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

**WASHINGTON, D.C. 20549**

 

**FORM 10-KSB**

 

**AnnualReport Pursuant to Section 13 or 15(d)**

**ofthe Securities Exchange Act of 1934**

**Forthe Fiscal Year Ended December 31, 2005**

 

**Commission File Number 1-13463**

 

**BIO-KEYINTERNATIONAL, INC.**

(Name of small business issuer 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, NJ07719**

(Address of Principal Executive Offices) (Zip Code)

 

**(732) 359-1100**

Issuer’s telephone number, including area code.

 

Securities registered pursuant to Section 12(b) ofthe 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 file reports pursuant to Section13 or 15(d) of the Exchange Act.  o

 

Check whether the issuer (1) filedall reports required to be filed by Section 13 or 15(d) of theExchange Act during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days. Yes ý    No o

 

Check if there is nodisclosure of delinquent filers in response to Item 405 of Regulation S-Bcontained in this form, and no disclosure will be contained, to the best ofregistrants knowledge, in definitive proxy or information statements incorporatedby reference in Part III of this Form 10-KSB or any amendment to thisform 10-KSB. ý

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).

Yes o   No ý

 

State issuer’s revenues forits most recent fiscal year: $14,226,095

 

The aggregate market valueof the voting and non-voting common equity held by non-affiliates of theregistrant based on the closing sale price of the registrant’ common stock asreported on the OTC Bulletin Board on March 15, 2006 was $23,132,637. Theinformation provided shall in no way be construed as an admission that anyperson whose holdings are excluded from the figure is an affiliate or that anyperson whose holdings are included in the figure is not an affiliate, and any suchadmission is hereby disclaimed. The information provided is solely for therecord keeping purposes of the Securities and Exchange Commission.

 

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

 

Transitional Small BusinessDisclosure Formats (check one):

 

Yes o   No ý

 

 

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**DOCUMENTS INCORPORATED 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                                                                                               | 40     |
| Item 8        | Changes in and Disagreements with  Accountants on Accounting and Financial Disclosure                              | 41     |
| Item 8A  | Controls and Procedures                                                                                            | 41     |
| Item 8B  | Other Information                                                                                                  | 41     |
|          |                                                                                                               |   |
|          | PART  III                                                                                                          |   |
|          |                                                                                                               |   |
| Item 9        | Directors, Executive Officers, Promoters  and Control Persons;   Compliance with Section 16(a) of the Exchange Act | 42     |
| Item 10       | Executive Compensation                                                                                             | 44     |
| Item 11       | Security Ownership of Certain Beneficial  Owners and Management and Related Stockholder Matters                    | 47     |
| Item 12       | Certain Relationships and Related  Transactions                                                                    | 49     |
| Item 13       | Exhibits                                                                                                           | 50     |
| Item 14       | Principal Accountant Fees and Services                                                                             | 50     |
|          | Signatures                                                                                                         | 142    |

 

 

 

**PRIVATE SECURITIES LITIGATION REFORM ACT**

 

All statements other thanstatements of historical facts contained in this Annual Report on Form 10-KSB,including statements regarding our future financial position, business strategyand plans and objectives of management for future operations, areforward-looking statements. The words “anticipate,” “believe,” “estimate,” “will,”“may,” “future,” “plan,” “intend” and “expect” and similar expressionsgenerally identify forward-looking statements. Although we believe our plans,intentions and expectations reflected in the forward-looking statements arereasonable, we cannot be sure they will be achieved. Actual results may differmaterially from the forward-looking statements contained herein due to a numberof 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.

 

**PART I**

 

### **ITEM1. DESCRIPTION OF BUSINESS**

### ** **

BIO-key International, Inc.,a Delaware corporation (“the Company,” “BIO-key,” “we,” or “us), was founded in1993 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.

 

 OnSeptember 30, 2004, BIO-key completed a transaction with Aether Systems, Inc.to purchase its Mobil Government Division (“Mobile Government” or “AMG”), aleading provider of wireless data solutions for use by public safetyorganizations, primarily state, local police, fire and rescue and emergencymedical services organizations. The PacketCluster mobile information softwareis integrated with 50 separate State/NCIC databases, as well as other state,local and federal databases. Its open architecture and its publishedApplication Programming Interface (API) make it easy to interface with a widerange of information sources. PacketCluster products deliver real-timeinformation in seconds, freeing dispatchers to handle more pressingemergencies.

 

EffectiveJanuary 1, 2005, BIO-key International, Inc., a Minnesota corporation(“Old BIO-key”), reincorporated in the State of Delware. The reincorporationwas effected pursuant to an Agreement and Plan of Merger (the “Merger Agreement”)whereby Old BIO-key was merged with and into the Company, its wholly ownedsubsidiary, in order to reincorporate in the State of Delaware (the “Reincorporation”).As a result of the Reincorporation, the legal domicile of the Company is nowDelaware.

 

Pursuantto the Merger Agreement, 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 and conditionsas 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

share equal to the exerciseprice per share thereunder immediately before the Reincorporation; and (iv) eachwarrant, option or stock option plan of Old BIO-key was assumed by, andcontinues to be, a warrant, option or plan of the Company. Accordingly, as aresult of the Reincorporation, the shareholders of Old BIO-key becameshareholders of the Company, and Old BIO-key has been merged out of existenceby operation of law. Each certificate representing shares of capital stock ofOld BIO-key outstanding immediately before the Reincorporation, is deemed fromand after the Reincorporation for all corporate purposes to represent the samenumber of shares of capital stock of the Company.

 

Asa result of the recent mergers, and as discussed in Note M to theConsolidated Financial Statements, we have organized BIO-key International, Inc.into three reporting segments: Law Enforcement, Fire Safety and Biometrics.During 2005, the Company continued to integrate the products, operations andtechnologies acquired from Public Safety Group, Inc. and Aether Systems, Inc.

 

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**Products**

 

BIO-key®operates in three major segments—biometrics, law enforcement and fire safety.These segments are described below and a list of products in each line isnoted.

 

*Biometrics*

 

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

 

•                  **Vector Segment TechnologySDK (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’s biometric identification solutionthat offers large scale one to many user lookup with nothing but a singlefingerprint. This solution leverages the power of Oracle for large scalesolutions in the millions of users, or uses smaller databases for more modestapplications to 100,000 users.

 

•                  **WEB-key**®—BIO-key’s biometric platform thatoffers an enhanced level of security by securing the user’s authentication withtrusted communications and simple use. WEB-key runs on Windows or Linuxsystems.

 

•                  **Biometric Service ProviderTM**—BIO-key provides support for the BioAPI (astandards based solution meeting worldwide needs, see *www.bioapi.org*for details) for acompliant interface to applications using biometrics for verification andidentification. BIO-key enhances the traditional use of the BioAPI by addingsupport for CE devices, supporting identification calls and also providing asingle user interface for multiple fingerprint readers.

 

•                  **ID Director**TM—BIO-key’s solution for single sign onintegration with Computer Associates SiteMinder, Oracle’s Fusion MiddlewareSSO, and other solutions, utilizing the power and security of WEB-key. Thissolution provides a simple to implement, custom authentication scheme forcompanies looking to enhance authentication and add a level of security andaudit through re-authentication of a user at the transaction level.

 

TheCompany’s biometric identification technology improves both the accuracy andspeed of finger-based biometrics. The Company’s proprietary biometrictechnology scans a fingerprint and identifies a person, typically within a fewseconds or less, in databases of a million people or more. BIO-key canaccomplish this without using any other identifying data—a key differentiatorfor BIO-key since other biometric solutions may also require traditionaltoken/card identification. BIO-key’s core technology supports user enrollmenton over 40 different commercially available readers and in turn can offercompatibility among those readers through a single fingerprint template. Wehave also added INCITS 378-2004 support to our software development kits whichmakes our products compatible with all of the Registered Traveler projects, PIVinitiatives, and FIXS consortium solutions. We believe our fingerprintidentification technology has a broad range of possible information securityand access control applications, including:

 

•                  Securing Internet sites and electronictransactions

 

•                  Securing access to logical networks andapplications

 

•                  Securing access to buildings and restrictedareas

 

•                  Providing fast, accurate memberidentification services

 

•                  Securing mobile devices such as cell phonesand PDA’s

 

•                  Preventing identity theft with positiveidentification and false alias validation

 

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*Law Enforcement*

 

•                  **MobileCopTM**— A complete wireless query and messaging application that puts the powerof mobile and wireless technology to work for agencies of every size,MobileCopTM sets the standard for mobile law enforcement. Providing real-timeretrieval of motor vehicle, warrant and criminal history information, powerfulmobile integration capabilities, and an intuitive user interface, MobileCopdelivers the most in performance and it’s easy to see why over 1,200 lawenforcement agencies around the country have deployed MobileCop for fast andsecure access to critical information in the field.

 

•                  **PocketCop®**— PocketCop® is a softwaresolution that provides police officers and other security personnel instantaneousaccess to important criminal, civil, and private database information in awireless environment. PocketCop® is a handheld application that allows lawenforcement officers to access state and federal databases over the wirelessnetwork for Palm OS, Windows CE, and Pocket PC. Using a portable wirelesshandheld device and the PocketCop® application software, an authorized user canaccess suspect information such as wanted status, warrant status, vehicleregistration and driver license status. PocketCop® technology has been deployedin numerous police departments in the United States, including the deploymentfor the Massachusetts State Police.

 

•                  **IdentityMatchTM-**a web-based system thatallows law enforcement agencies to capture and store fingerprints online and toidentify subjects by matching their fingerprint against those stored in thedatabase, securely and in real time. Fingerprints can be captured using a livescan device 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 Enforcement products.These include:

 

•                  **Field Interview TrackerTM -**enables personnel to capture field contactinformation. The data is stored in a searchable database where it can belocated quickly. Police agencies can create online contact forms that meettheir specific needs and multiple agencies can share information while usingtheir own forms and procedures.

 

•                  **TStopTM -**was developed to enable law enforcementagencies to comply with state mandated and voluntary traffic stop reporting.Law enforcement 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 ApplicationProgramming 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’s PDonScene, this solution isused by both patrol and tactical teams, such as a SWAT, to manage people andresources at the scene of an incident or at a central location such as anemergency operations center. It can also be used for general event management.

 

•                  **InfoServerTM  -**BIO-key’s solution for an agency’s central messaging switch forapplication software service, State/NCIC interfaces, Computer Aided Dispatch(CAD) and Records Management Software (RMS) interfaces, data sharing and otherapplications.

 

*Fire Safety*

 

Inaddition to law enforcement/fire service mobile data solutions, BIO-key offersits Sunpro fire service/EMS records management software, FireRMSTM, that helpslarge and small agencies manage operations, track incidents and support fireprevention initiatives. FireRMS Mobile provides wireless query and messagingsolutions that extend computer aided dispatch, fire records, and other in-housedata sources to a mobile environment and provide mission-critical informationto emergency response personnel where and when they need it.

 

•                  **PacketCluster® RescueTM**—BIO-key’s mobile information solution forfire and EMS, runs off the same server as MobileCopTM. It provides much ofMobileCopTM****functionality withoutthe State/NCIC interface not required by fire service and EMS. Rescueprovides mission-critical data such as HAZMAT information and building plansthat fire service officers need to know while at a fire scene.

 

3

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•                  **FireRMS Records ManagementSoftware**— this NFIRS5.0-compliant fire records system helps manage operations, track incidents andsupport fire prevention initiatives. It is designed to speed data entry andreduce completion time for front-line personnel.

 

•                  **CAD Interfaces**—CAD interfaces provide a connection betweenBIO-key records and all major CAD systems with the most comprehensive real timeintegration. Incident reports are opened as soon as CAD dispatches a call.Incidents are current and ready to complete when the crew returns to thestation, streamlining and improving the accuracy of incident reporting.

