| ** **                                                                     | ** ** | **As Previously  Reported**                                                   | ** ** | **Effect of  Restatement** | ** ** | **As  Restated** | ** ** |
| **Revenues**                                                                   | ** ** | ** **                                                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Services                                                                       |       | $                                                                                  | 2,979      |   | $ | — |   | $ | 2,979 |   |
| License fees and other                                                         |       | 333,611                                                                            |       | (308,620 | ) | 24,991 |   |
|                                                                           |       | 336,590                                                                            |       | (308,620 | ) | 27,970 |   |
| **Costs and other expenses**                                                   | ** ** | ** **                                                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cost of services                                                               |       | 979                                                                                |       | — |   | 979 |   |
| Cost of license fees and other                                                 |       | 79,764                                                                             |       | — |   | 79,764 |   |
| Selling, general and administrative                                            |       | 569,379                                                                            |       | (18,200 | ) | 551,179 |   |
| Research, development and engineering                                          |       | 315,930                                                                            |       | — |   | 315,930 |   |
|                                                                           |       | 966,052                                                                            |       | (18,200 | ) | 947,852 |   |
| **Operating  loss**                                                            |       | (629,462                                                                           | )          | (290,420 | ) | (919,882 | ) |
| **Other income (deductions)**                                                  | ** ** | ** **                                                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| Interest expense                                                               |       | (197,922                                                                           | )          | (269,974 | ) | (467,896 | ) |
| Derivative and warrant fair value adjustments                                  |       | —                                                                             |       | 877,634 |   | 877,634 |   |
| Other income                                                                   |       | 1,399                                                                              |       | — |   | 1,399 |   |
| Total other income (deductions)                                                |       | (196,523                                                                           | )          | 607,660 |   | 411,137 |   |
| **NET  INCOME (LOSS)**                                                         |       | $                                                                                  | (825,985   | ) | $ | 317,240 |   | $ | (508,745 | ) |
|                                                                           |       |                                                                               |       |   |   |   |   |
| **Basic Earnings (Loss) per  Share:**                                          | ** ** | ** **                                                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                                    | * *   | * *                                                                           | * *   | * * | * * | * * | * * |
| Net income (loss)                                                              |       | $                                                                                  | (825,985   | ) | $ | 317,240 |   | $ | (508,745 | ) |
|                                                                           |       |                                                                               |       |   |   |   |   |
| Convertible preferred stock dividends and accretion                            |       | (136,755                                                                           | )          | — |   | (136,755 | ) |
|                                                                           |       |                                                                               |       |   |   |   |   |
| Net income (loss) attributable to common  shareholders                         |       | $                                                                                  | (962,740   | ) | $ | 317,240 |   | $ | (645,500 | ) |
|                                                                           |       |                                                                               |       |   |   |   |   |
| *Denominator*                                                                  | * *   | * *                                                                           | * *   | * * | * * | * * | * * |
| Weighted average common shares outstanding                                     |       | 19,117,761                                                                         |       | 19,117,761 |   | 19,117,761 |   |
|                                                                           |       |                                                                               |       |   |   |   |   |
| ***Basic  Earnings (Loss) per Share***                                         |       | $                                                                                  | (0.05      | ) | $ | 0.02 |   | $ | (0.03 | ) |
|                                                                           |       |                                                                               |       |   |   |   |   |
| **Diluted Earnings (Loss) per  Share:**                                        | ** ** | ** **                                                                         | ** ** | ** ** | ** ** | ** ** | ** ** |
| *Numerator*                                                                    | * *   | * *                                                                           | * *   | * * | * * | * * | * * |
| Net income (loss) attributable to common  shareholders                         |       | $                                                                                  | (962,740   | ) | $ | 317,240 |   | $ | (645,500 | ) |
|                                                                           |       |                                                                               |       |   |   |   |   |
| Effect of  Dilutive Securities:                                                |       |                                                                               |       |   |   |   |   |
| Convertible Debentures                                                         |       | —                                                                             |       | — |   | — |   |
|                                                                           |       |                                                                               |       |   |   |   |   |
| Net income (loss) attributable to common  shareholders and assumed conversions |       | $                                                                                  | (962,740   | ) | $ | 317,240 |   | $ | (645,500 | ) |
|                                                                           |       |                                                                               |       |   |   |   |   |
| *Denominator*                                                                  | * *   | * *                                                                           | * *   | * * | * * | * * | * * |
| Weighted average shares outstanding                                            |       | 19,117,761                                                                         |       | 19,117,761 |   | 19,117,761 |   |
|                                                                           |       |                                                                               |       |   |   |   |   |
| Effect of  Dilutive Securities:                                                |       |                                                                               |       |   |   |   |   |
| Convertible Debentures                                                         |       | —                                                                             |       | — |   | — |   |
|                                                                           |       |                                                                               |       |   |   |   |   |
| Diluted weighted average common shares and common  equivalents outstanding     |       | 19,117,761                                                                         |       | 19,117,761 |   | 19,117,761 |   |
|                                                                           |       |                                                                               |       |   |   |   |   |
| ***Diluted  Earnings (Loss) per Share***                                       |       | $                                                                                  | (0.05      | ) | $ | 0.02 |   | $ | (0.03 | ) |

 

125

----

 
| ** **                                                                                                  | ** ** | **As of March 31, 2005 (Unaudited)** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                                                  | ** ** | **As Previously  Reported**                              | ** ** | **Effect of  Restatement** | ** ** | **As  Restated** | ** ** |
| **ASSETS:**                                                                                                 | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash and cash  equivalents                                                                                  |       | $                                                             | 1,370,585  |   | $ | — |   | $ | 1,370,585 |   |
| Receivables                                                                                                 |       |                                                          |       |   |   |   |   |
| Billed, less allowance for doubtful receivables of  $209,102                                                |       | 2,482,388                                                     |       | (50,890 | ) | 2,431,498 |   |
| Unbilled                                                                                                    |       | 605,523                                                       |       | — |   | 605,523 |   |
| Due from selling  stockholders and other                                                                    |       | 60,793                                                        |       | (32,000 | ) | 28,793 |   |
| Costs and  earnings in excess of billings on uncompleted contracts                                          |       | 6,040,927                                                     |       | — |   | 6,040,927 |   |
| Inventory                                                                                                   |       | 29,599                                                        |       | — |   | 29,599 |   |
| Prepaid expenses                                                                                            |       | 208,222                                                       |       | — |   | 208,222 |   |
| Total current assets                                                                                        |       | 10,798,037                                                    |       | (82,890 | ) | 10,715,147 |   |
| Equipment and  leasehold improvements, net                                                                  |       | 658,859                                                       |       | — |   | 658,859 |   |
| Costs and  earnings in excess of billings on uncompleted contracts                                          |       | 657,000                                                       |       | — |   | 657,000 |   |
| Deposits                                                                                                    |       | 2,258,191                                                     |       | — |   | 2,258,191 |   |
| Intangible  assets—less accumulated amortization                                                       |       | 3,954,286                                                     |       | (70,672 | ) | 3,883,614 |   |
| Deferred  financing costs, net                                                                              |       | —                                                        |       | 821,036 |   | 821,036 |   |
| Goodwill                                                                                                    |       | 11,374,946                                                    |       | (43,635 | ) | 11,331,311 |   |
| Total non-current assets                                                                                    |       | 18,903,282                                                    |       | 706,729 |   | 19,610,011 |   |
| **TOTAL  ASSETS**                                                                                           |       | $                                                             | 29,701,319 |   | $ | 623,839 |   | $ | 30,325,158 |   |
| **LIABILITIES:**                                                                                            | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Current  maturities of long-term obligations                                                                |       | $                                                             | 3,254,511  |   | $ | (862,769 | ) | $ | 2,391,742 |   |
| Accounts payable                                                                                            |       | 1,109,874                                                     |       | 23,810 |   | 1,133,684 |   |
| Billings in  excess of costs and earnings on uncompleted contracts                                          |       | 1,404,165                                                     |       | — |   | 1,404,165 |   |
| Accrued  liabilities                                                                                        |       | 5,448,507                                                     |       | (43,635 | ) | 5,404,872 |   |
| Deferred rent                                                                                               |       | 405,605                                                       |       | — |   | 405,605 |   |
| Deferred revenue                                                                                            |       | 3,535,164                                                     |       | — |   | 3,535,164 |   |
| Total current  liabilities                                                                                  |       | 15,157,826                                                    |       | (882,594 | ) | 14,275,232 |   |
| Long-term  obligations, net of discount and current maturities                                              |       | 2,696,322                                                     |       | 3,326,951 |   | 6,023,273 |   |
| Deferred rent                                                                                               |       | 1,205,468                                                     |       | — |   | 1,205,468 |   |
| Deferred revenue                                                                                            |       | 53,317                                                        |       | — |   | 53,317 |   |
| Total non-current liabilities                                                                               |       | 3,955,107                                                     |       | 3,326,951 |   | 7,282,058 |   |
| **TOTAL  LIABILITIES**                                                                                      |       | 19,112,933                                                    |       | 2,444,357 |   | 21,557,290 |   |
| **STOCKHOLDERS’ EQUITY (DEFICIT):**                                                                    | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Preferred  stock-authorized, 5,000,000 shares of $.0001 (liquidation preference of $100  per share)         |       |                                                          |       |   |   |   |   |
| Series A7%  Convertible; issued and outstanding, 51,182 shares                                         |       | 5                                                             |       | — |   | 5 |   |
| Common stock -  authorized, 85,000,000 shares issued and outstanding 44,344,251 shares of  $.0001 par value |       | 4,434                                                         |       | — |   | 4,434 |   |
| Additional  paid-in capital                                                                                 |       | 48,451,055                                                    |       | (1,261,436 | ) | 47,189,619 |   |
| Accumulated  deficit                                                                                        |       | (37,867,108                                                   | )          | (559,082 | ) | (38,426,190 | ) |
| **TOTAL  STOCKHOLDERS’ EQUITY (DEFICIT)**                                                              |       | 10,588,386                                                    |       | (1,820,518 | ) | 8,767,868 |   |
| **TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY (DEFICIT)**                                              |       | $                                                             | 29,701,319 |   | $ | 623,839 |   | $ | 30,325,158 |   |

 

126

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| ** **                                                                                                  | ** ** | **As of June 30, 2005 (Unaudited)** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                                                                  | ** ** | **As Previously  Reported**                             | ** ** | **Effect of  Restatement** | ** ** | **As  Restated** | ** ** |
| **ASSETS:**                                                                                                 | ** ** | ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash and cash  equivalents                                                                                  |       | $                                                            | 1,972,453  |   | $ | — |   | $ | 1,972,453 |   |
| Receivables                                                                                                 |       |                                                         |       |   |   |   |   |
| Billed, less allowance for doubtful receivables of  $166,853                                                |       | 1,842,283                                                    |       | (29,870 | ) | 1,812,413 |   |
| Unbilled                                                                                                    |       | 676,682                                                      |       | — |   | 676,682 |   |
| Due from selling  stockholders and other                                                                    |       | 60,342                                                       |       | (32,000 | ) | 28,342 |   |
| Costs and  earnings in excess of billings on uncompleted contracts                                          |       | 6,724,902                                                    |       | — |   | 6,724,902 |   |
| Inventory                                                                                                   |       | 31,301                                                       |       | — |   | 31,301 |   |
| Prepaid expenses                                                                                            |       | 476,899                                                      |       | — |   | 476,899 |   |
| Total current assets                                                                                        |       | 11,784,862                                                   |       | (61,870 | ) | 11,722,992 |   |
| Equipment and  leasehold improvements, net                                                                  |       | 649,468                                                      |       | — |   | 649,468 |   |
| Deposits                                                                                                    |       | 2,260,065                                                    |       | — |   | 2,260,065 |   |
| Intangible  assets—less accumulated amortization                                                       |       | 4,090,313                                                    |       | (401,028 | ) | 3,689,285 |   |
| Deferred  financing costs, net                                                                              |       | —                                                       |       | 1,166,929 |   | 1,166,929 |   |
| Goodwill                                                                                                    |       | 11,182,681                                                   |       | (43,635 | ) | 11,139,046 |   |
| Total non-current assets                                                                                    |       | 18,182,527                                                   |       | 722,266 |   | 18,904,793 |   |
| **TOTAL  ASSETS**                                                                                           |       | $                                                            | 29,967,389 |   | $ | 660,396 |   | $ | 30,627,785 |   |
| **LIABILITIES:**                                                                                            | ** ** | ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Current  maturities of long-term obligations                                                                |       | $                                                            | 3,327,417  |   | $ | (1,140,471 | ) | $ | 2,186,946 |   |
| Accounts payable                                                                                            |       | 947,523                                                      |       | 23,810 |   | 971,333 |   |
| Billings in  excess of costs and earnings on uncompleted contracts                                          |       | 1,152,126                                                    |       | — |   | 1,152,126 |   |
| Accrued  liabilities                                                                                        |       | 5,151,042                                                    |       | (43,635 | ) | 5,107,407 |   |
| Deferred rent                                                                                               |       | 417,895                                                      |       | — |   | 417,895 |   |
| Deferred revenue                                                                                            |       | 3,050,907                                                    |       | — |   | 3,050,907 |   |
| Total current liabilities                                                                                   |       | 14,046,910                                                   |       | (1,160,296 | ) | 12,886,614 |   |
| Long-term  obligations, net of discount and current maturities                                              |       | 5,347,335                                                    |       | 3,248,310 |   | 8,595,645 |   |
| Deferred rent                                                                                               |       | 1,096,271                                                    |       | — |   | 1,096,271 |   |
| Deferred revenue                                                                                            |       | 53,317                                                       |       | — |   | 53,317 |   |
| Total non-current liabilities                                                                               |       | 6,496,923                                                    |       | 3,248,310 |   | 9,745,233 |   |
| **TOTAL  LIABILITIES**                                                                                      |       | 20,543,833                                                   |       | 2,088,014 |   | 22,631,847 |   |
| **STOCKHOLDERS’ EQUITY (DEFICIT):**                                                                    | ** ** | ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Preferred  stock-authorized, 5,000,000 shares of $.0001 (liquidation preference of $100  per share)         |       |                                                         |       |   |   |   |   |
| Series A 7%  Convertible; issued and outstanding, 47,557 shares                                        |       | 5                                                            |       | — |   | 5 |   |
| Common stock -  authorized, 85,000,000 shares, issued and outstanding 44,952,217 shares of  .0001 par value |       | 4,495                                                        |       | — |   | 4,495 |   |
| Additional  paid-in capital                                                                                 |       | 50,261,385                                                   |       | (2,286,590 | ) | 47,974,795 |   |
| Accumulated  deficit                                                                                        |       | (40,842,329                                                  | )          | 858,973 |   | (39,983,356 | ) |
| **TOTAL  STOCKHOLDERS’ EQUITY (DEFICIT)**                                                              |       | 9,423,556                                                    |       | (1,427,617 | ) | 7,995,939 |   |
| **TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY (DEFICIT)**                                              |       | $                                                            | 29,967,389 |   | $ | 660,396 |   | $ | 30,627,785 |   |