 

•                  **RMS Interfaces**—RMS interfaces provide a mechanism tointegrate patient care reports collected in the field with the NIBRS report.Patient data is populated in the appropriate fields, eliminating redundant dataentry.

 

•                  **Other Interfaces**—BIO-key provides interfaces to other thirdparty solutions including EMS billing, EMS county/state interfaces,professional staffing solutions and others.

 

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

 

•                  **EMS Field Data Collection**—Regist*r Express from MedDataSolutionsenables EMS field data collection for efficient collection of patent data whereit is generated.

 

•                  **Geographic Data Analysis**—FireViewTM from the Omega Group allows Fireand EMS agencies to analyze their deployment strategies.

 

•                  **Personnel Staffing**—TelestaffTM from PDSI automates and managescomplex Fire/RMS agency staffing needs and is integrated with FireRMS’sPersonnel and Roster modules.

 

•                  **Incident Command Module**—FDonSceneTM by FieldSoft provides incidentmanagement, responder accountability, and tactical survey or preplan browsersoftware solutions. FDonScene interfaces with PacketCluster Rescue to supportincident management-en route or on scene.

 

**CurrentBusiness Plan**

 

BIO-key’s current businessplan is to:

 

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

 

•                  **License WEB-key®,** the Company’s security centricweb-based biometric authentication solution.

 

•                  **Provide for “deviceindependent” finger identification matching**for virtually any application by using the latest advances in scanningtechnology.

 

•                  **License its wirelesssoftware solutions for the public safety market**directly to counties, cities and towns acrossNorth America as well as through systems integrators and resellers.

 

•                  **Leverage its FireRMS suite ofproducts**for the growingEmergency Medical Service data collection and reporting market.

 

•                  **Integrate its coretechnology competencies**toleverage new business opportunities and develop new markets for its innovativeproducts.

 

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**Markets**

 

*LawEnforcement*

BIO-key’s InfoServerTM, MobileCopTM and PocketCop® LawEnforcement products are the leading wireless mobile data communicationsclient/server solution, implemented in more than 1,200 agencies nationwide.Providing immediate access to mission-critical data and enabling in-fieldreporting, BIO-key software keeps officers on the street, improving theirproductivity and enhances officer safety. BIO-key solutions are able to runacross any and all wireless infrastructures and integrate with virtually allcomputer-aided dispatch (CAD) and records management systems. This makes us aproven leader in multi-agency cooperation and interoperability, which areabsolutely critical in times of large-scale natural and terrorist threats.

 

•         *Growth potential*—BIO-key’s large base of more than 1,200 lawenforcement agencies continues to be a strength that helps leverage additionalsales from both existing customers and new customers. A key opportunity is thegrowing awareness of the need for multi-agency interoperability. In thesesituations, 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.

 

These capabilities position BIO-key well to workwith leading CAD vendors, even with vendors that have mobile data solutions butdo not have the depth of interoperability capability that BIO-key offers.

 

An additional growth area is the introduction ofBIO-key’s finger-based biometric identification to law enforcement. In additionto now offering biometric login to  ourtraditional 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’sunderstanding of law enforcement requirements and its fingerprint technology,present opportunities for the law enforcement business segment in the comingyear.

 

*Fire Safety*

BIO-key’s FireRMS fire records management software is a flexiblesolution available for Fire Service and EMS**agencies. Itis a comprehensive collection of modules that manage a range of activities fromdaily scheduling to vehicle maintenance. FireRMS streamlines data collectionacross all areas of department operations, and integrates with other departmentsystems to provide a seamless solution for data access, whether in the stationor on the scene of an incident. In addition to helping first respondersefficiently deliver traditional fire safety and services and respond to massiveemergency situations, it enables adherence to NFIRS, NEMSIS, HIPAA, and ISOrequirements. The solutions also bring the station into the field with mobiledata communications solutions, and most recently, FireRMS Mobile, which bringsthe capabilities of FireRMS to first responders where and when they most needto report and access critical information.

 

•        *Growth potential*—agrowth opportunity for the fire business segment is in the mobile market withthe RMS mobile products. BIO-key’s FireRMS Mobile solutions extend the power ofour FireRMS product to the field. Inspectors, for example, can now perform occupancyinspections over a wireless or synched connection using a pen tablet. Thisapproach eliminates redundant data entry, and provides immediate updates ofcritical information and notification of violations. Likewise, EMS workers cancollect critical patient data and relay the data to medical personnel. This newmobile approach to fire and EMS data collection and access offers greatpotential among both new and existing FireRMS customers.

 

*Finger-based Biometric Identification*

Finally, BIO-key is a leader in finger-based biometric identification.In partnerships with OEMs, integrators, and solution providers, we providebiometric software solutions to private and public sector customers. BIO-key’spatented vector segment technology is the foundation for these solutions.

 

5

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BIO-key’s WEB-key ®is a cost-effective, easy-to-deploy, fingerprint-based strongauthentication system. This unique solution allows users to positively identifythemselves to any application with the simple scan of their finger. Thiscapability is a significant improvement in both convenience and security overother alternatives and provides companies with a cost-effective solution tothwart phishing attacks and comply with government regulations and legislationsuch as FFIEC compliance, HIPAA, Sarbanes-Oxley, and the Electronic SignaturesAct. BIO-key couples these capabilities with device interoperability andsystem flexibility and scalability. BIO-key enables the use of about 40different fingerprint sensor technologies to enroll and identify employees,customers or business partners. Most recently, BIO-key integrated its biometriccapabilities with its public safety mission with the introduction of IdentityMatchTM, a real-time,in-station solution that allows law enforcement professionals to capturefingerprints from a suspect or captured from a crime scene and compare them tofingerprints. BIO-key has also formed relationships with providers of biometriclogon software 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.

 

For example, BIO-key has implemented programs thatwill enable biometric access. These include a national pilot with a largefitness center chain to provide finger-based membership and access to itslocations around the country; with IdentiPHI to provide strong network basedauthentication on BIO-key technology; and with the Pegasus Program to authenticateusers accessing a nationwide information-sharing system designed by andfor the nation’s sheriffs. These represent the kind of partnership-basedopportunities BIO-key may see in the finger-based biometric market.

 

In parallel, BIO-key is both strengthening securityand improving user and system administrator convenience by integratingbiometric log-in, as well as two-factor authentication, with its lawenforcement and fire safety products. This is a true differentiator topotential new customers, and creates add-on opportunities with existingcustomers.

 

**Competition**

 

Themarkets for BIO-key products and technologies are developing and arecharacterized by intense competition and rapid technological change. Noassurance can be given that our competitors will not develop new or enhancedtechnologies that will offer superior price, performance, or features, orrender BIO-key products or technologies obsolete.

 

*Biometrics*

 

Inaddition to companies that provide existing commonplace methods of restrictingaccess to facilities 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, andBioscrypt.

 

Themost recent automated fingerprint identification product sales in the markethave been deployed for government and law enforcement applications, typicallyat more cost 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-keyhas found that commercial markets have been slow to widely purchase biometricsas a viable alternative to their current security methods. As a result, theprimary competition for biometric technology consists of traditional securitymethods such as passwords, PINs, cards, and tokens.

 

Withrespect to competing biometrics technologies, each has its strength andweaknesses and none has emerged as a market leader:

 

•                  *Fingerprint identification*is generally viewed as inexpensive andnon-intrusive.

 

•                  *Iris scanning*is viewed as accurate, but can be expensiveand inconvenient to use.

 

•                  *Facial recognition*has recently received substantial attention;however, it can have accuracy limitations and be highly dependent on ambientlighting conditions, angle of view and other factors.

 

Themarket for biometric technology is evolving. Computer breaches, identity theft,phishing and 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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## ***Law Enforcement***

## *** ***

Thepublic safety market comprises agencies at all government levels, with a rangeof users, from a few to many hundreds. BIO-key competitors in the mobile datamarket include Computer Aided Dispatch/Records Management companies such asPrintrak, InfoCop and Motorola. Each has comprehensive CAD and/or RMS offeringsand has augmented those with their own mobile data and field reportingsolutions. While these solutions may not be as functionally rich as theBIO-key suite of products, they are sometimes less expensive. They also providea complete solution from one vendor.

 

*FireSafety*

 

Thefire records management market includes a large number of RMS vendors includingFirehouse, FDM and ETI. These and other competing companies represent a widerange of organizations, from large integration companies, to small garagecompanies, and offer products similar in scope to BIO-key’s FireRMS. Thefunctionality and price of these products also encompass wide ranges offeatures and costs.

 

**Marketingand Distribution**

 

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

 

•                  During the past year, BIO-key hasstrengthened its alliance with Oracle and has been recognized as a CertifiedPartner in the Oracle Partner Network. BIO-key supports the Oracle e-business suite ofapplications and provides the biometric enabler for the Oracle Single Sign onproduct. As an Oracle development partner, BIO-key provides the underlyingdatabase used for true user identification and on demand alias checking. As adevelopment partner, BIO-key participates in Oracle Trade Shows such as OracleOpen World and Oracle Apps World.

 

•                  BIO-key has strategic alliances withtechnology leaders including Oracle, Netegrity, Hewlett Packard, Dell, Verizon,Sprint/Nextel, Cingular and others.

 

•                  BIO-key is also promoting biometrictechnology and its offerings through industry trade shows, public speakingengagements, press activities and partner marketing programs

 

•                  BIO-key is directing licensing efforts tooriginal equipment manufacturers, application developers and systemintegrators.

 

•                  BIO-key is building a reseller, integratorand partner network as well as a direct sales team.

 

Followingare the specific marketing/sales programs in place:

 

•                  *Direct Selling Efforts*— BIO-key now has a base of area salesdirectors who are responsible for both the law enforcement and fire safetymarkets. This team of sales professionals brings extensive experience intechnical solution and relationship-based selling. They are supported by apre-sales team that includes system engineering and proposal management and apost-sales program management, implementation and training professionals.Included in this team are individuals who are themselves former police officersand firefighters.

 

BIO-key’s direct sales force also includesarea sales directors for the OEM and Federal Government markets, each of whombrings not only extensive sales experience but also expertise in emergingbiometric technologies. The BIO-key sales force is rounded out by Inside Sales,which is responsible for maintaining and supporting our existing install base,acting as a front-line support for any inquiries on our product line, andfacilitating activities that make the field team more productive.

 

•                  *Conferences and Trade Shows*— BIO-key attends andactively participates in various product-related conferences and trade shows inthe technology and security industries to generate market awareness ofbiometric and wireless mobile data technology generally and our offeringsspecifically. BIO-key’s public safety software often is featured at ourbusiness partners’ booths at these events, showcasing the interoperability ofthe two products.

 

•                  *Strategic Alliance*— BIO-key’s strategic alliances andreseller agreements with other vendors play a significant role in our overallsales efforts. In the past year, BIO-key has initiated and bolstered numerousimportant and promising long-term relationships. Just a few examples 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  help review existing deployment policies anddevelop new strategies, to complement BIO-key’s range of solutions for Fire/EMSagencies.

•         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 MarketingAlliance—*BIO-key hasestablished a strategic marketing alliance with Hewlett Packard to provideBIO-key handheld technology for the Massachusetts State Police.

 

•                  *Reseller Relationships*—BIO-key has established resellerrelationships with companies that resell BIO-key public safety software.

 

**Licensing**

 

BIO-keytargets both Internet infrastructure companies and large portal providers aspossible licensees 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-keyis also addressing the security needs of application providers in the followingvertical markets:

 

•                  *Government*—Using BIO-key’s technology, Northup Grummandeployed an application within the Department of Defense to cross-credentialvisitors and contractors to certain military bases.

 

•                  *Education*—Educational Biometric Technologies, LunchByte Systems and Identimetrics have incorporated BIO-key technology to enableschool children to pay for school lunch programs and checkout library booksusing their fingerprints. VST technology enables schools to enroll thesechildren and reduces the administrative costs of managing passwords andcollecting payments.