 

127

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| ** **                                                                                                     | ** ** | **As of September 30, 2005 (Unaudited)** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                                                                                     | ** ** | **As Previously**                                            | ** ** | **Effect of** | ** ** | **As** | ** ** |
| ** **                                                                                                     | ** ** | **Reported**                                                      | ** ** | **Restatement** | ** ** | **Restated** | ** ** |
| **ASSETS:**                                                                                                    |       |                                                              |       |   |   |   |   |
| Cash and cash  equivalents                                                                                     |       | $                                                                 | 1,497,188  |   | $ | — |   | $ | 1,497,188 |   |
| Receivables                                                                                                    |       |                                                              |       |   |   |   |   |
| Billed, less allowance for doubtful receivables of  $134,292                                                   |       | 2,980,298                                                         |       | — |   | 2,980,298 |   |
| Unbilled                                                                                                       |       | 122,662                                                           |       | — |   | 122,662 |   |
| Costs and  earnings in excess of billings on uncompleted contracts                                             |       | 5,243,350                                                         |       | — |   | 5,243,350 |   |
| Inventory                                                                                                      |       | 3,465                                                             |       | — |   | 3,465 |   |
| Prepaid expenses                                                                                               |       | 207,718                                                           |       | — |   | 207,718 |   |
| Total current assets                                                                                           |       | 10,054,681                                                        |       | — |   | 10,054,681 |   |
| Equipment and  leasehold improvements, net                                                                     |       | 609,375                                                           |       | — |   | 609,375 |   |
| Deposits                                                                                                       |       | 1,757,037                                                         |       | — |   | 1,757,037 |   |
| Intangible  assets—less accumulated amortization                                                          |       | 4,752,050                                                         |       | (1,243,521 | ) | 3,508,529 |   |
| Deferred  financing costs, net                                                                                 |       | —                                                            |       | 1,813,499 |   | 1,813,499 |   |
| Goodwill                                                                                                       |       | 11,120,395                                                        |       | 268,365 |   | 11,388,760 |   |
| Total non-current assets                                                                                       |       | 18,238,857                                                        |       | 838,343 |   | 19,077,200 |   |
| **TOTAL  ASSETS**                                                                                              |       | $                                                                 | 28,293,538 |   | $ | 838,343 |   | $ | 29,131,881 |   |
| **LIABILITIES:**                                                                                               |       |                                                              |       |   |   |   |   |
| Current  maturities of long-term obligations                                                                   |       | $                                                                 | 2,236,901  |   | $ | (1,168,935 | ) | $ | 1,067,966 |   |
| Accounts payable                                                                                               |       | 941,177                                                           |       | 23,810 |   | 964,987 |   |
| Billings in  excess of costs and earnings on uncompleted contracts                                             |       | 61,402                                                            |       | — |   | 61,402 |   |
| Accrued  liabilities                                                                                           |       | 5,175,101                                                         |       | — |   | 5,175,101 |   |
| Deferred rent                                                                                                  |       | 430,558                                                           |       | — |   | 430,558 |   |
| Deferred revenue                                                                                               |       | 3,883,787                                                         |       | 268,365 |   | 4,152,152 |   |
| Total current liabilities                                                                                      |       | 12,728,926                                                        |       | (876,760 | ) | 11,852,166 |   |
| Long-term  obligations, net of discount and current maturities                                                 |       | 6,561,868                                                         |       | 808,594 |   | 7,370,462 |   |
| Deferred rent                                                                                                  |       | 983,765                                                           |       | — |   | 983,765 |   |
| Deferred revenue                                                                                               |       | 570,136                                                           |       | — |   | 570,136 |   |
| Total non-current liabilities                                                                                  |       | 8,115,769                                                         |       | 808,594 |   | 8,924,363 |   |
| **TOTAL  LIABILITIES**                                                                                         |       | 20,844,695                                                        |       | (68,166 | ) | 20,776,529 |   |
| **STOCKHOLDERS’  EQUITY (DEFICIT):**                                                                      |       |                                                              |       |   |   |   |   |
| Preferred  stock-authorized, 5,000,000 shares of $.0001 (liquidation preference of $100  per share)            |       |                                                              |       |   |   |   |   |
| Series A 7% Convertible; issued and  outstanding, 44,557 shares                                           |       | 4                                                                 |       | — |   | 4 |   |
| Common stock—authorized,  85,000,000 shares, issued and outstanding 46,306,588 shares of .0001 par  value |       | 4,630                                                             |       | — |   | 4,630 |   |
| Additional paid-in  capital                                                                                    |       | 51,560,705                                                        |       | (2,750,407 | ) | 48,810,298 |   |
| Accumulated  deficit                                                                                           |       | (44,116,496                                                       | )          | 3,656,916 |   | (40,459,580 | ) |
| **TOTAL  STOCKHOLDERS’ EQUITY (DEFICIT)**                                                                 |       | 7,448,843                                                         |       | 906,509 |   | 8,355,352 |   |
| **TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY (DEFICIT)**                                                 |       | $                                                                 | 28,293,538 |   | $ | 838,343 |   | $ | 29,131,881 |   |

 

128

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|                                                                                                        | ** ** | **As of March 31, 2004 (Unaudited)** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                                                  | ** ** | **As Previously  Reported**                              | ** ** | **Effect of  Restatement** | ** ** | **As  Restated** | ** ** |
| **ASSETS:**                                                                                                 |       |                                                          |       |   |   |   |   |
| Cash and cash  equivalents                                                                                  |       | $                                                             | 478,419    |   | $ | — |   | $ | 478,419 |   |
| Receivables                                                                                                 |       | 860,901                                                       |       | (399,645 | ) | 461,256 |   |
| Billed, less  allowance for doubtful receivables of $4,000                                                  |       |                                                          |       |   |   |   |   |
| Escrow                                                                                                      |       | 11,248,803                                                    |       | — |   | 11,248,803 |   |
| Due from selling  stockholders and other                                                                    |       | 153,988                                                       |       | — |   | 153,988 |   |
| Inventory                                                                                                   |       | 59,624                                                        |       | — |   | 59,624 |   |
| Prepaid expenses                                                                                            |       | 34,404                                                        |       | — |   | 34,404 |   |
| Total current assets                                                                                        |       | 12,836,139                                                    |       | (399,645 | ) | 12,436,494 |   |
| Equipment and  leasehold improvements, net                                                                  |       | 75,866                                                        |       | — |   | 75,866 |   |
| Other                                                                                                       |       | 4,827,747                                                     |       | — |   | 4,827,747 |   |
| Total non-current assets                                                                                    |       | 4,903,613                                                     |       | — |   | 4,903,613 |   |
| **TOTAL  ASSETS**                                                                                           |       | $                                                             | 17,739,752 |   | $ | (399,645 | ) | $ | 17,340,107 |   |
| **LIABILITIES:**                                                                                            |       |                                                          |       |   |   |   |   |
| Note Payable                                                                                                |       | $                                                             | 400,000    |   | $ | — |   | $ | 400,000 |   |
| Advances from  stockholders                                                                                 |       | 60,958                                                        |       | — |   | 60,958 |   |
| Accounts payable                                                                                            |       | 540,862                                                       |       | — |   | 540,862 |   |
| Accrued  liabilities                                                                                        |       | 141,930                                                       |       | (23,450 | ) | 118,480 |   |
| Deferred revenue                                                                                            |       | 175,467                                                       |       | (55,810 | ) | 119,657 |   |
| Total current liabilities                                                                                   |       | 1,319,217                                                     |       | (79,260 | ) | 1,239,957 |   |
| Long-term  obligations, net of discount and current maturities                                              |       | 375,000                                                       |       | — |   | 375,000 |   |
| Deferred revenue                                                                                            |       | 58,301                                                        |       | — |   | 58,301 |   |
| Total non-current liabilities                                                                               |       | 433,301                                                       |       | — |   | 433,301 |   |
| **TOTAL  LIABILITIES**                                                                                      |       | 1,752,518                                                     |       | (79,260 | ) | 1,673,258 |   |
| **STOCKHOLDERS’  EQUITY (DEFICIT):**                                                                   |       |                                                          |       |   |   |   |   |
| Preferred  stock-authorized, 5,000,000 shares of $.01 (liquidation preference of $100  per share)           |       |                                                          |       |   |   |   |   |
| Series C 7% Convertible; issued and  outstanding, 88,532 shares                                        |       | 885                                                           |       | — |   | 885 |   |
| Common stock—authorized,  85,000,000 shares, issued and outstanding 35,889,649 shares of .01 par value |       | 358,897                                                       |       | — |   | 358,897 |   |
| Additional  paid-in capital                                                                                 |       | 44,323,275                                                    |       | (150,248 | ) | 44,173,027 |   |
| Accumulated  deficit                                                                                        |       | (28,695,823                                                   | )          | (170,137 | ) | (28,865,960 | ) |
| **TOTAL  STOCKHOLDERS’ EQUITY (DEFICIT)**                                                              |       | 15,987,234                                                    |       | (320,385 | ) | 15,666,849 |   |
| **TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY (DEFICIT)**                                              |       | $                                                             | 17,739,752 |   | $ | (399,645 | ) | $ | 17,340,107 |   |

 

129

----

 
| ** **                                                                                                 | ** ** | **As of June 30, 2004 (Unaudited)** | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                                                                 | ** ** | **As Previously  Reported**                             | ** ** | **Effect of  Restatement** | ** ** | **As  Restated** | ** ** |
| **ASSETS:**                                                                                                |       |                                                         |       |   |   |   |   |
| Cash and cash  equivalents                                                                                 |       | $                                                            | 3,837,147  |   | $ | — |   | $ | 3,837,147 |   |
| Marketable debt  securities                                                                                |       | —                                                       |       | — |   | — |   |
| Receivables                                                                                                |       | 1,188,560                                                    |       | (412,805 | ) | 775,755 |   |
| Billed, less  allowance for doubtful receivables of $6,000                                                 |       |                                                         |       |   |   |   |   |
| Escrow                                                                                                     |       | 50,000                                                       |       | — |   | 50,000 |   |
| Due from selling  stockholders and other                                                                   |       | 154,515                                                      |       | — |   | 154,515 |   |
| Inventory                                                                                                  |       | 36,910                                                       |       | — |   | 36,910 |   |
| Prepaid expenses                                                                                           |       | 71,697                                                       |       | — |   | 71,697 |   |
| Total current assets                                                                                       |       | 5,338,829                                                    |       | (412,805 | ) | 4,926,024 |   |
| Equipment and  leasehold improvements, net                                                                 |       | 127,536                                                      |       | — |   | 127,536 |   |
| Marketable debt  securities                                                                                |       | 5,887,500                                                    |       | — |   | 5,887,500 |   |
| Intangible  assets—less accumulated amortization                                                      |       | 4,593,692                                                    |       | — |   | 4,593,692 |   |
| Other                                                                                                      |       | 115,377                                                      |       | — |   | 115,377 |   |
| Total non-current assets                                                                                   |       | 10,724,105                                                   |       | — |   | 10,724,105 |   |
| **TOTAL  ASSETS**                                                                                          |       | $                                                            | 16,062,934 |   | $ | (412,805 | ) | $ | 15,650,129 |   |
| **LIABILITIES:**                                                                                           |       |                                                         |       |   |   |   |   |
| Advances from  stockholders                                                                                |       | $                                                            | 22,944     |   | $ | — |   | $ | 22,944 |   |
| Accounts payable                                                                                           |       | 550,973                                                      |       | 23,810 |   | 574,783 |   |
| Accrued  liabilities                                                                                       |       | 292,944                                                      |       | (25,950 | ) | 266,994 |   |
| Deferred rent                                                                                              |       | 226,235                                                      |       | — |   | 226,235 |   |
| Total current liabilities                                                                                  |       | 1,093,096                                                    |       | (2,140 | ) | 1,090,956 |   |
| **TOTAL  LIABILITIES**                                                                                     |       | 1,093,096                                                    |       | (2,140 | ) | 1,090,956 |   |
| **STOCKHOLDERS’ EQUITY (DEFICIT):**                                                                   |       |                                                         |       |   |   |   |   |
| Preferred  stock-authorized, 5,000,000 shares of $.01 (liquidation preference of $100  per share)          |       | 757                                                          |       | — |   | 757 |   |
| Series C 7%  Convertible; issued and outstanding, 75,682 shares                                       |       |                                                         |       |   |   |   |   |
| Common stock—authorized  85,000,000 shares, issued and outstanding 38,430,829 shares of .01 par value |       | 384,308                                                      |       | — |   | 384,308 |   |
| Additional  paid-in capital                                                                                |       | 44,559,202                                                   |       | (150,248 | ) | 44,408,954 |   |
| Accumulated deficit                                                                                        |       | (29,974,429                                                  | )          | (260,417 | ) | (30,234,846 | ) |
| **TOTAL  STOCKHOLDERS’ EQUITY (DEFICIT)**                                                             |       | 14,969,838                                                   |       | (410,665 | ) | 14,559,173 |   |
| **TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY (DEFICIT)**                                             |       | $                                                            | 16,062,934 |   | $ | (412,805 | ) | $ | 15,650,129 |   |

 

130

----

** **
| ** **                                                                                                 | ** ** | **As of September 30, 2004 (Unaudited)** | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                                                                                 | ** ** | **As Previously  Reported**                                  | ** ** | **Effect of  Restatement** | ** ** | **As  Restated** | ** ** |
| **ASSETS:**                                                                                                |       |                                                              |       |   |   |   |   |
| Cash and cash  equivalents                                                                                 |       | $                                                                 | 2,971,569  |   | $ | — |   | $ | 2,971,569 |   |
| Receivables                                                                                                |       |                                                              |       |   |   |   |   |
| Billed, less allowance for doubtful receivables of  $1,014,161                                             |       | 3,489,028                                                         |       | (332,220 | ) | 3,156,808 |   |
| Due from selling  stockholders and other                                                                   |       | 196,714                                                           |       | (32,000 | ) | 164,714 |   |
| Costs and  earnings in excess of billings on uncompleted contracts                                         |       | 6,619,726                                                         |       | — |   | 6,619,726 |   |
| Inventory                                                                                                  |       | 76,985                                                            |       | — |   | 76,985 |   |
| Prepaid expenses                                                                                           |       | 388,923                                                           |       | — |   | 388,923 |   |
| Total current assets                                                                                       |       | 13,742,945                                                        |       | (364,220 | ) | 13,378,725 |   |
| Equipment and  leasehold improvements, net                                                                 |       | 578,225                                                           |       | — |   | 578,225 |   |
| Marketable debt  securities                                                                                |       | 1,000,000                                                         |       | — |   | 1,000,000 |   |
| Deposits                                                                                                   |       | 2,769,691                                                         |       | — |   | 2,769,691 |   |
| Deferred  offering costs                                                                                   |       | 80,000                                                            |       | 976,201 |   | 1,056,201 |   |
| Intangible  assets—less accumulated amortization                                                      |       | 16,268,614                                                        |       | — |   | 16,268,614 |   |
| Other                                                                                                      |       | 194,665                                                           |       | — |   | 194,665 |   |
| Total non-current assets                                                                                   |       | 20,891,195                                                        |       | 976,201 |   | 21,867,396 |   |
| **TOTAL  ASSETS**                                                                                          |       | $                                                                 | 34,634,140 |   | $ | 611,981 |   | $ | 35,246,121 |   |
| **LIABILITIES:**                                                                                           |       |                                                              |       |   |   |   |   |
| Current  maturities of long-term obligations                                                               |       | $                                                                 | 2,159,129  |   | $ | (1,076,849 | ) | $ | 1,082,280 |   |
| Advances from  stockholders                                                                                |       | 17,931                                                            |       | — |   | 17,931 |   |
| Accounts payable                                                                                           |       | 1,720,790                                                         |       | 23,810 |   | 1,744,600 |   |
| Accrued  liabilities                                                                                       |       | 4,465,112                                                         |       | (30,950 | ) | 4,434,162 |   |
| Deferred rent                                                                                              |       | 441,732                                                           |       | — |   | 441,732 |   |
| Deferred revenue                                                                                           |       | 4,755,277                                                         |       | — |   | 4,755,277 |   |
| Total current liabilities                                                                                  |       | 13,559,971                                                        |       | (1,083,989 | ) | 12,475,982 |   |
| Long-term  obligations, net of discount and current maturities                                             |       | 5,880,871                                                         |       | 1,360,309 |   | 7,241,180 |   |
| Deferred rent                                                                                              |       | 1,636,098                                                         |       | — |   | 1,636,098 |   |
| Deferred revenue                                                                                           |       | 59,707                                                            |       | — |   | 59,707 |   |
| Total non-current liabilities                                                                              |       | 7,576,676                                                         |       | 1,360,309 |   | 8,936,985 |   |
| **TOTAL  LIABILITIES**                                                                                     |       | 21,136,647                                                        |       | 276,320 |   | 21,412,967 |   |
| **STOCKHOLDERS’ EQUITY (DEFICIT):**                                                                   |       |                                                              |       |   |   |   |   |
| Preferred  stock-authorized, 5,000,000 shares of $.01 (liquidation value of $100 per  share)               |       | 737                                                               |       | — |   | 737 |   |
| Series C 7%  Convertible; issued and outstanding, 73,682 shares                                       |       |                                                              |       |   |   |   |   |
| Common stock—authorized  85,000,000 shares, issued and outstanding 38,962,281 shares of .01 par value |       | 389,623                                                           |       | — |   | 389,623 |   |
| Additional  paid-in capital                                                                                |       | 44,949,815                                                        |       | (58,727 | ) | 44,891,088 |   |
| Accumulated  deficit                                                                                       |       | (31,842,682                                                       | )          | 394,388 |   | (31,448,294 | ) |
| **TOTAL  STOCKHOLDERS’ EQUITY (DEFICIT)**                                                             |       | 13,497,493                                                        |       | 335,661 |   | 13,833,154 |   |
| **TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY (DEFICIT)**                                             |       | $                                                                 | 34,634,140 |   | $ | 611,981 |   | $ | 35,246,121 |   |

 

131

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|                                                                                                        | ** ** | **As of March 31, 2003 (Unaudited)** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                                                  | ** ** | **As Previously  Reported**                              | ** ** | **Effect of  Restatement** | ** ** | **As  Restated** | ** ** |
| **ASSETS:**                                                                                                 |       |                                                          |       |   |   |   |   |
| Cash and cash  equivalents                                                                                  |       | $                                                             | 339,838    |   | $ | — |   | $ | 339,838 |   |
| Receivables                                                                                                 |       |                                                          |       |   |   |   |   |
| Billed                                                                                                      |       | 11,195                                                        |       | — |   | 11,195 |   |
| Prepaid expenses                                                                                            |       | 52,366                                                        |       | — |   | 52,366 |   |
| Total current assets                                                                                        |       | 403,399                                                       |       | — |   | 403,399 |   |
| Other                                                                                                       |       | 123,962                                                       |       |   |   | 123,962 |   |
| Total non-current assets                                                                                    |       | 123,962                                                       |       | — |   | 123,962 |   |
| **TOTAL  ASSETS**                                                                                           |       | $                                                             | 527,361    |   | $ | — |   | $ | 527,361 |   |
| **LIABILITIES:**                                                                                            |       |                                                          |       |   |   |   |   |
| Current  maturities of long-term obligations                                                                |       | $                                                             | 6,645,832  |   | $ | — |   | $ | 6,645,832 |   |
| Accounts payable                                                                                            |       | 245,687                                                       |       | — |   | 245,687 |   |
| Accrued  liabilities                                                                                        |       | 732,175                                                       |       | — |   | 732,175 |   |
| Total current liabilities                                                                                   |       | 7,623,694                                                     |       | — |   | 7,623,694 |   |
| Long-term  obligations, net of discount and current maturities                                              |       | 980,000                                                       |       | 238,866 |   | 1,218,866 |   |
| Total non-current liabilities                                                                               |       | 980,000                                                       |       | 238,866 |   | 1,218,866 |   |
| **TOTAL  LIABILITIES**                                                                                      |       | 8,603,694                                                     |       | 238,866 |   | 8,842,560 |   |
| **STOCKHOLDERS’  EQUITY (DEFICIT):**                                                                   |       |                                                          |       |   |   |   |   |
| Preferred  stock-authorized, 5,000,000 shares of $.01 (liquidation preference of $100  per share)           |       | 184                                                           |       | — |   | 184 |   |
| Series B 9%  Convertible; issued and outstanding, 18,430 shares                                        |       |                                                          |       |   |   |   |   |
| Common stock—authorized,  85,000,000 shares, issued and outstanding 14,377,406 shares of .01 par value |       | 143,774                                                       |       | — |   | 143,774 |   |
| Additional  paid-in capital                                                                                 |       | 16,440,399                                                    |       | — |   | 16,440,399 |   |
| Accumulated  deficit                                                                                        |       | (24,660,690                                                   | )          | (238,866 | ) | (24,899,556 | ) |
| **TOTAL  STOCKHOLDERS’ EQUITY (DEFICIT)**                                                              |       | (8,076,333                                                    | )          | (238,866 | ) | (8,315,199 | ) |
| **TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY (DEFICIT)**                                              |       | $                                                             | 527,361    |   | $ | — |   | $ | 527,361 |   |

 

132

----

 
| ** **                                                                                                  | ** ** | **As of June 30, 2003 (Unaudited)** | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                                                                  | ** ** | **As Previously  Reported**                             | ** ** | **Effect of  Restatement** | ** ** | **As  Restated** | ** ** |
| **ASSETS:**                                                                                                 |       |                                                         |       |   |   |   |   |
| Cash and cash  equivalents                                                                                  |       | $                                                            | 254,766    |   | $ | — |   | $ | 254,766 |   |
| Receivables                                                                                                 |       |                                                         |       |   |   |   |   |
| Billed                                                                                                      |       | 7,428                                                        |       | — |   | 7,428 |   |
| Prepaid expenses                                                                                            |       | 93,529                                                       |       | — |   | 93,529 |   |
| Total current assets                                                                                        |       | 355,723                                                      |       | — |   | 355,723 |   |
| Other                                                                                                       |       | 130,066                                                      |       | — |   | 130,066 |   |
| Total non-current assets                                                                                    |       | 130,066                                                      |       | — |   | 130,066 |   |
| **TOTAL  ASSETS**                                                                                           |       | $                                                            | 485,789    |   | $ | — |   | $ | 485,789 |   |
| **LIABILITIES:**                                                                                            |       |                                                         |       |   |   |   |   |
| Current  maturities of long-term obligations                                                                |       | $                                                            | 8,337,378  |   | $ | 393,330 |   | $ | 8,730,708 |   |
| Accounts payable                                                                                            |       | 332,384                                                      |       | — |   | 332,384 |   |
| Accrued  liabilities                                                                                        |       | 907,846                                                      |       | — |   | 907,846 |   |
| Total current liabilities                                                                                   |       | 9,577,608                                                    |       | 393,330 |   | 9,970,938 |   |
| **TOTAL  LIABILITIES**                                                                                      |       | 9,577,608                                                    |       | 393,330 |   | 9,970,938 |   |
| **STOCKHOLDERS’ EQUITY (DEFICIT):**                                                                    |       |                                                         |       |   |   |   |   |
| Preferred  stock-authorized, 5,000,000 shares of $.01 (liquidation preference of $100  per share)           |       | 146                                                          |       | — |   | 146 |   |
| Series B 9%  Convertible; issued and outstanding, 14,630 shares                                        |       |                                                         |       |   |   |   |   |
| Common stock—authorized,  85,000,000 shares, issued and outstanding 15,861,519 shares of .01 par value |       | 158,615                                                      |       | — |   | 158,615 |   |
| Additional  paid-in capital                                                                                 |       | 16,480,472                                                   |       | — |   | 16,480,472 |   |
| Accumulated  deficit                                                                                        |       | (25,731,052                                                  | )          | (393,330 | ) | (26,124,382 | ) |
| **TOTAL  STOCKHOLDERS’ EQUITY (DEFICIT)**                                                              |       | (9,091,819                                                   | )          | (393,330 | ) | (9,485,149 | ) |
| **TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY (DEFICIT)**                                              |       | $                                                            | 485,789    |   | $ | — |   | $ | 485,789 |   |

 