 

•                  *Commerce:*ChoicePoint has implemented a check cashingsolution using BIO-key’s VST technology to reduce fraud and identity theft.

 

•                  *Patient Records andInformation 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 several companiesfocusing on financial applications such as point of sale systems and employeetrusted identification cards, as well as customer facing applications over theInternet. BIO-key has also begun work with several financial institutions toincorporate its technology for secure access to money transfers for institutionalcustomers.

 

**IntellectualProperty Rights**

 

Webelieve that our intellectual property is important to our biometric, lawenforcement and fire 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—We have 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”.

 

Copyrightsand trade secrets—We take measures to ensure copyright and license protectionfor our 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 and development efforts are concentrated on enhancing thefunctionality, reliability and integration of our current products as well asdeveloping new and innovative products for the biometrics, law enforcement andfire markets. Although BIO-key believes that its identificationtechnology is one of the most advanced and discriminating fingerprinttechnologies available today, the markets in which BIO-key compete arecharacterized by rapid technological change and evolving standards. In order tomaintain its position in the market, BIO-key will continue to upgrade andrefine its existing technologies.

 

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In 2005, BIO-keyannounced the launch of IdentityMatch, our fingerprint identification system. IdentityMatchoffers a tool for agencies to store and search fingerprints and the associateddemographic data, the ability to compare new prints with those previouslycaptured as a low-cost AFIS alternative or to be used for a wide variety ofroutine identification transactions not supported by AFIS. IdentityMatchTM iscurrently being tested by a number of customers.

 

Duringfiscal years 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-keyis not currently subject to direct regulation by any government agency, otherthan regulations generally applicable to businesses or related to specificproject requirements. In the event of any international sales, the companywould be subject to various domestic and foreign laws regulating such exportsand export activities.

 

**EnvironmentalRegulations**

 

Asof the date of this report, BIO-key has not incurred any material expensesrelating to our compliance with federal, state, or local environmental laws anddoes not expect to incur any material expenses in the foreseeable future.

 

**Employeesand Consultants**

 

BIO-keycurrently employs 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) insales and marketing. BIO-key also uses the services of ten (10) consultantswho provide 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 significantrevenue since inception and recurring losses from operations, our auditors haveincluded an explanatory paragraph in their opinion as to the substantial doubtabout our ability to continue as a going concern.**

 

Dueto, among other factors, our history of losses (excluding gains from valuationchanges in embedded derivatives) and limited revenue, our independent auditorshave included 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.

 

**Since our formation, we have historically generated minimalrevenue and have sustained substantial operating losses.**

 

Asof December 31, 2005, we had negative working capital of approximately $3,600,000and an accumulated deficit of approximately $42,226,000. Since our inception,we have focused almost exclusively on developing our core technologies and,until the fourth quarter of 2004 have not generated any significant revenue. Inorder to increase revenue, we have developed a direct sales force andanticipate the need to retain additional sales, marketing and technical supportpersonnel and may need to incur substantial expenses. We cannot assure youthat we will be able to secure these necessary resources, that a significantmarket for our technologies will develop or that we will be able to achieve ourtargeted revenue.

 

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**We have identified material weaknesses in our internalcontrol over financial reporting and have failed to maintain an effectivesystem of disclosure controls and procedures. If we are unable to successfullyaddress such material weaknesses or if we continue to maintain an ineffectivesystem of disclosure controls and procedures, we may not be able toaccurately report our financial results or prevent fraud. As a result, currentand potential stockholders could lose confidence in our financial reporting;this would harm our business and the trading price of our common stock.**

 

Aftera review of our March 31, 2005, June 30, 2005 and September 30,2005 quarterly operating results, as well as our 2005 annual operating results,conducted pursuant to Rule 13a-15 under the Securities Exchange Act of1934, as amended (the “Exchange Act”), our Co-Chief Executive Officers and ourChief 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-KSB forthe fiscal year ended December 31, 2005 as being inadequate to providesuch assistance.

 

Inaddition, our independent auditors, DS&B, Ltd., notified the AuditCommittee of our Board of Directors on April 18, 2005 that they believedthere were reportable conditions during 2004 and 2005 which constituted amaterial weakness in our internal controls. These weaknesses concerneddeficiencies in the design and implementation of our internal controls and thefact that, due to two recent acquisitions, we were not staffed properly in ouraccounting and reporting department and may not have had appropriateaccounting and reporting software. For these reasons, we were not able to meetour schedule for preparing our audit and for filing our annual report on Form 10-KSBfor the fiscal year ended December 31, 2004 in a timely manner.

 

Effectiveinternal control over financial reporting and disclosure controls andprocedures are necessary for us to provide reliable financial reports and effectivelyprevent fraud and to operate successfully as a public company. We have in thepast discovered, as described above, and may in the future discover, areasof our 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 operating resultswould be harmed.

 

We cannot be certain that our efforts toimprove the material weaknesses in our internal control over financialreporting and the ineffectiveness of our disclosure controls and procedureswill be successful or that we will be able to maintain adequate controls overour financial processes and reporting in the future. We will need to commitsubstantial resources, including substantial time from our management team’saccounting personnel and from external consultants, to implement and integrateinto our organization improved disclosure controls and additional proceduresgenerally and to improve systems to report financial information on a timelybasis. Any failure or delay to develop or maintain effective controls, ordifficulties encountered in their implementation or in other effectiveimprovement of our internal and disclosure controls could materially harm ouroperating results or cause us to fail to meet our reporting obligations. If weare unable to adequately establish or improve our internal controls overfinancial reporting, our external auditors may not be able to issue anunqualified opinion on the effectiveness of our internal controls. Ineffectiveinternal and disclosure controls could also cause investors to lose confidencein our reported financial information, which would likely have a significantnegative effect on the trading price of our securities.

 

**Our****biometric****technology has yet to gainwidespread market acceptance and we do not know how large of a market willdevelop for our technology.**

 

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 biometricsgenerally, it remains an undeveloped, evolving market. Biometric basedsolutions compete with more traditional security methods including keys, cards,personal identification numbers and security personnel. Acceptance ofbiometrics as an alternative to such traditional methods depends upon a numberof factors including:

 

•                  the reliability of biometric solutions

 

•                  public perception regarding privacy concerns

 

•                  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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**Biometric technology is a new approach to Internet security****which****must be accepted in orderfor our WEB-key**® **solution to generate significant revenue.**

 

OurWEB-key ® authenticationinitiative represents a new approach to Internet security which has beenadopted on a limited basis by companies which distribute goods, content orsoftware applications 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 outweigh implementationcosts, our solution will not gain market acceptance.

 

**Our software products may contain defects which willmake it more difficult for us to establish and maintain customers.**

 

Althoughwe have completed the development of our core biometric technology, it has onlybeen used 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 ourtechnology or require design modifications. These could adversely affect ourcompetitive position and cause us to lose potential customers or opportunities.Since our technologies are intended to be utilized to secure physical andelectronic access, the effect of any such bugs or delays will likely have adetrimental impact on us. In addition, given that biometric technologygenerally, and our biometric technology specifically, has yet to gainwidespread acceptance in the market, any delays would likely have a moredetrimental impact on our business than if we were a more established company.

 

Whilewe have commenced a significant sales and marketing effort, we have only begunto develop a significant distribution channel and may not have theresources or ability to sustain these efforts or generate any meaningful sales.

 

**In order to generate revenue from our biometric products, weare dependent upon independent original equipment manufacturers, systemintegrators and application developers, which we do not control. As a result,it may be more difficult to generate sales.**

 

Wemarket our technology through licensing arrangements with:

 

•                  Original equipment manufacturers, systemintegrators and application developers which develop and market products andapplications which can then be sold to end users

 

•                  Companies which distribute goods, services orsoftware applications over the Internet

 

Asa technology licensing company, our success will depend upon the ability ofthese manufacturers 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 orapplications acceptable to end users or generate any meaningful revenue for us.These third parties may also offer the products of our competitors to endusers.

 

**We derive nearly all of our revenue from governmentcontracts, which are often non-standard, involve competitive bidding, may besubject to cancellation with or without penalty and may produce volatilityin earnings and revenue.**

 

Mostof our business involves providing products and services under contracts withU.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:

 

•                  include provisions that allow the governmentagency to terminate the contract without penalty under some circumstances;

 

•                  be subject to purchasing decisions ofagencies that are subject to political influence;

 

•                  contain onerous procurement procedures; and

 

•                  be subject to cancellation if governmentfunding 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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**We face intense competition and may not have thefinancial and human resources necessary to keep up with rapid technologicalchanges, which may result in our technology becoming obsolete.**

 

TheInternet, facility access control and information security markets are subjectto rapid technological change and intense competition. We compete with bothestablished biometric companies and a significant number of startup enterprisesas well as providers of more traditional methods of access control. Most of ourcompetitors have substantially greater financial and marketing resources thanwe do and may independently develop superior technologies, which may resultin our technology becoming less competitive or obsolete. We may not beable to keep pace with this change. If we are unable to develop newapplications or enhance our existing technology in a timely manner in responseto technological changes, we will be unable to compete in our chosen markets.In addition, if one or more other biometric technologies such as voice, face,iris, hand geometry or blood vessel recognition are widely adopted, it wouldsignificantly reduce the potential market for our fingerprint identificationtechnology.

 

**We depend on key employees and members of our managementteam, including our Chairman of the Board and Co-Chief Executive Officer, inorder to achieve our goals. We cannot assure you that we will be able to retainor attract such persons.**

 

Aloss of our current Chairman of the Board of Directors or Co-Chief ExecutiveOfficer could severely and negatively impact our operations. We have had anemployment contract with Michael W. DePasquale, our Co-Chief Executive Officerthrough March 28, 2008. Although the contract does not prevent him fromresigning, it does contain confidentiality and non-compete clauses which areintended to prevent him from working for a competitor within one year afterleaving our Company. Our success depends on our ability to attract, train andretain employees with expertise in developing, marketing and selling softwaresolutions. In order to successfully market our technology, we will need toretain additional engineering, technical support and marketing personnel. Themarket for such persons remains highly competitive and our limited financialresources will make it more difficult for us to recruit and retain qualifiedpersons.

 

**We can not assure you that the limited intellectual propertyprotection for our core technology provides a meaningful competitive advantageor barrier to entry against our competitors.**

 

Oursuccess and ability to compete is dependent in part upon proprietaryrights to our technology. We rely primarily on a combination of patent,copyright and trademark laws, trade secrets and technical measures to protectour propriety rights. We have filed a patent application relating to both theoptic technology and biometrics solution components of our technology whereinseveral claims have been allowed. In May 2005, the U.S. Patent Officeissued us a patent for our Vector Segment fingerprint technology (VST), BIO-key’score biometric analysis and identification technology. We cannot assure youthat any additional patents will be issued that we will have the resources toprotect any patent from infringement. Although we believe our technology doesnot currently infringe upon patents held by others, we can not assure you thatsuch infringements do not exist or will not exist in the future, particularlyas the number of products and competitors in the biometric industry segmentgrows.

 

**We may need to obtain additional financing to executeour business plan, which may not be available. If we are unable to raiseadditional capital or generate significant revenue, we may not be able tocontinue operations.**

 

Sinceour inception, we have not generated any significant revenue (other thanrevenue from acquired businesses) and have experienced substantial losses,including approximately $11,499,000 during 2005, excluding the impact relatedto embedded derivatives. In March 2004, we completed a private placementequity offering that resulted in approximately $12,000,000 in gross proceeds tothe 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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**We may not be able to successfully complete theintegration of PSG and AMG into our operations.**

 

Theintegration of PSG and AMG into our operations involves a number of risks,including:

 

•                  difficulty integrating operations andpersonnel;

 

•                  diversion of management attention;

 

•                  potential disruption of ongoing business;

 

•                  inability to retain key personnel;

 

•                  inability to successfully incorporate theacquired products and services into our product and service offerings and todevelop new products and services; and

 

•                  impairment of relationships with employees,customers or vendors.