133

----

** **
| ** **                                                                                                   | ** ** | **As of September 30, 2003 (Unaudited)** | ** ** |
|--------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                                                                                   | ** ** | **As Previously  Reported**                                  | ** ** | **Effect of  Restatement** | ** ** | **As  Restated** | ** ** |
| **ASSETS:**                                                                                                  |       |                                                              |       |   |   |   |   |
| Cash and cash  equivalents                                                                                   |       | $                                                                 | 58,774     |   | $ | — |   | $ | 58,774 |   |
| Receivables                                                                                                  |       |                                                              |       |   |   |   |   |
| Billed                                                                                                       |       | 147,378                                                           |       | — |   | 147,378 |   |
| Prepaid expenses                                                                                             |       | 118,183                                                           |       | — |   | 118,183 |   |
| Total current assets                                                                                         |       | 324,335                                                           |       | — |   | 324,335 |   |
| Equipment and  leashold improvements, net                                                                    |       | 38,573                                                            |       | — |   | 38,573 |   |
| Other                                                                                                        |       | 144,703                                                           |       | — |   | 144,703 |   |
| Total non-current assets                                                                                     |       | 183,276                                                           |       | — |   | 183,276 |   |
| **TOTAL  ASSETS**                                                                                            |       | $                                                                 | 507,611    |   | $ | — |   | $ | 507,611 |   |
| **LIABILITIES:**                                                                                             |       |                                                              |       |   |   |   |   |
| Current  maturities of long-term obligations                                                                 |       | $                                                                 | 9,075,170  |   | $ | 550,117 |   | $ | 9,625,287 |   |
| Advances from  stockholders                                                                                  |       | 38,532                                                            |       | — |   | 38,532 |   |
| Accounts payable                                                                                             |       | 219,918                                                           |       | — |   | 219,918 |   |
| Accrued  liabilities                                                                                         |       | 1,109,126                                                         |       | — |   | 1,109,126 |   |
| Deferred revenue                                                                                             |       | 10,000                                                            |       | — |   | 10,000 |   |
| Total current liabilities                                                                                    |       | 10,452,746                                                        |       | 550,117 |   | 11,002,863 |   |
| **TOTAL  LIABILITIES**                                                                                       |       | 10,452,746                                                        |       | 550,117 |   | 11,002,863 |   |
| **STOCKHOLDERS’ EQUITY (DEFICIT):**                                                                     |       |                                                              |       |   |   |   |   |
| Preferred  stock-authorized, 5,000,000 shares of $.01 (liquidation preference of $100  per share)            |       | 119                                                               |       | — |   | 119 |   |
| Series B 9%  Convertible; issued and outstanding, 11,930 shares                                         |       |                                                              |       |   |   |   |   |
| Common stock—authorized,  85,000,000 shares, issued and outstanding 17,202,776 shares of $.01 par value |       | 170,208                                                           |       | — |   | 170,208 |   |
| Additional  paid-in capital                                                                                  |       | 16,590,140                                                        |       | — |   | 16,590,140 |   |
| Accumulated  deficit                                                                                         |       | (26,705,602                                                       | )          | (550,117 | ) | (27,255,719 | ) |
| **TOTAL  STOCKHOLDERS’ EQUITY (DEFICIT)**                                                               |       | (9,945,135                                                        | )          | (550,117 | ) | (10,495,252 | ) |
| **TOTAL LIABILITIES AND  STOCKHOLDERS’ EQUITY (DEFICIT)**                                               |       | $                                                                 | 507,611    |   | $ | — |   | $ | 507,611 |   |

 

134

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| ** **                                                                            | ** ** | **Three Months Ended March 31, 2005 (Unaudited)** | ** ** |
|---------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------|------------|
| ** **                                                                            | ** ** | **As Previously  Reported**                                                | ** ** | **Effect of  Restatement** | ** ** | **As  Restated** | ** ** |
| **Cash flow from operating  activities**                                              |       |                                                                            |       |   |   |   |   |
| Net income (loss)                                                                     |       | $                                                                               | (2,683,717 | ) | $ | 3,286,220 |   | $ | 602,503 |   |
| **Adjustments  to reconcile net income (loss) to cash used in operating activities:** |       |                                                                            |       |   |   |   |   |
| Derivative and warrant fair value adjustments                                         |       |                                                                            |       | (3,576,881 | ) | (3,576,881 | ) |
| Depreciation                                                                          |       | 58,590                                                                          |       | — |   | 58,590 |   |
| Amortization                                                                          |       |                                                                            |       |   |   |   |   |
| Intangible assets                                                                     |       | 222,993                                                                         |       | — |   | 222,993 |   |
| Discounts on convertible debt related to warrants  and beneficial conversion features |       | 133,341                                                                         |       | 329,861 |   | 463,202 |   |
| Allowance for doubtful receivables                                                    |       | 19,790                                                                          |       | — |   | 19,790 |   |
| Deferred rent                                                                         |       | (94,057                                                                         | )          | — |   | (94,057 | ) |
| Loss on sale of investment                                                            |       | 20,000                                                                          |       | — |   | 20,000 |   |
| **Change  in assets and liabilities:**                                                |       |                                                                            |       |   |   |   |   |
| Accounts receivable trade                                                             |       | (616,393                                                                        | )          | (39,200 | ) | (655,593 | ) |
| Costs and earnings in excess of billings on  uncompleted contracts                    |       | 92,235                                                                          |       | — |   | 92,235 |   |
| Prepaid expenses and other                                                            |       | (18,195                                                                         | )          | — |   | (18,195 | ) |
| Accounts payable                                                                      |       | (238,721                                                                        | )          | — |   | (238,721 | ) |
| Billings in excess of costs and earnings on  uncompleted contracts                    |       | 1,054,043                                                                       |       | — |   | 1,054,043 |   |
| Accrued liabilities                                                                   |       | 776,864                                                                         |       | — |   | 776,864 |   |
| Deferred revenue                                                                      |       | 350,922                                                                         |       | — |   | 350,922 |   |
| Net cash used in operating activities                                                 |       | (922,305                                                                        | )          | — |   | (922,305 | ) |
|                                                                                  |       |                                                                            |       |   |   |   |   |
| **Cash flow from investing  activities**                                              |       |                                                                            |       |   |   |   |   |
| Net cash provided by investing activities                                             |       | 1,459,595                                                                       |       | — |   | 1,459,595 |   |
| **Cash flow from financing  activities**                                              |       |                                                                            |       |   |   |   |   |
| Net cash used in financing activities                                                 |       | (122,935                                                                        | )          | — |   | (122,935 | ) |
|                                                                                  |       |                                                                            |       |   |   |   |   |
| **Net  increase in cash and equivalents**                                             |       | 414,355                                                                         |       | — |   | 414,355 |   |
| **Cash  and cash equivalents, beginning of period**                                   |       | 956,230                                                                         |       | — |   | 956,230 |   |
| **Cash and cash equivalents, end  of period**                                         |       | $                                                                               | 1,370,585  |   | $ | — |   | $ | 1,370,585 |   |

 

135

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| ** **                                                                            | ** ** | **Six Months Ended June 30, 2005 (Unaudited)** | ** ** |
|---------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|
| ** **                                                                            | ** ** | **As Previously**                                                       | ** ** | **Effect of** | ** ** | **As** | ** ** |
| ** **                                                                            | ** ** | **Reported**                                                                 | ** ** | **Restatement** | ** ** | **Restated** | ** ** |
| **Cash flow from operating  activities**                                              |       |                                                                         |       |   |   |   |   |
| Net income (loss)                                                                     |       | $                                                                            | (5,627,943 | ) | $ | 4,704,274 |   | $ | (923,669 | ) |
| **Adjustments  to reconcile net income (loss) to cash used in operating activities:** |       |                                                                         |       |   |   |   |   |
| Derivative and warrant fair value adjustments                                         |       |                                                                         |       | (4,950,248 | ) | (4,950,248 | ) |
| Depreciation                                                                          |       | 115,618                                                                      |       | — |   | 115,618 |   |
| Amortization                                                                          |       |                                                                         |       |   |   |   |   |
| Intangible assets                                                                     |       | 455,634                                                                      |       | — |   | 455,634 |   |
| Discounts on convertible debt related to warrants  and beneficial conversion features |       | 311,534                                                                      |       | 306,194 |   | 617,728 |   |
| Allowance for doubtful receivables                                                    |       | 36,865                                                                       |       | — |   | 36,865 |   |
| Deferred rent                                                                         |       | (190,964                                                                     | )          | — |   | (190,964 | ) |
| Loss on sale of investment                                                            |       | 20,000                                                                       |       | — |   | 20,000 |   |
| Options and warrants issued for service                                               |       | 529,968                                                                      |       | — |   | 529,968 |   |
| **Change  in assets and liabilities:**                                                |       |                                                                         |       |   |   |   |   |
| Accounts receivable trade                                                             |       | (26,761                                                                      | )          | (60,220 | ) | (86,981 | ) |
| Costs and earnings in excess of billings on  uncompleted contracts                    |       | 65,260                                                                       |       | — |   | 65,260 |   |
| Inventories                                                                           |       | (1,702                                                                       | )          | — |   | (1,702 | ) |
| Prepaid expenses and other                                                            |       | (356,571                                                                     | )          | — |   | (356,571 | ) |
| Accounts payable                                                                      |       | (411,986                                                                     | )          | — |   | (411,986 | ) |
| Billings in excess of costs and earnings on  uncompleted contracts                    |       | 802,004                                                                      |       | — |   | 802,004 |   |
| Accrued liabilities                                                                   |       | 659,932                                                                      |       | — |   | 659,932 |   |
| Deferred revenue                                                                      |       | (133,335                                                                     | )          | — |   | (133,335 | ) |
| Net cash used in operating activities                                                 |       | (3,752,447                                                                   | )          | — |   | (3,752,447 | ) |
|                                                                                  |       |                                                                         |       |   |   |   |   |
| **Cash flow from investing  activities**                                              |       |                                                                         |       |   |   |   |   |
| Net cash provided by investing activities                                             |       | 1,388,731                                                                    |       | — |   | 1,388,731 |   |
|                                                                                  |       |                                                                         |       |   |   |   |   |
| **Cash flow from financing  activities**                                              |       |                                                                         |       |   |   |   |   |
| Net cash provided by                                                                  |       | 3,379,939                                                                    |       | — |   | 3,379,939 |   |
|                                                                                  |       |                                                                         |       |   |   |   |   |
| **Net  increase in cash and equivalents**                                             |       | 1,016,223                                                                    |       | — |   | 1,016,223 |   |
| **Cash  and cash equivalents, beginning of period**                                   |       | 956,230                                                                      |       | — |   | 956,230 |   |
| **Cash and cash equivalents, end  of period**                                         |       | $                                                                            | 1,972,453  |   | $ | — |   | $ | 1,972,453 |   |

 

136

----

 
| ** **                                                                            | ** ** | **Nine Months Ended September 30, 2005 (Unaudited)** | ** ** |
|---------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------|------------|
| ** **                                                                            | ** ** | **As Previously  Reported**                                                   | ** ** | **Effect of  Restatement** | ** ** | **As  Restated** | ** ** |
| **Cash flow from operating  activities**                                              |       |                                                                               |       |   |   |   |   |
| Net income (loss)                                                                     |       | $                                                                                  | (8,716,279 | ) | $ | 7,345,263 |   | $ | (1,371,016 | ) |
| **Adjustments  to reconcile net income (loss) to cash used in operating activities:** |       |                                                                               |       |   |   |   |   |
| Derivative and warrant fair value adjustments                                         |       |                                                                               |       | (8,160,305 | ) | (8,160,305 | ) |
| Depreciation                                                                          |       | 179,642                                                                            |       | — |   | 179,642 |   |
| Amortization                                                                          |       |                                                                               |       |   |   |   |   |
| Intangible assets                                                                     |       | 1,504,600                                                                          |       | — |   | 1,504,600 |   |
| Discounts on convertible debt related to warrants  and beneficial conversion features |       | —                                                                             |       | 1,067,927 |   | 1,067,927 |   |
| Allowance for doubtful receivables                                                    |       | 22,440                                                                             |       | — |   | 22,440 |   |
| Deferred rent                                                                         |       | (290,807                                                                           | )          | — |   | (290,807 | ) |
| Loss on sale of investment                                                            |       | 20,000                                                                             |       | — |   | 20,000 |   |
| Options and warrants issued for service                                               |       | 542,758                                                                            |       | — |   | 542,758 |   |
| **Change  in assets and liabilities:**                                                |       |                                                                               |       |   |   |   |   |
| Accounts receivable trade                                                             |       | (804,799                                                                           | )          | (58,090 | ) | (862,889 | ) |
| Costs and earnings in excess of billings on uncompleted  contracts               |       | 1,546,812                                                                          |       | — |   | 1,546,812 |   |
| Inventories                                                                           |       | 26,134                                                                             |       | — |   | 26,134 |   |
| Prepaid expenses and other                                                            |       | (27,047                                                                            | )          | (194,795 | ) | (221,842 | ) |
| Accounts payable                                                                      |       | (418,332                                                                           | )          | — |   | (418,332 | ) |
| Billings in excess of costs and earnings on  uncompleted contracts                    |       | 24,173                                                                             |       | — |   | 24,173 |   |
| Accrued liabilities                                                                   |       | 683,989                                                                            |       | — |   | 683,989 |   |
| Deferred revenue                                                                      |       | 1,174,224                                                                          |       | — |   | 1,174,224 |   |
| Net cash used in operating activities                                                 |       | (4,532,492                                                                         | )          | — |   | (4,532,492 | ) |
|                                                                                  |       |                                                                               |       |   |   |   |   |
| **Cash flow from investing  activities**                                              |       |                                                                               |       |   |   |   |   |
| Net cash provided by investing activities                                             |       | 1,832,571                                                                          |       | — |   | 1,832,571 |   |
|                                                                                  |       |                                                                               |       |   |   |   |   |
| **Cash flow from financing  activities**                                              |       |                                                                               |       |   |   |   |   |
| Net cash provided by financing activities                                             |       | 3,240,879                                                                          |       | — |   | 3,240,879 |   |
|                                                                                  |       |                                                                               |       |   |   |   |   |
| **Net  increase in cash and equivalents**                                             |       | 540,958                                                                            |       | — |   | 540,958 |   |
| **Cash  and cash equivalents, beginning of period**                                   |       | 956,230                                                                            |       | — |   | 956,230 |   |
| **Cash and cash equivalents, end  of period**                                         |       | $                                                                                  | 1,497,188  |   | $ | — |   | $ | 1,497,188 |   |

 

137

----

| ** **                                                                            | ** ** | **Three Months Ended March 31, 2004 (Unaudited)** | ** ** |
|---------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------|------------|
| ** **                                                                            | ** ** | **As Previously  Reported**                                                | ** ** | **Effect of  Restatement** | ** ** | **As  Restated** | ** ** |
| **Cash flow from operating  activities**                                              |       |                                                                            |       |   |   |   |   |
| Net income (loss)                                                                     |       | $                                                                               | (911,878   | ) | $ | 62,739 |   | $ | (849,139 | ) |
| **Adjustments  to reconcile net loss to cash used in operating activities:**          |       | —                                                                          |       |   |   |   |   |
| Derivative and warrant fair value adjustments                                         |       |                                                                            |       | (323,128 | ) | (323,128 | ) |
| Depreciation                                                                          |       | 6,995                                                                           |       | — |   | 6,995 |   |
| Amortization                                                                          |       |                                                                            |       |   |   |   |   |
| Discounts on convertible debt related to warrants  and beneficial conversion features |       | —                                                                          |       | 230,424 |   | 230,424 |   |
| Allowance for doubtful receivables                                                    |       | 2,000                                                                           |       | — |   | 2,000 |   |
| Write off deferred offering costs                                                     |       | 81,900                                                                          |       | — |   | 81,900 |   |
| **Change  in assets and liabilities:**                                                |       |                                                                            |       |   |   |   |   |
| Accounts receivable trade                                                             |       | (334,292                                                                        | )          | 35,215 |   | (299,077 | ) |
| Costs and earnings in excess of billings on  uncompleted contracts               |       | —                                                                          |       | — |   | — |   |
| Inventories                                                                           |       | 6,233                                                                           |       | — |   | 6,233 |   |
| Prepaid expenses and other                                                            |       | 131,525                                                                         |       | — |   | 131,525 |   |
| Accounts payable                                                                      |       | (124,191                                                                        | )          | — |   | (124,191 | ) |
| Accrued liabilities                                                                   |       | 103,494                                                                         |       | (5,250 | ) | 98,244 |   |
| Deferred revenue                                                                      |       | 83,280                                                                          |       | — |   | 83,280 |   |
| Net cash used in operating activities                                                 |       | (954,934                                                                        | )          | — |   | (954,934 | ) |
|                                                                                  |       |                                                                            |       |   |   |   |   |
| **Cash flow from investing  activities**                                              |       |                                                                            |       |   |   |   |   |
| Net cash used in investing activities                                                 |       | (573,205                                                                        | )          | — |   | (573,205 | ) |
|                                                                                  |       |                                                                            |       |   |   |   |   |
| **Cash flow from financing  activities**                                              |       |                                                                            |       |   |   |   |   |
| Net cash provided by financing activities                                             |       | 993,768                                                                         |       | — |   | 993,768 |   |
|                                                                                  |       |                                                                            |       |   |   |   |   |
| **Net  decrease in cash and equivalents**                                             |       | (534,371                                                                        | )          | — |   | (534,371 | ) |
| **Cash  and cash equivalents, beginning of period**                                   |       | 1,012,790                                                                       |       | — |   | 1,012,790 |   |
| **Cash and cash equivalents, end  of period**                                         |       | $                                                                               | 478,419    |   |   |   | $ | 478,419 |   |
|                                                                                       |            |                                                                                 |            |  |  |  |  |  |  |  |

 

138

----

** **
| ** **                                                                            | ** ** | **Six Months Ended June 30, 2004 (Unaudited)** | ** ** |
|---------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|
| ** **                                                                            | ** ** | **As Previously  Reported**                                             | ** ** | **Effect of  Restatement** | ** ** | **As  Restated** | ** ** |
| **Cash flow from operating  activities**                                              |       |                                                                         |       |   |   |   |   |
| Net loss                                                                              |       | $                                                                            | (2,172,586 | ) | $ | (27,541 | ) | $ | (2,200,127 | ) |
| **Adjustments  to reconcile net loss to cash used in operating activities:**          |       |                                                                         |       |   |   |   |   |
| Derivative and warrant fair value adjustments                                         |       | —                                                                       |       | (323,128 | ) | (323,128 | ) |
| Depreciation                                                                          |       | 17,015                                                                       |       | — |   | 17,015 |   |
| Amortization                                                                          |       |                                                                         |       |   |   |   |   |
| Intangible assets                                                                     |       | 108,329                                                                      |       | — |   | 108,329 |   |
| Discounts on convertible debt related to warrants  and beneficial conversion features |       | —                                                                       |       | 230,424 |   | 230,424 |   |
| Allowance for doubtful receivables                                                    |       | 4,000                                                                        |       |   |   | 4,000 |   |
| **Change  in assets and liabilities:**                                                |       |                                                                         |       |   |   |   |   |
| Accounts receivable trade                                                             |       | (664,478                                                                     | )          | 104,185 |   | (560,293 | ) |
| Inventories                                                                           |       | 28,947                                                                       |       |   |   | 28,947 |   |
| Prepaid expenses and other                                                            |       | 155,351                                                                      |       | — |   | 155,351 |   |
| Accounts payable                                                                      |       | (114,080                                                                     | )          | 23,810 |   | (90,270 | ) |
| Accrued liabilities                                                                   |       | 254,508                                                                      |       | (7,750 | ) | 246,758 |   |
| Deferred revenue                                                                      |       | 75,747                                                                       |       | — |   | 75,747 |   |
| Net cash used in operating activities                                                 |       | (2,307,247                                                                   | )          | — |   | (2,307,247 | ) |
|                                                                                  |       |                                                                         |       |   |   |   |   |
| **Cash flow from investing  activities**                                              |       |                                                                         |       |   |   |   |   |
| Net cash used in investing activities                                                 |       | (6,541,265                                                                   | )          | — |   | (6,541,265 | ) |
|                                                                                  |       |                                                                         |       |   |   |   |   |
| **Cash flow from financing  activities**                                              |       |                                                                         |       |   |   |   |   |
| Net cash provided by financing activities                                             |       | 11,672,869                                                                   |       | — |   | 11,672,869 |   |
|                                                                                  |       |                                                                         |       |   |   |   |   |
| **Net  increase in cash and equivalents**                                             |       | 2,824,357                                                                    |       | — |   | 2,824,357 |   |
| **Cash  and cash equivalents, beginning of period**                                   |       | 1,012,790                                                                    |       | — |   | 1,012,790 |   |
| **Cash and cash equivalents, end  of period**                                         |       | $                                                                            | 3,837,147  |   | — |   | $ | 3,837,147 |   |
|                                                                                       |            |                                                                              |            |  |  |  |  |  |  |  |

 

139

----

 
| ** **                                                                            | ** ** | **Nine Months Ended September 30, 2004 (Unaudited)** | ** ** |
|---------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------|------------|
| ** **                                                                            | ** ** | **As Previously  Reported**                                                   | ** ** | **Effect of  Restatement** | ** ** | **As  Restated** | ** ** |
| **Cash flow from operating  activities**                                              |       |                                                                               |       |   |   |   |   |
| Net income (loss)                                                                     |       | $                                                                                  | (4,032,750 | ) | $ | 627,264 |   | $ | (3,405,486 | ) |
| **Adjustments  to reconcile net loss to cash used in operating activities:**          |       |                                                                               |       |   |   |   |   |
| Derivative and warrant fair value adjustments                                         |       |                                                                               |       | (840,719 | ) | (840,719 | ) |
| Depreciation                                                                          |       | 31,617                                                                             |       | — |   | 31,617 |   |
| Amortization                                                                          |       |                                                                               |       |   |   |   |   |
| Intangible assets                                                                     |       | 216,658                                                                            |       | — |   | 216,658 |   |
| Discounts on convertible debt related to warrants  and beneficial conversion features |       | —                                                                             |       | 230,424 |   | 230,424 |   |
| Allowance for doubtful receivables                                                    |       | 106,000                                                                            |       | — |   | 106,000 |   |
| Gain on sale of marketable securities                                                 |       | (33,125                                                                            | )          | — |   | (33,125 | ) |
| Options and warrants issued for services and other                                    |       | 24,850                                                                             |       | — |   | 24,850 |   |
| **Change  in assets and liabilities:**                                                |       |                                                                               |       |   |   |   |   |
| Accounts receivable trade                                                             |       | (260,951                                                                           | )          | 147,600 |   | (113,351 | ) |
| Inventories                                                                           |       | 35,559                                                                             |       | — |   | 35,559 |   |
| Prepaid expenses and other                                                            |       | 125,343                                                                            |       | — |   | 125,343 |   |
| Accounts payable                                                                      |       | (719                                                                               | )          | 23,810 |   | 23,091 |   |
| Accrued liabilities                                                                   |       | 242,105                                                                            |       | (104,750 | ) | 137,355 |   |
| Deferred revenue                                                                      |       | 70,598                                                                             |       | — |   | 70,598 |   |
| Net cash used in operating activities                                                 |       | (3,474,815                                                                         | )          | 83,629 |   | (3,391,186 | ) |
|                                                                                  |       |                                                                               |       |   |   |   |   |
| **Cash flow from investing  activities**                                              |       |                                                                               |       |   |   |   |   |
| Net cash used in investing activities                                                 |       | (14,613,892                                                                        | )          | — |   | (14,613,892 | ) |
|                                                                                  |       |                                                                               |       |   |   |   |   |
| **Cash flow from financing  activities**                                              |       |                                                                               |       |   |   |   |   |
| Net cash provided by financing activities                                             |       | 20,047,486                                                                         |       | (83,629 | ) | 19,963,857 |   |
|                                                                                  |       |                                                                               |       |   |   |   |   |
| **Net  increase in cash and equivalents**                                             |       | 1,958,779                                                                          |       | — |   | 1,958,779 |   |
| **Cash  and cash equivalents, beginning of period**                                   |       | 1,012,790                                                                          |       | — |   | 1,012,790 |   |
| **Cash and cash  equivalents, end of period      **     |       | $                                                                                  | 2,971,569  |   | — |   | $ | 2,971,569 |   |
|                                                                                       |            |                                                                                    |            |  |  |  |  |  |  |  |

 

140

----

 
| ** **                                                                            | ** ** | **Three Months Ended March 31, 2003 (Unaudited)** | ** ** |
|---------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------|------------|
| ** **                                                                            | ** ** | **As Previously  Reported**                                                | ** ** | **Effect of  Restatement** | ** ** | **As  Restated** | ** ** |
| **Cash flow from operating  activities**                                              |       |                                                                            |       |   |   |   |   |
| Net loss                                                                              |       | $                                                                               | (1,055,286 | ) | $ | (238,866 | ) | $ | (1,294,152 | ) |
| **Adjustments  to reconcile net loss to cash used in operating activities:**          |       |                                                                            |       |   |   |   |   |
| Derivative and warrant fair value adjustments                                         |       | —                                                                          |       | 119,247 |   | 119,247 |   |
| Amortization                                                                          |       |                                                                            |       |   |   |   |   |
| Discounts on convertible debt related to warrants  and beneficial conversion features |       | 138,546                                                                         |       | 119,619 |   | 258,165 |   |
| Options and warrants issued for services and other                                    |       | 156,000                                                                         |       |   |   | 156,000 |   |
| **Change  in assets and liabilities:**                                                |       |                                                                            |       |   |   |   |   |
| Accounts receivable trade                                                             |       | 56,803                                                                          |       | — |   | 56,803 |   |
| Prepaid expenses and other                                                            |       | (1,469                                                                          | )          | — |   | (1,469 | ) |
| Accounts payable                                                                      |       | (109,007                                                                        | )          | — |   | (109,007 | ) |
| Accrued liabilities                                                                   |       | 159,474                                                                         |       | — |   | 159,474 |   |
| Net cash used in operating activities                                                 |       | (654,939                                                                        | )          | — |   | (654,939 | ) |
|                                                                                  |       |                                                                            |       |   |   |   |   |
| **Cash flow from investing  activities**                                              |       |                                                                            |       |   |   |   |   |
| Net cash used in investing activities                                                 |       | (1,971                                                                          | )          | — |   | (1,971 | ) |
|                                                                                  |       |                                                                            |       |   |   |   |   |
| **Cash flow from financing  activities**                                              |       |                                                                            |       |   |   |   |   |
| Net cash provided by financing activities                                             |       | 980,000                                                                         |       | — |   | 980,000 |   |
|                                                                                  |       |                                                                            |       |   |   |   |   |
| **Net  increase in cash and equivalents**                                             |       | 323,090                                                                         |       | — |   | 323,090 |   |
| **Cash  and cash equivalents, beginning of period**                                   |       | 16,748                                                                          |       | — |   | 16,748 |   |
| **Cash and cash equivalents, end  of period**                                         |       | $                                                                               | 339,838    |   | $ | — |   | $ | 339,838 |   |