 

Failureto overcome these risks or any other problems encountered in connection withthe acquisitions of PSG and AMG could slow our growth or lower the quality ofour services, which could reduce customer demand. The result could be amaterial adverse effect on our financial position and results of operations.

 

**We may not achieve profitability with respect to the lawenforcement and public safety components of our business if we are unable tomaintain, improve and develop the wireless data services we offer.**

 

Webelieve that our future business prospects depend in part on our abilityto maintain and improve our current services and to develop new ones on atimely basis. Our services will have to achieve market acceptance, maintaintechnological competitiveness and meet an expanding range of customerrequirements. As a result of the complexities inherent in our serviceofferings, major new wireless data services and service enhancements requirelong development and testing periods. We may experience difficulties thatcould delay or prevent the successful development, introduction or marketing ofnew services and service enhancements. Additionally, our new services andservice enhancements may not achieve market acceptance. If we cannoteffectively develop and improve services we may not be able to recover ourfixed costs or otherwise become profitable.

 

**Our law enforcement and public safety division depends uponwireless networks owned and controlled by others.**

 

Ifwe do not have continued access to sufficient capacity on reliable networks, wemay be unable to deliver services and our sales could decrease. Ourability to grow and achieve profitability partly depends on our ability to buysufficient capacity on the networks of wireless carriers such as VerizonWireless, Bell South Corporation, Metrocall, Motient and AT&T Wireless andon the reliability and security of their systems. All of our services aredelivered using airtime purchased from third parties. We depend on thesecompanies to provide uninterrupted and bug free service and would not be ableto satisfy our customers’ needs if they failed to provide the required capacityor needed level 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 wireless carriersare, or could become, our competitors and if they compete with us they may refuseto provide us with their services.

 

**New laws and regulations that impact our law enforcement andpublic safety division could increase our costs or reduce our opportunities toearn revenue.**

 

Weare not currently subject to direct regulation by the Federal CommunicationsCommission or any other governmental agency, other than regulations applicableto businesses 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.

 

**If we fail to adequately manage our resources, it could havea severe negative impact on our financial results or stock price.**

 

Wecould be subject to fluctuations in technology spending by existing andpotential customers. Accordingly, we will have to actively manage expenses in arapidly changing 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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**We granted a blanket security interest in all of our assetsto the holders of our secured debt. If we are unable to make our requiredmonthly payments on such debt, or any other event of default occurs, it couldhave a material adverse effect on our business and operations, and the debtholders may foreclose on our assets.**

 

Aspart of our secured convertible debt financing transactions, we granted toLaurus Master 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.

 

Thecash required to pay such accelerated amounts on the secured notes following anevent of default would most likely come out of our working capital. As we relyon our working capital for our day to day operations, such a default could havea material 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; stockholders may notreceive any proceeds from disposition of our assets and may lose theirentire investment in our stock.

 

**Our obligations under our debt securities may adverselyaffect our ability to enter into potential significant transactions with otherparties.**

 

Asa result of our debt financing transactions with Laurus Master Fund, Ltd.,the Shaar Fund, Ltd. and other institutional and accredited investors, weincurred significant repayment obligations, and we agreed to certainrestrictive covenants. In particular, for so long as 25% of the aggregateprincipal amount of the convertible term notes remains outstanding, we willneed the consent of the holders of such notes before we can take certainactions, including the following:

 

•                  pay any dividends;

 

•                  merge, effect a material reorganization,liquidate or dissolve;

 

•                  materially change the scope of our business;or

 

•                  create, incur or assume any debt (other thancertain trade debt, equipment financings and debt for the purchase of assets inthe 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 ourassets, joint venture, or similar transaction), it is likely that we would haveto pay off such debt obligations and have the applicable security interestsreleased. Although we have the right at any time to prepay our debtobligations, we can only do so upon payment of either 110% or 120% of the thenprincipal balance, plus all other amounts owing under the notes. See the “LongTerm Obligations” footnote of this report. Based on an aggregate principalbalance of $11.3 million at December 31, 2005, a complete prepaymentwould require a cash payment of approximately $12.7 million. Theseprovisions could have the practical effect of increasing the costs of anypotential significant transaction, and restrict our ability to enter into anysuch transaction.

 

**Our obligations to the holders of our outstanding preferredstock may further affect our ability to enter into potential significanttransactions with other parties.**

 

Wewill need to obtain the consent of the holders of a majority of the thenoutstanding shares of our convertible preferred stock before we can takecertain actions, including the following:

 

•                  a sale or other disposition of any materialassets;

 

•                  an acquisition of a material amount ofassets;

 

•                  engaging in a merger, reorganization orconsolidation; or

 

•                  incur or guaranty any indebtedness in excessof $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**

 

**We have issued a substantial number of securities that areconvertible into shares of our common stock which will result in substantialdilution to the ownership interests of our existing shareholders.**

 

Asof March 15th, 2006, approximately 45,764,000 shares of ourcommon stock were reserved for issuance upon exercise or conversion of thefollowing securities:

 

•                  15,273,000 shares upon conversion of outstandingconvertible term notes;

 

•                  20,729,000 shares upon exercise ofoutstanding stock options and warrants;

 

•                  1,878,000 shares upon exercise of optionsavailable for future grant under our existing option plans; and

 

•                  7,884,000 shares or more upon conversion ofour outstanding shares of convertible preferred stock and cumulative dividends inarrears.

 

Theexercise or conversion of these securities will result in a significantincrease in the number of outstanding shares and substantially dilute the ownershipinterests of our existing shareholders.

 

**A substantial number of our convertible securities areconvertible into shares of common stock at a conversion price of $.70 pershare. Most of these shares are eligible for public resale. The trading priceof our common stock and our ability to raise additional financing may beadversely affected by the influx into the market of such a substantial numberof shares.**

 

Ouroutstanding Series A Convertible Preferred Stock and cumulative dividendsin arrears are convertible into 7,287,987 shares of common stock as of December 31,2005 at a per share conversion price of $.70. Although many of the sharesissuable upon conversion of our Series A Convertible Preferred Stock areeligible 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 A Convertible Preferred Shares to suchlower price. This would require us to issue additional shares upon conversionof our Series A 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.

 

InJanuary 2006, the Company issued Convertible Term Notes in the aggregateprincipal amount of $1,000,000 to certain investors. The Convertible Notes areconvertible into 1,000,000 shares of Series B Convertible Preferred Stockof the Company, which shares are convertible into shares of the Common Stock ofthe Company at an initial fixed conversion of $0.70 per share for an aggregateamount of 1,428,571 shares. Although many of the shares issuable uponconversion of our Series B Convertible Preferred Stock are eligible forpublic resale under Securities Exchange Commission Rule 144, we have agreedto file a registration statement to cover the public resale of all ofthese shares. This significant increase in the number of shares available forpublic sale may have a negative impact on the trading price of our sharesand substantially dilute the ownership interests of our existing shareholders.In the event that our stock trades below $.70 per share, in order to raiseadditional financing we would likely be required to issue additional shares ofcommon stock or securities convertible into common stock at a purchase orconversion price, as applicable, of less than $.70 per share. Any issuance ofshares at a purchase price of less than $.70 per share would reduce theconversion 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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**Applicable SEC Rules governing the trading of “pennystocks” limits the trading and liquidity of our common stock, which may affectthe trading price of our common stock.**

 

Ourcommon stock currently trades on the OTC Bulletin Board. Since our common stockcontinues to trade below $5.00 per share, our common stock is considered a “pennystock” and is subject to SEC rules and regulations, which imposelimitations upon the manner in which our shares can be publicly traded. Theseregulations require the delivery, prior to any transaction involving a pennystock, of a disclosure schedule explaining the penny stock market and theassociated risks. Under these regulations, certain brokers who recommend suchsecurities to persons other than established customers or certain accreditedinvestors must make a special written suitability determination regarding sucha purchaser and receive such purchaser’s written agreement to a transactionprior to sale. These regulations have the effect of limiting the tradingactivity of our common stock and reducing the liquidity of an investment in ourcommon stock.

 

**We do not intend to pay dividends in the foreseeable future.**

 

Wehave never declared or paid a dividend on our common stock. In addition, theterms of our outstanding Convertible Preferred Shares preclude us fromdeclaring or paying a dividend on our common stock unless a dividend is alsodeclared or paid, as applicable, on our Convertible Preferred Shares. We intendto retain earnings, if any, for use in the operation and expansion of ourbusiness and, therefore, do not anticipate paying any dividends on our commonstock in the foreseeable future.

 

**The trading price of our common stock may be volatile.**

 

Thetrading price of our shares has from time to time fluctuated widely and in thefuture may 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. In recentyears broad stock market indices, in general, and the securities of technologycompanies, in particular, have experienced substantial price fluctuations. Suchbroad market fluctuations may adversely affect the future-trading price ofour common stock.

 

**ITEM 2. DESCRIPTION OF PROPERTY**

 

Wedo not own any real estate. We conduct operations from leased premises inMarlborough, Massachusetts (38,000 square feet), Eagan, Minnesota (6,800 squarefeet), Wall, New Jersey (2,180 square feet) and Winter Park, Florida (900square feet). We believe that our current facilities are adequate for theforeseeable future.

 

**ITEM 3.LEGAL PROCEEDINGS**

 

Priorto our acquisition of PSG in March 2004, PSG had been named as a defendantin a civil 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 OF MATTERS TO A VOTE OF SECURITY HOLDERS**

 

Nomatters were submitted to a vote of security holders in the fourth quarter of2005.

 

16

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**PART II**

 

**ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDERMATTERS**

 

Ourcommon stock currently trades on the OTC Bulletin Board under the symbol “BKYI”.The following table sets forth the range of high and low bid prices per shareof our common stock for each of the calendar quarters identified below asreported by the OTC Bulletin Board. These quotations represent inter-dealerprices, without retail mark-up,markdown or commission, 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, 2004  |       | $          | 1.40       |       | $          | 0.53 |   |
| Quarter  ended September 30, 2004 |       | .59        |       | 0.38       |       |
| Quarter  ended June 30, 2004      |       | .64        |       | 0.30       |       |
| Quarter  ended March 31, 2004     |       | .73        |       | 0.35       |       |
|                                        |            |            |            |            |            |  |  |

 

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

 

**Holders**

 

Asof March 15, 2006, the number of stockholders of record of our commonstock was 192. Based on broker inquiry conducted in connection with thedistribution of proxy solicitation materials in connection with the Company’sspecial meeting of shareholders in February 2005, we believe that thereare approximately 4,816 beneficial owners of our common stock.

 

**Dividends**

 

Wehave not paid any cash dividends to date, and have no intention of paying anycash dividends on our common stock in the foreseeable future. The terms of ouroutstanding Convertible Preferred Stock preclude us from declaring or paying adividend on our common stock unless a dividend is also declared or paid, asapplicable, on our Convertible Preferred Stock. The declaration and payment ofdividends is also subject to the discretion of our Board of Directors andcertain limitations imposed under the Delaware General Corporation Law. Thetiming, amount and form of dividends, if any, will depend on, among otherthings, our results of operations, financial condition, cash requirements andother factors 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 4,120,345 shares of common stockupon  conversion of $2,538,938 principalamount and $551,321 of accrued interest due under our Secured Convertible Notedated November 26, 2001. The shares were issued in a private placementtransaction exempt from the registration requirements of the Securities Actpursuant to Section 4(2) thereunder without payment of underwritingdiscounts or commission to any person.

 

(b)          On March 3, 2004, the Company issued65,000 shares of Series C convertible preferred stock to The ShaarFund Ltd. in exchange for the cancellation of $5,736,232 principal amountof outstanding convertible promissory notes and $763,768 of accrued interestdue thereunder. The Series C convertible preferred is convertible at theoption of the holder into common stock at a conversion price of $.75 per share,subject to certain anti-dilution adjustments. The securities were issued to oneaccredited investor in a private placement transaction exempt from theregistration requirements of the Securities Act pursuant to Section 4(2) thereunder,without payment of underwriting discounts or commissions to any person.