 

141

----

 
| ** **                                                                            | ** ** | **Six Months Ended June 30, 2003 (Unaudited)** | ** ** |
|---------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|
| ** **                                                                            | ** ** | **As Previously  Reported**                                             | ** ** | **Effect of  Restatement** | ** ** | **As  Restated** | ** ** |
| **Cash flow from operating  activities**                                              |       |                                                                         |       |   |   |   |   |
| Net loss                                                                              |       | $                                                                            | (2,070,771 | ) | $ | (393,330 | ) | $ | (2,464,101 | ) |
| **Adjustments  to reconcile net loss to cash used in operating activities:**          |       |                                                                         |       |   |   |   |   |
| Derivative and warrant fair value adjustments                                         |       | —                                                                       |       | 91,888 |   | 91,888 |   |
| Amortization                                                                          |       |                                                                         |       |   |   |   |   |
| Discounts on convertible debt related to warrants  and beneficial conversion features |       | 277,092                                                                      |       | 301,442 |   | 578,534 |   |
| Options and warrants issued for services and other                                    |       | 156,000                                                                      |       | — |   | 156,000 |   |
| **Change  in assets and liabilities:**                                                |       |                                                                         |       |   |   |   |   |
| Accounts receivable trade                                                             |       | 60,570                                                                       |       | — |   | 60,570 |   |
| Prepaid expenses and other                                                            |       | (42,633                                                                      | )          | — |   | (42,633 | ) |
| Accounts payable                                                                      |       | (22,310                                                                      | )          | — |   | (22,310 | ) |
| Accrued liabilities                                                                   |       | 335,145                                                                      |       | — |   | 335,145 |   |
| Net cash used in operating activities                                                 |       | (1,306,907                                                                   | )          | — |   | (1,306,907 | ) |
|                                                                                  |       |                                                                         |       |   |   |   |   |
| **Cash flow from investing  activities**                                              |       |                                                                         |       |   |   |   |   |
| Net cash used ininvesting activities                                                  |       | (8,075                                                                       | )          | — |   | (8,075 | ) |
|                                                                                  |       |                                                                         |       |   |   |   |   |
| **Cash flow from financing  activities**                                              |       |                                                                         |       |   |   |   |   |
| Net cash provided by financing activities                                             |       | 1,553,000                                                                    |       | — |   | 1,553,000 |   |
|                                                                                  |       |                                                                         |       |   |   |   |   |
| **Net  increase in cash and equivalents**                                             |       | 238,018                                                                      |       | — |   | 238,018 |   |
| **Cash  and cash equivalents, beginning of period**                                   |       | 16,748                                                                       |       | — |   | 16,748 |   |
| **Cash and cash equivalents, end  of period**                                         |       | $                                                                            | 254,766    |   | — |   | $ | 254,766 |   |
|                                                                                       |            |                                                                              |            |  |  |  |  |  |  |  |

 

142

----

 
| ** **                                                                            | ** ** | **Nine Months Ended September 30, 2003 (Unaudited)** | ** ** |
|---------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------|------------|
| ** **                                                                            | ** ** | **As Previously  Reported**                                                   | ** ** | **Effect of  Restatement** | ** ** | **As  Restated** | ** ** |
| **Cash flow from operating  activities**                                              |       |                                                                               |       |   |   |   |   |
| Net loss                                                                              |       | $                                                                                  | (3,000,088 | ) | $ | (550,117 | ) | $ | (3,550,205 | ) |
| **Adjustments  to reconcile net loss to cash used in operating activities:**          |       |                                                                               |       |   |   |   |   |
| Derivative and warrant fair value adjustments                                         |       | —                                                                             |       | 20,089 |   | 20,089 |   |
| Depreciation                                                                          |       | 38,819                                                                             |       | — |   | 38,819 |   |
| Amortization                                                                          |       |                                                                               |       |   |   |   |   |
| Discounts on convertible debt related to warrants  and beneficial conversion features |       | 415,634                                                                            |       | 530,028 |   | 945,662 |   |
| Options and warrants issued for services and other                                    |       | 156,000                                                                            |       | — |   | 156,000 |   |
| **Change  in assets and liabilities:**                                                |       |                                                                               |       |   |   |   |   |
| Accounts receivable trade                                                             |       | (79,380                                                                            | )          | — |   | (79,380 | ) |
| Prepaid expenses and other                                                            |       | 8,714                                                                              |       | — |   | 8,714 |   |
| Accounts payable                                                                      |       | (134,776                                                                           | )          | — |   | (134,776 | ) |
| Accrued liabilities                                                                   |       | 536,425                                                                            |       | — |   | 536,425 |   |
| Deferred revenue                                                                      |       | 10,000                                                                             |       |   |   | 10,000 |   |
| Net cash used in operating activities                                                 |       | (2,048,652                                                                         | )          | — |   | (2,048,652 | ) |
|                                                                                  |       |                                                                               |       |   |   |   |   |
| **Cash flow from investing  activities**                                              |       |                                                                               |       |   |   |   |   |
| Net cash used in investing activities                                                 |       | (100,104                                                                           | )          | — |   | (100,104 | ) |
|                                                                                  |       |                                                                               |       |   |   |   |   |
| **Cash flow from financing  activities**                                              |       |                                                                               |       |   |   |   |   |
| Net cash provided by financing activities                                        |       | 2,190,782                                                                          |       | — |   | 2,190,782 |   |
|                                                                                  |       |                                                                               |       |   |   |   |   |
| **Net  increase in cash and equivalents**                                             |       | 42,026                                                                             |       | — |   | 42,026 |   |
| **Cash  and cash equivalents, beginning of period**                                   |       | 16,748                                                                             |       | — |   | 16,748 |   |
| **Cash and cash equivalents, end  of period**                                         |       | $                                                                                  | 58,774     |   | — |   | $ | 58,774 |   |
|                                                                                       |            |                                                                                    |            |  |  |  |  |  |  |  |

 

143

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The following tables summarize, for each of the quarters and for each ofthe interim balance sheet dates presented, the impact of each category ofadjustment on previously reported revenue, and assets, liabilities andaccumulated deficit.

**Impact of Adjustments on Revenuefor the three months ended (Unaudited)**
| ** **                  | ** ** | **3/31/2005** | ** ** | **6/30/2005** | ** ** | **9/30/2005** | ** ** | **12/31/05** | ** ** |
|-----------------------------|------------|---------------|------------|---------------|------------|---------------|------------|--------------|------------|
| **As  previously reported** |       | $             | 3,900,391  |          | $          | 3,664,532     |       | $            | 3,202,601  |   | $ | 3,368,481 |   |
| Revenue  recognition        |       | 39,200        |       | 21,020        |       | 29,870        |       | —       |       |
| **As restated**             |       | $             | 3,939,591  |          | $          | 3,685,552     |       | $            | 3,232,471  |   | $ | 3,368,481 |   |

 
| ** **                  | ** ** | **3/31/2004** | ** ** | **6/30/2004** | ** ** | **9/30/2004** | ** ** | **12/31/2004** | ** ** |
|-----------------------------|------------|---------------|------------|---------------|------------|---------------|------------|----------------|------------|
| **As  previously reported** |       | $             | 311,886    |          | $          | 519,114       |       | $              | 308,818    |   | $ | 4,418,413 |   |
| Revenue  recognition        |       | (35,215       | )          | (92,780       | )          | (43,415       | )          | 334,130        |       |
| **As restated**             |       | $             | 276,671    |          | $          | 426,334       |       | $              | 265,403    |   | $ | 4,752,543 |   |

 
| ** **                  | ** ** | **3/31/2003** | ** ** | **6/30/2003** | ** ** | **9/30/2003** | ** ** | **12/31/2003** | ** ** |
|-----------------------------|------------|---------------|------------|---------------|------------|---------------|------------|----------------|------------|
| **As  previously reported** |       | $             | 27,504     |          | $          | 13,020        |       | $              | 146,987    |   | $ | 336,590 |   |
| Revenue  recognition        |       | —        |       | —        |       | —        |       | (308,620       | )          |
| **As restated**             |       | $             | 27,504     |          | $          | 13,020        |       | $              | 146,987    |   | $ | 27,970 |   |

 

144

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** **

**Impact of Adjustments on Consolidated Balance SheetAccounts (Unaudited)**
| ** **                                        | ** ** | **As of March 31, 2005** | ** ** | **As of March 31, 2004** | ** ** |
|---------------------------------------------------|------------|----------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                        | ** ** | **Total  Assets**                            | ** ** | **Liabilities**                              | ** ** | **Stockholders’  Equity  (Deficit)** | ** ** | **Total  Assets** | ** ** | **Total  Liabilities** | ** ** | **Stockholders’  Equity  (Deficit)** | ** ** |
| **As  previously reported**                       |       | $                                            | 29,701,319 |                                         | $          | 19,112,933 |   | $ | 10,588,386 |   | $ | 17,739,752 |   | $ | 1,752,518 |   | $ | 15,987,234 |   |
| Revenue  recognition and related SG&A expense |       | (82,890                                      | )          | 23,810                                       |       | (106,700 | ) | (399,645 | ) | (79,260 | ) | (320,385 | ) |
| Debt financing                                    |       | 706,729                                      |       | 2,420,547                                    |       | (1,713,818 | ) |   |   | — |   | — |   |
| Total  Adjustments                                |       | 623,839                                      |       | 2,444,357                                    |       | (1,820,518 | ) | (399,645 | ) | (79,260 | ) | (320,385 | ) |
| **As restated**                                   |       | $                                            | 30,325,158 |                                         | $          | 21,557,290 |   | $ | 8,767,868 |   | $ | 17,340,107 |   | $ | 1,673,259 |   | $ | 15,666,848 |   |

 
| ** **                                        | ** ** | **As of March 31, 2003** | ** ** |
|---------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                        | ** ** | **Total**                                    | ** ** | ** ** | ** ** | **Stockholders’  Equity** | ** ** |
| ** **                                        | ** ** | **Assets**                                   | ** ** | **Liabilities** | ** ** | **(Deficit)** | ** ** |
| **As  previously reported**                       |       | $                                            | 527,361    |   | $ | 8,603,694 |   | $ | (8,076,333 | ) |
| Revenue  recognition and related SG&A expense |       | —                                       |       | — |   | — |   |
| Debt financing                                    |       | —                                       |       | 238,866 |   | (238,866 | ) |
| Total  Adjustments                                |       | —                                       |       | 238,866 |   | (238,866 | ) |
| **As restated**                                   |       | $                                            | 527,361    |   | $ | 8,842,560 |   | $ | (8,315,199 | ) |

 

145

----

**Impact of Adjustments on Consolidated Balance SheetAccounts (Unaudited)**
| ** **                                        | ** ** | **As of June 30, 2005** | ** ** | **As of June 30, 2004** | ** ** |
|---------------------------------------------------|------------|---------------------------------------------|------------|----------------------------------------|------------|
| ** **                                        | ** ** | **Total  Assets**                           | ** ** | **Liabilities**                        | ** ** | **Stockholders’  Equity  (Deficit)** | ** ** | **Total  Assets** | ** ** | **Total  Liabilities** | ** ** | **Stockholders’  Equity  (Deficit)** | ** ** |
| **As  previously reported**                       |       | $                                           | 29,967,389 |                                   | $          | 20,543,833 |   | $ | 9,423,556 |   | $ | 16,062,934 |   | $ | 1,093,096 |   | $ | 14,969,838 |   |
| Revenue  recognition and related SG&A expense |       | (61,870                                     | )          | 23,810                                 |       | (85,680 | ) | (412,805 | ) | (2,140 | ) | (410,665 | ) |
| Debt financing                                    |       | 722,266                                     |       | 2,064,204                              |       | (1,341,937 | ) | — |   | — |   | — |   |
| Total  Adjustments                                |       | 660,396                                     |       | 2,088,014                              |       | (1,427,617 | ) | (412,805 | ) | (2,140 | ) | (410,665 | ) |
| **As restated**                                   |       | $                                           | 30,627,785 |                                   | $          | 22,631,847 |   | $ | 7,995,939 |   | $ | 15,650,129 |   | $ | 1,090,956 |   | $ | 14,559,173 |   |

 
| ** **                                             | ** ** | **As of June 30, 2003** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                             | ** ** | ** **                                  | ** ** | ** ** | ** ** | **Stockholders’** | ** ** |
| ** **                                             | ** ** | **Total**                                   | ** ** | ** ** | ** ** | **Equity** | ** ** |
| ** **                                             | ** ** | **Assets**                                  | ** ** | **Liabilities** | ** ** | **(Deficit)** | ** ** |
| **As  previously reported**                            |       | $                                           | 485,789    |   | $ | 9,577,608 |   | $ | (9,091,819 | ) |
| Revenue  recognition and related SG&A expense      |       | —                                      |       | — |   | — |   |
| Debt financing                                         |       | —                                      |       | 393,330 |   | (393,330 | ) |
| Total  Adjustments       |       | —                                      |       | 393,330 |   | (393,330 | ) |
| **As restated**                                        |       | $                                           | 485,789    |   | $ | 9,970,938 |   | $ | (9,485,149 | ) |