 

17

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(c)           On March 30, 2004, the Company issued5,257 shares of Series C convertible preferred stock to The Shaar Fund Ltd.in exchange for the cancellation of all of our issued and outstanding shares ofSeries B preferred stock. The Series C convertible preferred areconvertible 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.

 

(d)           On March 30, 2004, the Companyissued 18,275 shares of Series C convertible preferred stock to The ShaarFund Ltd. in exchange for the cancellation of $1,777,500 principal amountof outstanding convertible promissory notes and $49,963 of accrued interest duethereunder. The Series C convertible preferred are convertible at theoption of the holder into common stock at a conversion price of $.75 per share,subject to certain anti-dilution adjustments. The securities were issued to oneaccredited investor in a private placement transaction exempt from theregistration requirements of the Securities Act pursuant to Section 4(2) thereunder,without payment of underwriting discounts or commissions to any person.

 

(e)           On March 30, 2004, the Company issued anaggregate of 2,422,108 shares of common stock to ten (10) individuals andHarward Investments, Inc. in connection with the Company’s acquisition ofPublic 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 anaggregate of 8,888,928 shares of common stock and warrants to purchase4,444,464 shares of common stock to forty-nine (49) accredited investorsfor aggregate gross proceeds of approximately $12,000,000 in cash. 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.

 

(g)          On April 29, 2004, the Company issued3,750 shares of Series C convertible preferred stock to Thomas J.Colatosti in exchange for the cancellation of $375,000 principal amount ofoutstanding 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 Companyissued secured convertible term notes in the aggregate principal amount of$5,050,000 and warrants to purchase 1,122,222 shares of common stock at anexercise price of $1.35 per share to Laurus Master 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.

 

(i)              On September 29, 2004, the Companyissued secured convertible term notes in the aggregate principal amount of$4,950,000 and warrants to purchase 1,099,997 shares of common stock at anexercise price of $1.35 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.

 

(j)              In September 2004, the Company issuedconsultants warrants to purchase 620,667 shares of the Company’s common stockat an exercise price of $1.55 per share. The warrants have a term of five (5) yearsand vest immediately. 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.

 

(k)           On May 31, 2005, the Company issuedsecured convertible term notes in the aggregate principal amount of $2,794,723and warrants to purchase 828,066 shares of common stock at an exercise price of$1.50 per share to The Shaar Fund Ltd. and other institutional andaccredited investors. 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.

 

(l)              On June 8, 2005, the Company issuedsecured convertible term notes in the aggregate principal amount of $2,000,000and warrants to purchase 444,444 shares of common stock at an exercise price of$1.55 per share to Laurus Master Fund, Ltd. 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.

 

18

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(m)            On August 31, 2005, the Company enteredinto an Amendment and Waiver with Laurus Master Fund, Ltd.(“Laurus “) pursuantto which Laurus allowed the Company to defer certain payments of monthlyprincipal due under the Secured Convertible Term Note dated September 29,2004. The Company issued 612,166 shares of its Common Stock to Laurus asconsideration for this principal 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.

 

(n)              On August 31, 2005, the Company enteredinto an Amendment and Waiver with The Shaar Fund Ltd. and otherinstitutional and accredited investors pursuant to which these investorsallowed the Company to defer certain payments of monthly principal due underthe Secured Convertible Term Note dated September 29, 2004. The Companyissued 263,706 shares of its Common Stock to these investors as considerationfor this principal payment deferral. 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.

 

(o)              On January 23, 2006, BIO-keyInternational, Inc. entered into an Amendment and Waiver with Lauruspursuant to which Laurus allowed the Company to extend the maturity of theSecured 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 enteredinto an Amendment and Waiver with The Shaar Fund Ltd. and other institutionaland accredited investors pursuant to which these investors allowed the Companyto extend the maturity of the Subordinated Notes issued by the Company on September 29,2004 and on May 31, 2005. Additionally, the interest rate was fixed atfifteen percent (15%) and all principal amounts are due at the maturity dateand shall be paid in shares of Common Stock priced at $0.70 per share if theaverage closing price of the Common Stock for the thirty (30) trading daysimmediately preceding the maturity date is greater than $1.10. Interest shallbe paid, at the Company’s election, in cash or shares of Common Stock, with theCommon Stock priced at the average closing price of the Common Stock for theten (10) trading days immediately preceding the repayment date. Thecurrently applicable fixed conversion price was amended to $0.70 per share. Inaddition, the exercise price of all warrants to purchase Common Stock held bythe Subordinated Note Holders that currently have an exercise price greaterthan $1.00 per share was reset to$1.00 per share. In connection with this financing,we also reduced the conversion price of the Series A Convertible Preferredshares held by the Shaar Fund Ltd. to $0.70 per share.

 

(q)              On January 23, 2006, the Company issuedConvertible Term Notes in the aggregate principal amount of $1,000,000 tocertain investors. The Convertible Notes are convertible into 1,000,000 sharesof Shares of Series B Convertible Preferred Stock of the Company at an initialfixed conversion of $0.70 per share for an aggregate amount of 1,428,571shares. These securities were issued in a private placement transaction exemptfrom 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.

** **

**ConvertiblePreferred Stock**

 

InMarch 2004, we designated 100,000 shares of preferred stock as Series CConvertible Preferred Stock (the “Series A Convertible Preferred Shares”).When the Company reincorporated in Delaware, the Series A ConvertiblePreferred Shares were re-named as Series A Convertible Preferred Stock ofwhich 44,557 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.

 

TheSeries A Convertible Preferred Shares accrue a cumulative annual dividendof 7% on the $100 face amount of such shares payable June 15 and December 15each year in shares of common stock. In the event of a liquidation, dissolutionor winding up of the Company, the Series A Convertible Preferred Shareshave a 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 convertible intocommon stock at a conversion price of $.70 per share. The conversion price issubject 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.

 

Weare required to obtain 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 A Convertible Preferred Shares orissue any shares of preferred stock, rights, options, warrants, or any othersecurities convertible into common stock of the Company, other than thoseissued to employees of the Company in the ordinary course of their employmentor to consultants or other persons providing services to the Company so long assuch issuances do not exceed 500,000 shares of common stock. 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.

 

InJanuary 2006, the Company designated 1,000,000 shares of preferred stockas Series B Convertible Preferred Stock, all of which are issued andoutstanding. The following describes the material provisions of the Series BConvertible Preferred Shares which are more fully set forth in the Certificateof Designation 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$1 face 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 or distributionto holders of our common stock. The Series B Convertible Preferred Sharesare convertible into common stock at a conversion price of $.70 per share. Theconversion price is subject to proportional adjustment in the event of stocksplits, stock dividends or reclassifications. Subject to certain exceptions, inthe event we issue additional shares of common stock at a purchase price lessthan the conversion price of the Series B Convertible Preferred Shares,the conversion price shall be lowered to such lesser 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.

For as long as twenty-fivepercent (25%) of the Series B Convertible Preferred Stock  are outstanding, we are required to obtainthe consent of the holders of a majority of the Series B ConvertiblePreferred Shares in order to, among other things, issue any shares of preferredstock that are equal to or have a preference over the Series B ConvertiblePreferred Shares or issue any shares of preferred stock, rights, options,warrants, or any other securities convertible into common stock of the Company,other than those issued to employees of the Company in the ordinary course oftheir employment or to consultants or other persons providing services to theCompany. We are also required to obtain such consent in order to, among other things,complete a sale or other disposition of any material assets, complete anacquisition of a material amount of assets, engage in a merger, reorganizationor consolidation, or incur or guaranty any indebtedness in excess of $50,000

 

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**ITEM 6.****MANAGEMENT’S DISCUSSION ANDANALYSIS OR PLAN OF OPERATION**

 

ThisManagement’s Discussion and Analysis or Plan of Operation and other parts ofthis Report contain forward-looking statements that involve risks anduncertainties. All forward-looking statements included in this Report are basedon information available to us on the date hereof, and we assume no obligationto update any such forward-looking statements. Our actual results could differmaterially from those anticipated in these forward-looking statements as aresult of a number of factors, including those set forth in the sectioncaptioned “ **RISK FACTORS** ” in Item 1 and elsewhere in thisReport. The following should be read in conjunction with our audited financialstatements 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, and howwe 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 ACCOUNTING POLICIESprovides 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 ACCOUNTING STANDARDSby reference to Note 1 to the Consolidated Financial Statements provides adescription of accounting standards which we have not yet been required toimplement and may be applicable to our operations, as well as those significantaccounting standards which were adopted during 2005.

 

**OVERVIEW**

 

Our Business

 

  Wedevelop and market proprietary fingerprint identification biometric technologyand software solutions. We also deliver advanced identification solutions andinformation services to law enforcement departments, public safety agencies andother government 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 the developmentof automated, finger identification technology that can be used without the aidof non-automated methods of identification such as a personal identification,password, token, smart card, ID card, credit card, passport, driver’s licenseor other form of possession or knowledge based identification. This advancedBIO-keyTM identification technology improves both the accuracy and speed offinger-based biometrics and is the only finger identification algorithm thathas been certified by the International Computer Security Association (ICSA).

 

Since our inception in 1993,we have spent substantial time and effort in completing the development of whatwe believe is the most discriminating and effective finger biometric technologyavailable. During the past two years, our focus has shifted to marketing andselling this technology and completing strategic acquisitions that can help usleverage our capability to deliver identification solutions. We have built adirect sale force of professionals with substantial experience in selling technologysolutions to government and corporate customers. We expect to continue to addadditional qualified personnel beyond 2005.

 

On March 30, 2004, weacquired all of the outstanding capital stock of Public SafetyGroup, Inc., a privately-held provider of wireless solutions for lawenforcement and public safety markets based in Winter Park, Florida, inexchange for an aggregate of 2,422,108 shares of our common stock, $500,000 incash, and our assumption of $600,000 in aggregate net liabilities of PSG. The acquisitionwas completed pursuant to the terms of an agreement and plan of merger by andamong the Company, BIO-key Acquisition Corp., a wholly-owned subsidiary of theCompany, PSG and all of the shareholders of PSG. As a result of thistransaction, PSG became a wholly-owned subsidiary of the Company.

 

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On September 30, 2004,we completed our acquisition of the Mobile Government Division from AetherSystems Inc. Pursuant to the Asset Purchase Agreement dated as ofAugust 16, 2004 by and among the Company, Aether, CeruleanTechnology, Inc. and SunPro, Inc., the Company paid Aether a purchaseprice of $10,000,000 in cash, subject to post-closing adjustments to reflectchanges in Aether Mobile Government’s working capital and cash flows sinceJune 30, 2004. Post-closing working capital adjustments resulted in anadditional payment by the Company of $341,878 in December 2004. Inconnection with this acquisition, the Company issued a subordinated securedpromissory note to Aether in the face amount of $6,884,588 (the “Aether Note”).The Aether Note evidences a contingent reimbursement obligation of the Companyto Aether and a surety fee payable by the Company to Aether, in each case withrespect to a letter of credit maintained by Aether for the Company’s benefit inconnection with the acquisition. The Company’s obligations under the AetherNote are secured by a security interest granted to Aether in all orsubstantially all of the Company’s assets, subordinate to the security interestdescribed in the “Long-Term Obligations” 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-timeinformation in seconds, without the need for human dispatchers or otherresources.

 

# **INTRODUCTION**

# ** **

During2005, the Company continued to integrate the products, operations andtechnology of the Mobile Government business, acquired from Aether Systems inSeptember 2004, in an effort to leverage new business opportunities. Ourfinancial objective is to increase revenue, manage expenses and attainprofitability. While total expenses have increased in dollars, they havedeclined as a percentage of revenue in 2005 and 2004. In the fourth quarter of2005, the Company restructured its operations into three business segments:Biometrics, Law Enforcement and Fire Safety. Each segment will be headed by a GeneralManager and organized to quickly respond to market needs as well as to drivedown costs to achieve profitability. Management believes that this initiativewill lead to increased opportunities in 2006 as the General Managers developtheir organizations. A detailed analysis of each segment can be found below.

 

**RESULTS OF OPERATIONS**

 

**Consolidated Results of Operations **

 

**Three Year % trend**

 
| ** **                            | ** ** | **Years ended December 31,** | ** ** |
|---------------------------------------|------------|---------------------------------------------|------------|
| ** **                            | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                            | ** ** | ** **                                  | ** ** | **(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 | % | 1498 | % |
| **Operating loss**                    |       | -58                                         | %          | -113 | % | -1398 | % |
|                                  |       |                                        |       |   |   |   |   |
| **Other income (deductions)**         |       |                                        |       |   |   |   |   |
| Total other income (deductions)       |       | 61                                          | %          | -139 | % | -486 | % |
| **NET INCOME (LOSS)**                 |       | 3                                           | %          | -252 | % | -1884 | % |

 

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As discussed in Note Mto the Consolidated Financial Statements, we have three reporting segments: LawEnforcement, Fire Safety and Biometrics. The Law Enforcement and Fire Safetysegments were purchased during 2004. As noted earlier, in the fourth quarter of2005 the Company restructured its operations into three business segments,prior to this segmentation of the business management evaluated the business asone consolidated operation.  For presentation and comparability purposesthe allocation of costs between segments for prior periods have been estimated.

 

The Company evaluatesperformance and allocates resources based on revenues and operating income(loss). Operating income (loss) for each segment includes selling, general andadministrative expenses directly attributable to the segment in addition tothose 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 notevaluate or 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    |       | $                         | —     |                      | $          | 5,323,863 |   | 208 | % | $ | 2,562,136 |   | n/a |   |
| License & other  |       | 2,638,938  |       | 1,920,642    |       | —       |       | 718,297                   |       | 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                        | %          | 84,610 |   | 791 | % |
| License & other  |       | 319,038    |       | 261,674      |       | 204,787      |       | 57,364                    |       | 22                        | %          | 56,887 |   | 28 | % |
|                 |       | 480,071    |       | 356,977      |       | 215,481      |       | 123,094                   |       | 34                        | %          | 141,497 |   | 66 | % |
|                 |       |       |       |         |       |         |       |                      |       |                      |       |   |   |   |   |
| *Total Revenue*      |       | $          | 14,226,095 |         | $          | 5,720,951    |       | $                         | 215,481    |                      | $          | 8,505,144 |   | 149 | % | $ | 5,505,471 |   | 2555 | % |
|                 |       |       |       |         |       |         |       |                      |       |                      |       |   |   |   |   |
| *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 |   | 2217 | % |

 

23

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*Revenues*

*LawEnforcement*

 

Theincrease in these revenue components from 2004 is primarily attributable to thefact that the business was acquired in the third quarter of 2004. Therefore2004 represents only one quarter of revenue, whereas 2005 reflects fourquarters of revenue. The increase was partially offset with a reduction ofrevenues related to long-term project work, which during 2005 has diminished asa result of the Company focusing the business to more of a licensing model.

 

*FireSafety*

 

Theincrease in these revenue components from 2004 is primarily attributable to thefact that the business was acquired in the third quarter of 2004. Therefore2004 represents only one quarter of revenue, whereas 2005 reflects fourquarters of revenue. This was compounded by a general increase in overallrevenue that can be attributed to a strengthened market presence through concertedefforts toward penetrating new markets by actively pursuing and marketing ourFire Safety 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*

 

During2004 and 2005 Biometric segment continues to show strong revenue growth yearover year. This is reflective of continued market acceptance of the product andstrategic channel relationships that have been developed. Additionally, theproduct has been a proven solution in the educational industry as well hasshown continued commercial integration and acceptance of the product.

 

***Costs of goods sold***

 

*LawEnforcement*

 

Licenseand other costs are attributable primarily to revenues derived from productsales for which we are required to pay a royalty. The slight decrease in costis primarily driven by the sales mix and is solely dependent specifically onwhat products were sold.

 

Servicecosts increased primarily because of personnel related costs that haveincreased over the prior year primarily from the inclusion of a full year ofcosts as compared to only one quarter in 2004. This was offset by reductionsrelated to a reduced concentration of project related revenues which areheavily burdened with labor costs, both employees and contracted labor. Assignificant project revenues declined after the first two quarters of 2005,this reduction offset the increase that would have occurred related tomaintaining a full twelve months of expense.

 

*FireSafety*

 

Licenseand other costs are attributable primarily to revenues derived from productsales for which we are required to pay a royalty. The slight increase in costis primarily driven by the sales volume in addition to product mix. These costsare solely dependent specifically on what products were sold.

 

Servicescosts have increased over the prior year primarily from the inclusion of a fullyear of costs as compared to only one quarter as well as contractors andrelated costs that have been incurred related to project and service relatedrevenues. There was a significant growth in service revenues for whichadditional outside contractors were used in providing some of those services.

 

*Biometrics*

 

Licenseand other costs are primarily related to the hardware costs related to sales ofbiometric fingerprint readers. The change in cost of goods sold is directlyattributable to the product mix between types of readers sold and the volume ofreaders sold. During 2004 and 2003 the volume attributable to readers remainedfairly constant whereas in 2005 volume decreased resulting in a reduction ofrelated product cost.

 

Servicecost has increased during 2005 related primarily to a higher percentage ofrevenue requiring software customization and integration costs as compared to2004 and 2003.

 

24

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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&Acosts increased during the year as a result of 2005 representing a full 12months worth of expenses as compared to 2004 which included only 3 months ofexpenses of the Law and Fire segments.  As noted above, these costs areallocated based on the Segment’s percentage of revenue.  Changes inSG&A costs between business segments are the result of the change in theirrespective percentage of BIO-key’s total revenue.

 

During2004 the increase in SG&A was primarily attributable to the acquisition ofMobile Government. The additional costs incurred were the result of legal andaudit costs surrounding both the acquisition of Mobile Government as well asPublic Safety Group. Additionally, theincrease was due to an increased workforce in sales and administrationfunctions as well as the associated overhead which results from fully loadedlabor charges associated with supporting larger operations. This increase wasoffset slightly by the elimination of non essential functions done in order toalign the business with its revised model of focusing sales through channelpartners and creating a model focused on licensing as oppose to integrationprojects.

 

25

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***Research, development and engineering***

 
| ** **          | ** ** | ** ** | ** ** | ** **   | ** ** | ** **   | ** ** | **2005 - 2004** | ** ** | **2004 - 2003** | ** ** |
|---------------------|------------|------------|------------|--------------|------------|--------------|------------|---------------------------|------------|---------------------------|------------|
| ** **          | ** ** | **2005**   | ** ** | **2004**     | ** ** | **2003**     | ** ** | **$ Chg**            | ** ** | **% Chg**            | ** ** | **$ Chg** | ** ** | **% Chg** | ** ** |
| ** **          | ** ** | ** ** | ** ** | **Restated** | ** ** | **Restated** | ** ** | ** **                | ** ** | ** **                | ** ** | ** ** | ** ** | ** ** | ** ** |
|                |       |       |       |         |       |         |       |                      |       |                      |       |   |   |   |   |
| **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& D costs have increased over 2004 primarily related to the acquisition ofMobile Government in Q3 of 2004. During 2005 the Company spent significantR&D resources in sustaining engineering related to the large customer baseas well as 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 Law Enforcementsegment.

 

*FireSafety*

 

R& D costs have increased over 2004 primarily related to the acquisition ofMobile Government in Q3 of 2004. Additionally, subsequent to the acquisition,the company had several engineering initiatives in the Fire segment. As notedabove a number of product enhancements were made to functionality across theentire software suite in addition to focused development of the new FireRMSmobile solution delivered to the market mid 2005. While remaining focused onachieving these product objectives, in conjunction with the Company wide costreduction initiatives, Fire Safety was able to realize an approximate reductionof 10% the fourth quarter 2004 run rate for R&D costs.

 

*Biometrics*

 

R& D costs have increased sequentially from 2003 to 2005. This isrepresentative of the increased spending to enhance the interoperability andfunctionality of the software. The company continues to spend in R&D toenhance the products usability in different markets as well as to develop theproduct for integration with products from BIO-key’s other segments. During2005, BIO-key released IdentityMatch, a product which integrates BIO-key’sadvanced biometric offerings with BIO-key’s mobile data and fire recordsmanagement solutions. BIO-key continues to develop further integration of itsBiometric software solutions in other products with in Company as well aspartnering with other solutions in the marketplace. Additionally, in May of2005 the Company was awarded a patent for its award-winning leadership VectorSegment fingerprint technology or “Image Identification System.”

 

26

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***Other income and expense***

 
| ** **                            | ** ** | ** ** | ** ** | ** **   | ** ** | ** **   | ** ** | **2005 - 2004** | ** ** | **2004 - 2003** | ** ** |
|---------------------------------------|------------|------------|------------|--------------|------------|--------------|------------|---------------------------|------------|---------------------------|------------|
| ** **                            | ** ** | **2005**   | ** ** | **2004**     | ** ** | **2003**     | ** ** | **$ Chg**            | ** ** | **% Chg**            | ** ** | **$ Chg** | ** ** | **%Chg** | ** ** |
| ** **                            | ** ** | ** ** |       | **Restated** |       | **Restated** |       |                      |       |                      |       |   |   |   |   |
|                                  |       |       |       |         |       |         |       |                      |       |                      |       |   |   |   |   |
| Interest expense                      |       | $          | (6,548,130 | )            | $          | (1,916,558   | )          | $                         | (1,909,788 | )                         | $          | (4,631,572 | ) | 242 | % | $ | (6,770 | ) | 0.4 | % |
| Ineterest income                      |       | 35,958     |       | 66,824       |       | —       |       | (30,866                   | )          | -46                       | %          | 66,824 |   | n/a |   |
| Gain on sale of marketable securities |       | (20,000    | )          | —       |       | —       |       | (20,000                   | )          | n/a                       |       | — |   | n/a |   |
| Non-cash interest income (expense)    |       | 15,213,186 |       | (6,003,137   | )          | 857,545      |       | 21,216,323                |       | -353                      | %          | (6,860,682 | ) | -800.0 | % |
| Other income (expense)                |       | (34,767    | )          | (55,300      | )          | 4,145        |       | 20,533                    |       | -37                       | %          | (59,445 | ) | -1434.1 | % |
|                                  |       |       |       |         |       |         |       |                      |       |                      |       |   |   |   |   |
|                                  |       | $          | 8,646,247  |         | $          | (7,908,171   | )          | $                         | (1,048,098 | )                         | $          | 16,554,418 |   | -209 | % | $ | (6,860,073 | ) | 655 | % |

 

Forthe year ended December 31, 2005, consolidated interest expense increased $4,631,572or 242% as compared to 2004, which was attributable to the increase in longterm debt from issuance of the 2004 and 2005 Senior and Subordinated notes. Forthe year ended December 31, 2004, consolidated interest expense increase $6,770or .4% 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 endedDecember 31, 2004, consolidated interest income increased $66,824 as comparedto 2003, which was attributable to deposits held in interest bearing accountsin 2004. No deposits were held in interest bearing accounts in 2003.

 

Forthe year ended December 31, 2005, consolidated non-cash interest income(expense) increased $21,216,323 or 353% 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 price ofour stock from $1.60 as of December 31, 2004 to $.69 as of December 31, 2005. Forthe year ended December 31, 2004, consolidated non-cash interest incomedecreased $6,860,682 or 800% as compared to 2003, which was also attributableto changes in the fair value of embedded derivatives and detachable warrantsissued with convertible debt. The major factor contributing to the largefluctuation in the fair value was due to the net increase in the market priceof our stock from $1.03 as of September 29, 2004 to $1.60 as of December 31,2004.