 

146

----

** **

**Impact of Adjustments on Consolidated Balance SheetAccounts (Unaudited)**
| ** **                                        | ** ** | **As of September 30, 2005** | ** ** | **As of September 30, 2004** | ** ** |
|---------------------------------------------------|------------|--------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                        | ** ** | **Total  Assets**                                | ** ** | **Liabilities**                             | ** ** | **Stockholders’  Equity  (Deficit)** | ** ** | **Total  Assets** | ** ** | **Total  Liabilities** | ** ** | **Stockholders’  Equity  (Deficit)** | ** ** |
| **As  previously reported**                       |       | $                                                | 28,293,538 |                                        | $          | 20,844,695 |   | $ | 7,448,843 |   | $ | 34,634,140 |   | $ | 21,136,647 |   | $ | 13,497,493 |   |
| Revenue  recognition and related SG&A expense |       | —                                           |       | 23,810                                      |       | (23,810 | ) | (364,220 | ) | (7,140 | ) | (357,080 | ) |
| Debt financing                                    |       | 838,343                                          |       | (91,976                                     | )          | 930,319 |   | 976,201 |   | 283,460 |   | 692,741 |   |
| Total  Adjustments                                |       | 838,343                                          |       | (68,166                                     | )          | 906,509 |   | 611,981 |   | 276,320 |   | 335,661 |   |
| **As restated**                                   |       | $                                                | 29,131,881 |                                        | $          | 20,776,529 |   | $ | 8,355,352 |   | $ | 35,246,121 |   | $ | 21,412,967 |   | $ | 13,833,154 |   |

 
| ** **                                        | ** ** | **As of September 30, 2003** | ** ** |
|---------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                        | ** ** | **Total  Assets**                                | ** ** | **Liabilities** | ** ** | **Stockholders’  Equity  (Deficit)** | ** ** |
| **As  previously reported**                       |       | $                                                | 507,611    |   | $ | 10,452,746 |   | $ | (9,945,135 | ) |
| Revenue  recognition and related SG&A expense |       | —                                           |       | — |   | — |   |
| Debt financing                                    |       | —                                           |       | 550,117 |   | (550,117 | ) |
| Total  Adjustments                                |       | —                                           |       | 550,117 |   | (550,117 | ) |
| **As restated**                                   |       | $                                                | 507,611    |   | $ | 11,002,863 |   | $ | (10,495,252 | ) |

 

147

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**SIGNATURES**

Pursuant to the requirements of Section 13 or 15(d) ofthe Securities Exchange Act of 1934, the Registrant has duly caused this reportto be signed on its behalf by the undersigned, thereunto duly authorized.
|                               |   | BIO-KEY INTERNATIONAL, INC. |
|-------------------------------|--------|----------------------------------|
|                          |   |                             |   |   |
| Date: June 19, 2006 |   | By:                              |   | /s/  MICHAEL W. DEPASQUALE |
|                          |   |                             |   | Michael W. DePasquale |
|                          |   |                             |   | Co-CHIEF EXECUTIVE OFFICER |

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, this report has been signed below by the followingpersons on behalf of the Registrant and in the capacities on the datesindicated.
| Signature                             | ** ** | **Title**                                              | ** ** | **Date**                |
|---------------------------------------|------------|--------------------------------------------------------|------------|-------------------------|
|                                  |       |                                                   |       |                    |
| /s/  MICHAEL  W. DEPASQUALE |       | Co-Chief Executive Officer and Director                |       | June 19, 2006 |
| Michael W.  DePasquale                |       |                                                   |       |                    |
|                                  |       |                                                   |       |                    |
| /s/  FRANCIS  J. CUSICK     |       | Chief Financial Officer, Principal Accounting  Officer |       | June 19, 2006 |
| Francis J.  Cusick                    |       |                                                   |       |                    |
|                                  |       |                                                   |       |                    |
| /s/  THOMAS  J. COLATOSTI   |       | Co-Chief Executive Officer and Chairman of the         |       | June 19, 2006 |
| Thomas J.  Colatosti                  |       | Board of Directors                                     |       |                    |
|                                  |       |                                                   |       |                    |
| /s/  JEFFREY  J. MAY        |       | Director                                               |       | June 19, 2006 |
| Jeffrey J. May                        |       |                                                   |       |                    |
|                                  |       |                                                   |       |                    |
| /s/  CHARLES  P. ROMEO      |       | Director                                               |       | June 19, 2006 |
| Charles P. Romeo                      |       |                                                   |       |                    |
|                                  |       |                                                   |       |                    |
| /s/  JOHN  SCHOENHERR       |       | Director                                               |       | June 19, 2006 |
| John Schoenherr                       |       |                                                   |       |                    |

 

148

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**EXHIBIT INDEX**
| Exhibit No. | ** ** | **Description**                                                                                                                                                                                                                              |
|------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2.1(1)           |       | Agreement and Plan of Merger dated as of  March 30, 2004 by and among BIO-key International, Inc., BIO-key  Acquisition Corp., Public Safety Group, Inc. (“PSG”) and each of the  shareholders of PSG               |
| 2.2(2)           |       | Asset Purchase Agreement dated as of August 16,  2004 by and among BIO-key International, Inc., Aether  Systems, Inc., Cerulean Technologies, Inc. and SunPro, Inc.                                                 |
| 2.3(3)           |       | Agreement and Plan of Merger dated as of  December 30, 2004 by and among BIO-key International, Inc., a  Delaware corporation, and BIO-key International, Inc., a Minnesota  corporation                                      |
| 3.1(3)           |       | Certificate of Incorporation of BIO-key  International, Inc., a Delaware corporation                                                                                                                                                    |
| 3.2(3)           |       | Certificate of Designation of Series A 7%  Convertible Preferred Stock of BIO-key International, Inc., a Delaware  corporation                                                                                                     |
| 3.3(3)           |       | By-Laws of BIO-key International, Inc., a  Delaware corporation                                                                                                                                                                         |
| 3.4 (19)         |       | Certificate of Amendment of Certificate of  Incorporation of BIO-key International, Inc., a Delaware corporation                                                                                                                        |
| 3.5 (16)         |       | Certificate of Designation of the Series B  Convertible Preferred Stock of the Company                                                                                                                                                  |
| 4.1(4)           |       | Specimen certificates for shares of BIO-key  International, Inc. common stock                                                                                                                                                           |
| 10.1(4)          |       | SAC Technologies, Inc. 1996 Stock Option Plan                                                                                                                                                                                           |
| 10.2(5)          |       | Amendment No. 1 to the SAC  Technologies, Inc. 1996 Stock Option Plan                                                                                                                                                              |
| 10.3(5)          |       | SAC Technologies, Inc. 1999 Stock Option Plan                                                                                                                                                                                           |
| 10.4(6)          |       | Warrant issued to The Shaar Fund Ltd.                                                                                                                                                                                                        |
| 10.5(6)          |       | Security Interest Provisions                                                                                                                                                                                                                 |
| 10.6(6)          |       | Employment Agreement by and between BIO-key  International, Inc. and Mira LaCous dated November 20, 2001                                                                                                                           |
| 10.7(6)          |       | Option to Purchase 140,000 Shares of Common Stock  issued to Mira LaCous                                                                                                                                                                     |
| 10.8(9)          |       | Option to Purchase 150,000 Shares of Common Stock  issued to Thomas J. Colatosti                                                                                                                                                             |
| 10.9(9)          |       | Non-Qualified Stock Option Agreement under the  registrant’s 1999 Stock Incentive Plan to Purchase 200,000 Shares of Common  Stock issued to Thomas J. Colatosti                                                                        |
| 10.10(9)         |       | Employment Agreement by and between BIO-key  International, Inc. and Michael W. DePasquale dated January 3, 2003                                                                                                                   |
| 10.11(9)         |       | Option to Purchase 580,000 Shares of Common Stock  issued to Michael W. DePasquale                                                                                                                                                           |
| 10.12(9)         |       | Note Purchase Agreement dated January 27, 2003                                                                                                                                                                                          |
| 10.13(9)         |       | Secured Convertible Promissory due June 30,  2004                                                                                                                                                                                       |
| 10.14(9)         |       | Option to Purchase 200,000 Shares of Common Stock  issued to Charles P. Romeo                                                                                                                                                                |
| 10.15(7)         |       | Amendment No. 1 to Note Purchase Agreement  dated October 31, 2003 by and between BIO-key International, Inc.  and The Shaar Fund Ltd.                                                                                        |
| 10.16(7)         |       | Securities Exchange Agreement dated March 3,  2004 by and between BIO-key International, Inc. and The Shaar Fund Ltd.                                                                                                              |
| 10.17(7)         |       | Registration Rights Agreement dated March 3,  2004 by and between BIO-key International, Inc. and The Shaar Fund Ltd.                                                                                                              |
| 10.18(7)         |       | Secured Convertible Promissory Note due  October 31, 2005 in the principal amount of up to $2,125,000                                                                                                                                   |
| 10.19(7)         |       | Secured Convertible Promissory Note due  October 31, 2005 in the principal amount of up to $375,000                                                                                                                                     |
| 10.20(7)         |       | Option to Purchase 500,000 Shares of Common Stock  issued to Michael W. DePasquale                                                                                                                                                           |
| 10.21(7)         |       | Option to Purchase 150,000 Shares of Common Stock  issued to Thomas J. Colatosti                                                                                                                                                             |
| 10.22(7)         |       | Option to Purchase 50,000 Shares of Common Stock  issued to Thomas J. Colatosti                                                                                                                                                              |
| 10.23(7)         |       | Option to Purchase 50,000 Shares of Common Stock  issued to Jeff May                                                                                                                                                                         |
| 10.24(7)         |       | Option to Purchase 50,000 Shares of Common Stock  issued to Charles Romeo                                                                                                                                                                    |
| 10.25(7)         |       | Option to Purchase 300,000 Shares of Common Stock  issued to Randy Fodero                                                                                                                                                                    |
| 10.26(10)        |       | Amendment Agreement dated March 30, 2004 by and  between BIO-key International, Inc. and The Shaar Fund Ltd.                                                                                                                       |
| 10.27(11)        |       | Securities Purchase Agreement dated as of  March 31, 2004 (the “March Securities Purchase Agreement”) by and  among BIO-key International, Inc. and each of the Purchasers named  therein                           |
| 10.28(11)        |       | Form of Warrant issued by BIO-key  International, Inc. pursuant to the March Securities Purchase  Agreement                                                                                                                   |
| 10.29(2)         |       | Securities Purchase Agreement dated as of  September 29, 2004 (the “Laurus Securities Purchase Agreement”) by and  between BIO-key International, Inc., Laurus Master Fund, Ltd. and the  other Purchasers party thereto |
| 10.30(2)         |       | Form of Secured Convertible Term Note issued by  BIO-key International, Inc. pursuant to the Laurus Securities Purchase  Agreement                                                                                                 |
| 10.31(2)         |       | Form of Common Stock Purchase Warrant issued by  BIO-key International, Inc. pursuant to the Laurus Securities Purchase  Agreement                                                                                                 |
| 10.32(2)         |       | Master Security Agreement dated as of  September 29, 2004 by and between BIO-key International, Inc.,  Public Safety Group, Inc. and Laurus Master Fund, Ltd., as Collateral  Agent                                           |
| 10.33(2)         |       | Subsidiary Guaranty dated as of September 29,  2004 made by Public Safety Group, Inc. in favor of Laurus Master Fund,  Ltd. and the other Purchasers party thereto                                                                 |
| 10.34(2)         |       | Stock Pledge Agreement dated as of September 29,  2004 by and between BIO-key International, Inc. and Laurus Master Fund,  Ltd. and the other Purchasers party thereto                                                             |
| 10.35(2)         |       | Registration Rights Agreement dated as of  September 29, 2004 by and between BIO-key International, Inc.,  Laurus Master Fund, Ltd. and the other Purchasers party thereto                                                         |
| 10.36(2)         |       | Securities Purchase Agreement dated as of  September 29, 2004 (the “Shaar Securities Purchase Agreement”) by and  between BIO-key International, Inc., The Shaar Fund, Ltd. and the other  Purchasers party thereto      |
| 10.37(2)         |       | Form of Convertible Term Note issued by BIO-key  International, Inc. pursuant to the Shaar Securities Purchase Agreement                                                                                                           |
| 10.38(2)         |       | Form of Common Stock Purchase Warrant issued by  BIO-key International, Inc. pursuant to the Shaar Securities Purchase  Agreement                                                                                                  |