 

27

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**LIQUIDITY AND 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 Company issued notes in 2004 and 2005which contained embedded derivatives. In 2004, the company recorded a loss ofapproximately $6,003,000 related to the increase in value of the derivatives. Theincrease in value was caused by the increase in the value of the underlyingBIO-key stock. In 2005, the company recorded a gain of approximately $15,213,000related to the decrease in value of the derivatives. The decrease in value isthe result of the decline in value of the underlying BIO-key stock.

•      A debt discount was recorded when the notes wereinitially recorded to reflect the FMV of derivatives and warrants related tothe debt. The discount is amortized ratably into earnings over the life of therelated debt. In 2004 and 2005, the company recorded non-cash interest expenserelated to the amortization of the debt discount of approximately $1,258,341and $4,124,759 respectively.

•      The Company recorded a $55,150 and $664,043charge in 2004 and 2005, respectively, for the non-cash expense of issuingoptions and warrants to non employees for services.

•      Finally, the Company recorded $550,421 and$1,509,880 in 2004 and 2005, respectively, for the non-cash expense related tothe amortization of intangibles assets.

 

For the year ended December31, 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. Costsand earnings in excess of billings on uncompleted contracts represent serviceswhich have been performed on long term contracts but have not been invoiced atyear end due to milestones contained within the contracts. In 2005, the Companywas able to bill the customer due to the fact that the milestones have beenreached.

 

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 also experienceda positive cash flow from an increase of $1,191,958 in deferred revenue from2004 to 2005 due to customers who had purchased and paid for maintenanceagreements which the company had to earn typically over a one year period.

 

The overall major drivers inoperating cash flow are the current operating costs which are greater than thecurrent revenues. The company has experienced improvements related to the ratioof operating expenses to revenues and expects this trend to continue to improveuntil such time as the Company is able to generate sustained profitability.

 

***FINANCING ACTIVITIES OVERVIEW***

 

***Financing Activities***

 

**2005 Senior 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 1/32 incrementsthereof, plus accrued interest, commencing October 1, 2005.

 

We entered into a SecuritiesPurchase 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 onJuly 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 common stockat the option of each note holder.

 

**2005 Amendment and Waivers**

 

The Company entered into anAmendment and Waiver with Laurus, dated as of August 31, 2005, pursuant towhich the Company was permitted to defer the payment of the monthly principalamounts 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 onSeptember 29,2004 (the “September 2004 Note”), and (b) theSecured Convertible Term Note in the original principal amount of $2,000,000issued by the Company to Laurus on June 8, 2005 (the “June 2005 Note”),such aggregate deferred principal amounts being equal to $625,000 and $187,500,respectively.  The deferred principal amount under the September 2004Note is now due on September 29,2007, the maturity date of that note, andwill be paid at the same time the final payments due with respect to that noteupon maturity.  The deferred principal amount under the June 2005 Noteis now due on June 7, 2008, the maturity date of that note, and will bepaid at the same time the final payments due with respect to that note uponmaturity.  The Company will remain obligated to pay all monthly interestamounts under these notes as they are currently 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.  Thedeferred principal amount under each Subordinated Note is now due onSeptember 29, 2007, the maturity date of each such note, and will be paidat the same time the final payments due with respect to each such note uponmaturity. The Company will remain obligated to pay all monthly interestamounts under these notes as they are currently due.

 

**2006 Amendment and Waiver**

 

The Company entered into anAmendment No. 1 to its Subordinated Secured Promissory Note, dated as ofJanuary 23, 2006, with Aether Systems, Inc.  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 was amended to increase such aggregate maximum principalamount to $7,884,588.

 

The Company entered into aSecurities Purchase Agreement, effective as of January 23, 2006, with TheShaar Fund, Ltd., Longview Fund, L.P. and Longview Special Finance. Under theSecurities Purchase Agreement, the Company issued to the Purchasers ConvertibleTerm Notes in the aggregate principal amount of $1,000,000. TheConvertible Notes converted into shares of the Series B Preferred Stock ofthe Company, which shares are convertible into shares of the Common Stock ofthe Company at an initial fixed conversion price of $0.70 per share.

 

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 the aggregateprincipal amount of $2,000,000 were amended as follows: (i) the maturitydate of the September 2004 Note was extended to January 1, 2008;(ii) the maturity date of the June 2005Note was extended toDecember 1, 2008, and (iii) the fixed conversion price under each ofthe Secured Notes was reset from $1.35 to $0.85 per share.  In addition,the exercise price of all warrants to purchase Common Stock of the Company heldby Laurus was reset to $1.00 per share.

 

Effective as ofJanuary 23, 2006, the Company also entered into an Amendment and Waiverwith certain holders of its Subordinated Convertible Promissory Notes. Underthe Subordinated Notes Amendment and Waiver, the Subordinated Notes issued bythe Company 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, toJanuary 1, 2009; (ii) the interest rate was fixed at fifteen percent(15%); (iii) all principal amounts are due at the maturity date and shallbe paid in shares of Common Stock priced at $0.70 per share if the averageclosing price of the Common Stock for the thirty (30) trading days immediatelypreceding the maturity date is greater than $1.10; (iv) interest shall bepaid, at the Company’s election, in cash or shares of Common Stock, with theCommon Stock priced at the average closing price of the Common Stock for theten (10) trading days immediately preceding the repayment date; and(v) the currently applicable fixed conversion price was amended to $0.70per share.  In addition, the exercise price of all warrants to purchaseCommon Stock held by the Subordinated Note Holders that currently have an exerciseprice greater than $1.00 per share was reset to $1.00 per share. In connectionwith this financing, 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 hadcash resources of approximately $1,830,000 and $11,277,000 of convertible debtas described in the “Long-Term Obligations” footnote of this report below. Wecurrently require approximately $1,700,000 per month to conduct ouroperations. During the fourth quarter of 2005, we generated approximately$3,368,000 of revenue and expect to increase quarterly revenue in 2006.

 

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.

 

**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 |   |

 

TheCompany does not own any real estate but conducts operations from four leasedpremises. These non-cancelable operating leases expire a various dates through2009. In addition to base rent, the Company pays for property taxes,maintenance, insurance and other occupancy expenses according to the terms ofthe individual leases. 

 

30

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RESTATEMENT

 

In the process of reviewing our registrationstatement for the securities issued in our June 2005 financing, the Securitiesand Exchange Commission (“SEC”) raised questions with regard to our convertibleterm notes suggesting that we consider EITF 00-19 “Accounting for DerivativeFinancial Instruments Indexed to, and Potentially Settled in, a Company’s OwnStock” to evaluate whether there were any embedded derivative instruments andif so, whether they should be accounted for as an equity or liabilityclassification. The SEC staff also commented that the Company should review theconvertible notes issued in fiscal 2003 and 2004. The SEC staff also asked usto review adjustments to revenue made in the fourth quarter of 2004. The SECstaff raised the question of whether the transactions had a material impact onpreviously filed Exchange Act reports and would be better characterized asrestatements.

 

Therewere several items that were identified as requiring restatement, these itemswere:

 

•      *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 ConvertibleFinancing 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 whether anyembedded derivative instruments qualify as equity instruments or as liabilities.As such certain embedded derivatives were identified that met the conditionsset forth under paragraph 12 of SFAS No. 133. These embedded derivativeinstruments have been evaluated using EITF 00-19 paragraphs 12 to 32 anddetermined that these instruments would not be classified as components of stockholdersequity. The instruments have been deemed liabilities, and as such will besubject to SFAS 133 and should be recorded at fair value. Features that havebeen evaluated and determined to require such treatment include:

 

•      The principal conversion option

 

•      The monthly payments conversion option

 

•      The interest 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.

 

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 inno accrual 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 financialinformation, and the failure to prevent them or detect them in our financialreporting process, were largely attributable to weak internal controls and aninadequate staff of competent accounting personnel with an appropriate level ofknowledge of GAAP.

 

As a result of our review and communications withthe SEC, 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 and ourpreviously reported unaudited financial statements for the first, second andthird 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, 2004and 2005 see Note X, Results by Quarter.

 

31

----

 

Thefollowing tables summarize the impact of all of these adjustments on previouslyreported revenue and assets, liabilities, and stockholders’ equity (deficit)for the years ended December 31, 2004 and 2003.

 
| ** **                 | ** ** | **Impact of Adjustments on Revenue**      | ** ** |
|----------------------------|------------|---------------------------------------------------------------|------------|
| ** **                 | ** ** | **For the Years Ended December 31,** | ** ** |
| ** **                 | ** ** | **2004**                                                      | ** ** | **2003** | ** ** |
|                       |       |                                                          |       |   |   |
| **As previously reported** |       | $                                                             | 5,558,231  |   | $ | 524,101 |   |
| Revenue recognition        |       | 162,720                                                       |       | (308,620 | ) |
| **As restated**            |       | $                                                             | 5,720,951  |   | $ | 215,481 |   |

 
| ** **                                       | ** ** | **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                                                           |       | 5,340,573 |   | (4,524,072 | ) | — |   | (57,543 | ) | 57,543 |   |
| Total Adjustments                                |       | 694,411                                                           |       | 5,364,383 |   | (4,669,972 | ) | (308,620 | ) | (75,743 | ) | (232,877 | ) |
| **As restated**                                  |       | $                                                                 | 31,539,092 |   | $ | 25,587,666 |   | $ | 5,951,426 |   | $ | 1,556,122 |   | $ | 10,924,988 |   | $ | (9,368,866 | ) |

 

32

----

 

Thefollowing tables present the effect of the restatement adjustments on theconsolidated Statement of Operations for the years ended December 31, 2004 and2003.

 
| ** **                                                                 | ** ** | **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                                             | )          | (1,249,550 | ) | (1,916,558 | ) |
| Derivative and warrant fair value  adjustments                             |       | —                                               |       | (6,003,137 | ) | (6,003,137 | ) |
| Other expense                                                              |       | (55,300                                              | )          | — |   | (55,300 | ) |
| Total other income (deductions)                                            |       | (655,484                                             | )          | (7,252,687 | ) | (7,908,171 | ) |
| **NET LOSS**                                                               |       | $                                                    | (7,237,465 | ) | $ | (7,108,167 | ) | $ | (14,345,632 | ) |
|                                                                       |       |                                                 |       |   |   |   |   |
| **Basic Loss per Share:**                                                  |       |                                                 |       |   |   |   |   |
| *Numerator*                                                                |       |                                                 |       |   |   |   |   |
| Net loss                                                                   |       | $                                                    | (7,237,465 | ) | $ | (7,108,167 | ) | $ | (14,345,632 | ) |
|                                                                       |       |                                                 |       |   |   |   |   |
| Convertible preferred stock dividends and  accretion                       |       | (414,240                                             | )          | 28,885 |   | (385,355 | ) |
| Net Loss attributable to common  shareholders                              |       | $                                                    | (7,651,705 | ) | $ | (7,079,282 | ) | $ | (14,730,987 | ) |
|                                                                       |       |                                                 |       |   |   |   |   |
| *Denominator*                                                              |       |                                                 |       |   |   |   |   |
| Weighted average common shares outstanding                                 |       | 34,806,201                                           |       | 34,806,201 |   | 34,806,201 |   |
| ***Basic Loss per Share***                                                 |       | $                                                    | (0.22      | ) | $ | (0.20 | ) | $ | (0.42 | ) |
|                                                                       |       |                                                 |       |   |   |   |   |
| **Diluted Loss per Share:**                                                |       |                                                 |       |   |   |   |   |
| *Numerator*                                                                |       |                                                 |       |   |   |   |   |
| Net loss attributable to common  shareholders                              |       | $                                                    | (7,651,705 | ) | $ | (7,079,282 | ) | $ | (14,730,987 | ) |
|                                                                       |       |                                                 |       |   |   |   |   |
| Effect of Dilutive Securities: Convertible  Debentures                     |       | —                                               |       | — |   | — |   |
|                                                                       |       |                                                 |       |   |   |   |   |
| Net loss attributable to common shareholders  and assumed conversions      |       | $                                                    | (7,651,705 | ) | $ | (7,079,282 | ) | $ | (14,730,987 | ) |
|                                                                       |       |                                                 |       |   |   |   |   |
| *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      | ) | $ | (0.20 | ) | $ | (0.42 | ) |

 

33

----

 
| ** **                                                                 | ** ** | **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 | ) |

 

34

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The following tables presentthe effect of the restatement adjustments on the Consolidated Balance Sheet asof December 31, 2004 and 2003.