 

149

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| 10.39(2)  |   | Registration Rights Agreement dated as of  September 29, 2004 by and between BIO-key International, Inc., The  Shaar Fund, Ltd. and the other Purchasers party thereto                                                                                                                       |
|-----------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.40(2)  |   | Intercreditor Agreement dated as of  September 30, 2004 by and among Laurus Master Fund, Ltd., individually  and as Collateral Agent, Aether Systems, Inc., Public Safety  Group, Inc. and BIO-key International, Inc.                                                             |
| 10.41(2)  |   | Subordination and Intercreditor Agreement dated as of  September 30, 2004 by and among Laurus Master Fund, Ltd., as Collateral  Agent, The Shaar Fund, Ltd., as Purchaser Agent, Aether Systems, Inc.,  Public Safety Group, Inc. and BIO-key International, Inc.                  |
| 10.42(2)  |   | Subordinated Secured Promissory Note dated  September 30, 2004 issued by BIO-key International, Inc. and Public  Safety Group, Inc. in favor of Aether Systems, Inc.                                                                                                               |
| 10.45(12) |   | Option to Purchase 300,000 shares of common stock  issued to Kenneth Souza                                                                                                                                                                                                                             |
| 10.46(12) |   | Employment Agreement dated as of October 4,  2004 by and between BIO-key International, Inc. and Kenneth Souza                                                                                                                                                                               |
| 10.47(12) |   | Option to Purchase 50,000 shares of common stock  issued to Richard Gaddy                                                                                                                                                                                                                              |
| 10.48(12) |   | BIO-key International, Inc. 2004 Stock  Incentive Plan                                                                                                                                                                                                                                            |
| 10.49(12) |   | Warrant to purchase 10,000 shares of Common Stock  issued to Krieger & Prager LLP on November 26, 2001                                                                                                                                                                                   |
| 10.50(12) |   | Warrant to purchase 100,000 shares of Common Stock  issued to The November Group Ltd. on July 14, 2004                                                                                                                                                                                       |
| 10.51(12) |   | Warrant to purchase 230,000 shares of Common Stock  issued to Jesup & Lamont Securities Corp. on March 31, 2004                                                                                                                                                                          |
| 10.52(12) |   | Warrant to purchase 105,000 shares of Common Stock  issued to Douglass Bermingham on March 31, 2004                                                                                                                                                                                               |
| 10.53(12) |   | Warrant to purchase 60,000 shares of Common Stock  issued to Mason Sexton on March 31, 2004                                                                                                                                                                                                       |
| 10.54(12) |   | Warrant to purchase 22,000 shares of Common Stock  issued to David Moss on March 31, 2004                                                                                                                                                                                                         |
| 10.55(12) |   | Warrant to purchase 22,000 shares of Common Stock  issued to Patrick Gaynes on March 31, 2004                                                                                                                                                                                                     |
| 10.56(12) |   | Warrant to purchase 5,000 shares of Common Stock  issued to Tom DuHamel on March 31, 2004                                                                                                                                                                                                         |
| 10.57(13) |   | Option to Purchase 155,000 shares of common stock  issued to Francis J Cusick                                                                                                                                                                                                                          |
| 10.58(13) |   | Option to Purchase 50,000 shares of common stock  issued to Charles P. Romeo                                                                                                                                                                                                                           |
| 10.59(14) |   | Securities Purchase Agreement, dated as of  June 8, 2005, by and between the Company and Laurus Fund, Ltd.                                                                                                                                                                                        |
| 10.60(14) |   | Common Stock Purchase Warrant issued pursuant to the  Securities Purchase Agreement, dated as of June 8, 2005, by and between  the Company and the Laurus Master Fund, Ltd.                                                                                                                       |
| 10.61(14) |   | Secured Convertible Term Note issued pursuant to the  Securities Purchase Agreement, dated as of June 8, 2005, by and between  the Company and Laurus Master Fund, Ltd.                                                                                                                           |
| 10.62(14) |   | Registration Rights Agreement, dated as of  June 8, 2005, by and between the Company and Laurus Fund, Ltd.                                                                                                                                                                                        |
| 10.63(14) |   | Securities Purchase Agreement, effective as of  May 31, 2005, by and among the Company, The Shaar Fund, Ltd. and the  other pursuant that are a party thereto                                                                                                                                     |
| 10.64(14) |   | Form of Common Stock Purchase warrant issued  pursuant to the Securities Purchase Agreement, effective as of May 31,  2005, by and among the Company, The Shaar Fund, Ltd. and the other purchasers  that are a party thereto                                                                |
| 10.65(14) |   | Form of Convertible Term Note issued pursuant  to the Securities Purchase Agreement, effective as of May 31, 2005, by  and among the Company, The Shaar Fund, Ltd. and the other purchasers that are  a party thereto                                                                        |
| 10.66(14) |   | Registration Rights Agreement, effective as of  May 31, 2005, by and among the Company, The Shaar Fund, Ltd.,  Jesup & Lamont and the other purchasers that are a party thereto                                                                                                          |
| 10.67(15) |   | Amendment and Waiver, dated as of August 31,  2005, by and between the Company and Laurus Master Fund, Ltd.                                                                                                                                                                                       |
| 10.68(15) |   | Amendment and Waiver, dated as of August 31,  2005, by and between the Company and The Shaar Fund, Ltd.                                                                                                                                                                                           |
| 10.69(15) |   | Amendment and Waiver, dated as of August 31,  2005, by and between the Company and Longview Special Finance                                                                                                                                                                                       |
| 10.70(15) |   | Amendment and Waiver, dated as of August 31,  2005, by and between the Company and Etienne Des Roys                                                                                                                                                                                               |
| 10.71(15) |   | Amendment and Waiver, dated as of August 31,  2005, by and between the Company and Eric Haber                                                                                                                                                                                                     |
| 10.72(15) |   | Amendment and Waiver, dated as of August 31,  2005, by and between the Company and Investors Management Corporation                                                                                                                                                                               |
| 10.73(15) |   | Amendment and Waiver, dated as of August 31,  2005, by and between the Company and The Tocqueville Fund                                                                                                                                                                                           |
| 10.74(15) |   | Amendment and Waiver, dated as of August 31,  2005, by and between the Company and The Tocqueville Amerique Value Fund                                                                                                                                                                            |
| 10.75(15) |   | Registration Rights Agreement, dated as of  August 31, 2005, by and among the Company, Laurus Master Fund, Ltd., The  Shaar Fund, Ltd., Longview Special Finance, Etienne Des Roys, Eric Haber,  Investors Management Corporation, The Tocqueville Fund and The Tocqueville  Amerique Value Fund. |
| 10.76(16) |   | Amendment and Waiver, dated as of January 23,  2006, by and between the Company and Laurus Master Fund, Ltd.                                                                                                                                                                                      |
| 10.77(16) |   | Registration Rights Agreement, dated as of January 23,  2006, by and between the Company and Laurus Master Fund, Ltd.                                                                                                                                                                             |
| 10.78(16) |   | Amendment and Waiver, dated as of January 23,  2006, by and among the Company and the holders of Subordinated Convertible  Promissory Notes of the Company                                                                                                                                        |
| 10.79(16) |   | Securities Purchase Agreement, dated as of  January 23, 2006, by and among the Company, The Shaar Fund Ltd.,  Longview Fund, L.P. and Longview Special Finance                                                                                                                                    |
| 10.80(16) |   | Form of Convertible Term Note issued pursuant  to the Securities Purchase Agreement, dated as of January 23, 2006, by  and among the Company, The Shaar Fund Ltd., Longview Fund, L.P. and Longview  Special Finance                                                                         |
| 10.81(16) |   | Form of Common Stock Purchase Warrant issued  pursuant to the Securities Purchase Agreement, dated as of January 23,  2006, by and among the Company, The Shaar Fund Ltd., Longview Fund, L.P. and  Longview Special Finance                                                                 |
| 10.82(16) |   | Registration Rights Agreement, dated as of  January 23, 2006 by and among the Company, The Shaar Fund, Ltd.,  Longview Fund, L.P. and Longview Special Finance                                                                                                                                    |
| 10.83(16) |   | Amendment No. 1 to Subordinated Secured  Promissory Note, dated as of January 23, 2006, by and between the  Company and Aether Systems, Inc.                                                                                                                                            |
| 10.84(17) |   | Compensation Agreement by and between the Company  and Thomas J. Colatosti dated February 7, 2006                                                                                                                                                                                                 |
| 10.85(18) |   | Employment Agreement by and between the Company and  Michael DePasquale dated March 28, 2006                                                                                                                                                                                                      |
| 10.86(20) |   | Form of Option Agreement used to grant a total  of 400,000 options to Purchase common stock to Francis J. Cusick, Michael W.  DePasquale, Randy Fodero, and Kenneth S. Saiza                                                                                                                      |
| 21.1(12)  |   | List of subsidiaries of BIO-key  International, Inc.                                                                                                                                                                                                                                              |
| 23.1(8)   |   | Consent of DS&B, Ltd.                                                                                                                                                                                                                                                                              |
| 31.1(8)   |   | Certificate of CO-CEO of Registrant required under  Rule 13a-14(a) under the Securities Exchange Act of 1934, as  amended                                                                                                                                                                    |
| 31.2(8)   |   | Certificate of CO-CEO of Registrant required under  Rule 13a-14(a) under the Securities Exchange Act of 1934, as  amended                                                                                                                                                                    |
| 31.3(8)   |   | Certificate of CFO of Registrant required under  Rule 13a-14(a) under the Securities Exchange Act of 1934, as  amended                                                                                                                                                                       |
| 32.1(8)   |   | Certificate of CO -CEO of Registrant required under  18 U.S.C. Section 1350, as amended                                                                                                                                                                                                      |
| 32.2(8)   |   | Certificate of CO -CEO of Registrant required under 18 U.S.C.  Section 1350, as amended                                                                                                                                                                                                      |
| 32.3(8)   |   | Certificate of CFO of Registrant required under 18 U.S.C.  Section 1350, as amended                                                                                                                                                                                                          |

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(1)           Filed as an exhibit to theregistrant’s current report on Form 8-K filed with the Securitiesand Exchange Commission on April 14, 2004 and incorporated herein byreference.

(2)           Filed as an exhibit to theregistrant’s current report on Form 8-K filed with the Securitiesand Exchange Commission on October 5, 2004 and incorporated herein byreference.

(3)           Filed as an exhibit to theregistrant’s current report on Form 8-K filed with the Securitiesand Exchange Commission on January 5, 2005 and incorporated herein byreference.

(4)           Filed as an exhibit to theregistrant’s registration statement on Form SB-2, File No. 333-16451dated February 14, 1997 and incorporated herein by reference.

150

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(5)           Filed as an exhibit to the registrant’sannual report on Form 10-KSB filed with the Securities and ExchangeCommission on April 14, 2000 and incorporated herein by reference.

(6)           Filed as an exhibit to theregistrant’s current report on Form 8-K filed with the Securitiesand Exchange Commission on November 26, 2001 and incorporated herein byreference.

(7)           Filed as an exhibit to theregistrant’s annual report on Form 10-KSB filed with the Securitiesand Exchange Commission on March 26, 2004 and incorporated herein byreference.

(8)           Filed herewith.

(9)           Filed as an exhibit to theregistrant’s annual report on Form 10-KSB filed with the Securitiesand Exchange Commission on March 31, 2003 and incorporated herein byreference.

(10)         Filed as an exhibit to theregistrant’s registration statement on Form SB-2, File No. 333-115037dated April 30, 2004 and incorporated herein by reference.

(11)         Filed as an exhibit to theregistrant’s current report on Form 8-K filed with the Securitiesand Exchange Commission on April 5, 2004 and incorporated herein byreference.

(12)         Filed as an exhibit to theregistrant’s registration statement on Form SB-2, File No. 333-120104dated October 29, 2004 and incorporated herein by reference.

(13)         Filed as an exhibit to theregistrant’s current report on Form 8-K filed with the Securitiesand Exchange Commission on March 4, 2005 and incorporated herein byreference.

(14)         Filed as an exhibit to theregistrant’s current report on Form 8-K filed with the Securitiesand Exchange Commission on June 14, 2005 and incorporated herein byreference.

(15)         Filed as an exhibit to theregistrant’s current report on Form 8-K filed with the Securitiesand Exchange Commission on September 7, 2005 and incorporated herein byreference.

(16)         Filed as an exhibit to theregistrant’s current report on Form 8-K filed with the Securitiesand Exchange Commission on January 25, 2006 and incorporated herein byreference.

(17)         Filed as an exhibit to theregistrant’s current report on Form 8-K filed with the Securitiesand Exchange Commission on February 9, 2006 and incorporated herein byreference.

(18)         Filed as an exhibit to theregistrant’s current report on Form 8-K filed with the Securitiesand Exchange Commission on March 29, 2006 and incorporated herein byreference.

(19)         Filed as an exhibit to the registrant’sproxy statement filed with the Securities and Exchange Commission on January 18,2006 and incorporated herein by reference.

(20)         Filed as an exhibit to theregistrant’s annual report on Form 10-KSB filed with the Securitiesand Exchange Commission on March 29, 2006 and incorporated herein byreference.

151

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