 

**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                    |       | 860,136 |   | 5,037,415 |   |
| 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  |   | $ | (177,145 | ) | $ | 3,078,037 |   |
| 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                   |       | (196,970 | ) | 13,356,705 |   |
| Long-term  obligations, net of discount and current maturities                                                                                                                  |       | 5,286,951                    |       | 5,561,353 |   | 10,848,304 |   |
| Deferred  rent                                                                                                                                                                  |       | 1,311,454                    |       | — |   | 1,311,454 |   |
| Deferred  revenue                                                                                                                                                               |       | 71,203                       |       | — |   | 71,203 |   |
| Total non-current liabilities                                                                                                                                                   |       | 6,669,608                    |       | 5,561,353 |   | 12,230,961 |   |
| TOTAL  LIABILITIES                                                                                                                                                              |       | 20,223,283                   |       | 5,364,383 |   | 25,587,666 |   |
| **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                   |       | 2,671,071 |   | 47,996,243 |   |
| Accumulated deficit                                                                                                                                                             |       | (35,111,205                  | )          | (7,341,043 | ) | (42,452,248 | ) |
| TOTAL STOCKHOLDERS’ EQUITY (DEFICIT)                                                                                                                                       |       | 10,621,398                   |       | (4,669,972 | ) | 5,951,426 |   |
| TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)                                                                                                                       |       | $                            | 30,844,681 |   | $ | 694,411 |   | $ | 31,539,092 |   |
|                                                                                                                                                                                 |            |                              |            |  |  |  |  |  |  |  |  |  |

 

35

----

 

**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                                                                                                                     |       | 150,206                                         |       | — |   | 150,206 |   |
| 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 |   |

 

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** **

**CRITICAL ACCOUNTING POLICIES**

 

1.             *Basis of Consolidation*

 

Theaccompanying consolidated financial statements include the accounts of BIO-keyInternational, Inc. and its wholly owned subsidiary (collectively, the Company)and are stated in conformity with accounting principles generally accepted inthe United States, pursuant to the rules and regulations of the Securities andExchange Commission. Intercompany accounts and transactions have beeneliminated in consolidation.

 

2.             *Revenue Recognition*

 

Revenuesfrom software licensing are recognized in accordance with Statement of Position(SOP) No. 97-2, Software Revenue Recognition, as amended by SOPNo. 98-9. Accordingly, revenue from software licensing is recognized whenall of the following criteria are met: persuasive evidence of an arrangementexists, delivery has occurred, the fee is fixed or determinable, andcollectability is probable.

 

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 forAcquisitions

 

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

 

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assetsacquired and liabilities assumed at their estimated fair values on the date ofthe acquisitions, as determined by management, and by appraisals with respectto identifiable intangible assets. Our accounting for these acquisitionsinvolves significant 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 classification ofdebt 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 financialinstruments*

 

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. Foroptions, warrants and bifurcated conversion options that are accounted for asderivative instrument liabilities, we determine the fair value of theseinstruments using the Black-Scholes option pricing model. That model requiresassumptions related to the remaining term of the instruments and risk-free ratesof return, our current common stock price and expected dividend yield, and theexpected volatility 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 IntangibleAssets*

 

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 eachyear using a number of criteria, including the value of the overall enterprise.As of December 31, 2005, the Company believes that no material impairmentexists. Future impairment charges from previous or future acquisitions, if any,will be reflected as an operating 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 DevelopmentExpenditures*

 

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

 

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potentialdilution that could occur if securities or other contracts to issue commonstock were exercised or converted into common stock and would then share in thenet income of the company. See note U. “Earnings Per 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 for IncomeTaxes,” includes the consideration of all available evidence, both positive andnegative, regarding historical operating results including recent years withreported losses, the estimated timing of future reversals of existing taxabletemporary differences, estimated future taxable income exclusive of reversingtemporary differences and carryforwards, and potential tax planning strategieswhich may be employed to prevent an operating loss or tax credit carry forwardfrom expiring unused. Because of the Companies historical performance andestimated future taxable income a full valuation allowance has beenestablished.

 

11.           *Accounting for Stock-BasedCompensation*

 

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.

 

OnDecember 31, 2005, the Company accelerated the vesting of certain of theoutstanding options to purchase shares of the Company’s common stock withoption exercise prices greater than the fair market value of the Company’scommon stock on such date.  The acceleration applies to all such optionsoutstanding as of December 31, 2005 under the Company’s 1996 Stock OptionPlan, 1999 Stock Option Plan and 2004 Stock Option Plan, except for optionsheld by the Company’s executive officers subject to Section 16(b) ofthe Securities Exchange Act of 1934, as amended, and the members of the Company’sBoard of Directors.  Options to purchase up to 897,614 shares of theCompany’s common stock, or 14% of the total shares of the Company’s commonstock subject to outstanding options, with a weighted average exercise price ofapproximately $1.09 and varying remaining vesting schedules, are subject tothis acceleration and become immediately vested and exercisable as ofDecember 31, 2005.  The number of shares, exercise prices and otherterms of the options subject to the acceleration remain unchanged.

 

Asa result of this acceleration, the Company expects to reduce its exposure tothe effects of the Financial Accounting Standards Board’s Statement ofFinancial Accounting Standards No. 123 (revised 2004), Share-Based Payment(FAS 123R), which requires companies to recognize stock-based compensationexpense associated with stock options based on the fair value method. TheCompany currently expects a reduction in stock-based compensation expenseassociated with this acceleration of approximately $330,000 for fiscal year2006 and approximately $225,000 for fiscal year 2007.

 

InDecember 2002, the Financial Accounting Standards Board (FASB) issued SFASBNo.148, Accounting for Stock-Based Compensation-Transition and Disclosure. SFASNo. 148 amends SFAS No. 123, Accounting for Stock-Based Compensation, toprovide alternative methods of transition for a voluntary charge to the fairvalue based method of accounting for stock-based employee compensation. Inaddition, SFAS No. 149 requires expanded more prominent disclosure in bothannual and interim financial statements about the method of stock-basedemployee compensation and the effect of the method on reported results.

 

TheCompany has not adopted a method under SFAS No. 148 to expense stock optionsbut rather 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 loss 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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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 and liabilities.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.

 

**OTHER MATTERS**

 

**Not Applicable**

 

**RECENT ACCOUNTING STANDARDS**

InNovember 2005, FASB issued FSP FAS 115-1 and FAS 124-1, “TheMeaning of Other-Than-Temporary Impairment and Its Application to CertainInvestments” (“FSP FAS 115-1”), which provides guidance on determiningwhen investments in certain debt and equity securities are considered impaired,whether that impairment is other-than-temporary, and on measuring suchimpairment loss. FSP FAS 115-1 also includes accounting considerationssubsequent to the recognition of an other-than temporary impairment andrequires certain disclosures about unrealized losses that have not beenrecognized as other-than-temporary impairments. FSP FAS 115-1 is requiredto be applied to reporting periods beginning after December 15, 2005. Weare required to adopt FSP FAS 115-1 in the first quarter of fiscal 2006. We donot expect that the adoption of the statement will have a material impact onour consolidated results or financial condition.

 

InMay 2005, FASB issued SFAS 154, “Accounting Changes and ErrorCorrections—a replacement of APB Opinion No. 20 and FASB StatementNo. 3”. SFAS 154 changes the requirements for the accounting for andreporting of a change in accounting principle, and applies to all voluntarychanges in accounting principle. It also applies to changes required by anaccounting pronouncement in the unusual instance that the pronouncement doesnot include specific transition provisions. This statement requiresretrospective application to prior periods’ financial statements of changes in accountingprinciple, unless it is impracticable to determine either the period-specificeffects or the cumulative effect of the change. SFAS 154 is effective foraccounting changes made in fiscal years beginning after December 15, 2005.We do not expect that adoption of this statement will have a material impact onour results of operations or financial condition.

 

InMarch 2005, the FASB issued FASB Interpretation No. 47, *Accounting for Conditional Asset RetirementObligations – an interpretation of FASB Statement No. 143*(FIN47), which requires companies to recognize a liability for the fair value of alegal obligation to perform asset retirement activities that are conditional ona future event if the amount can be reasonably estimated. We adopted the provisionsof 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.

 

InDecember 2004, the FASB issued SFAS No. 123 (revised 2004), *Share-Based Payment*(SFAS 123R). Thisstatement replaces SFAS No. 123 and supersedes *APB Opinion 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 afterDecember 15, 2005. We plan to adopt SFAS 123R on January 1, 2006using the modified prospective application method described in the statement.Under the modified prospective application method, we will apply the standardto new awards and to awards modified, repurchased, or cancelled after therequired effective date. Additionally, compensation cost for the unvestedportion of awards outstanding as of the required effective date will berecognized as compensation expense as the requisite service is rendered afterthe required effective date. We are evaluating the impact of adoptingSFAS 123R and expect that we will record substantial non-cash stockcompensation expenses. The adoption of SFAS 123R is not expected to have asignificant effect on our cash flows but is expected to have a significantadverse effect on our results of operations. The future impact of the adoptionof SFAS 123R cannot be predicted at this time because it will depend uponthe levels of share-based payments granted in the future. However, had weadopted SFAS 123R in prior periods, the impact would have approximated theimpact of SFAS 123 as described in the disclosure of pro forma net lossattributable to common stockholders included in the Stock-Based Compensationfootnote.

 

InNovember 2004, the FASB issued Statement No. 151,*Inventory Costs—an amendment of ARB No. 43, Chapter 4*,which amends and clarifies existing accounting literature regarding abnormalamounts of idle facility expense, freight, handling costs, and wasted material(spoilage).  This statement is effective for inventory costs incurredduring fiscal years beginning after June 15, 2005, with earlier applicationpermitted.  The provisions of this statement are to be appliedprospectively.  The adoption of this standard is not expected to have amaterial effect on the Company’s financial position, results of operations, orliquidity.

 

**ITEM 7.FINANCIAL STATEMENTS**

 

Seefinancial statements appearing at pages 52-141 of this report

 

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

 

Not applicable.

 

### **ITEM8A. CONTROLS AND PROCEDURES**

### ** **

### **Remediation of Previously Reported MaterialWeaknesses in Internal Control over Financial Reporting**

### ** **

In Item 3 (Controls and Procedures) of our 10-QSB filings for the periods endedMarch 31, 2005, June 30, 2005 and September 30, 2005, we noted that ourindependent auditors, in a letter to the Audit Committee of the Company’s Boardof Directors dated April 18, 2005, had identified material weaknesses in theCompany’s internal control systems.

 

In order to ensure that the Companyadequately addresses all existing internal control issues, the Companyinitiated follow-up discussions with its auditors to better determine whatconstituted these material weaknesses. During these discussions the auditorsnoted the following weaknesses in the Company’s internal controls: inadequatesystem to capture disclosure items, inadequate internal process of review foraccount reconciliations, inadequate documentation of internal controls andinadequate internal processes around drafting of periodic filings with theSecurities and Exchange Commission.

 

In response, the Company has addressed, or isin the process of addressing, each item as follows:

 

•      InadequateSystem to capture Disclosure Items

•      In order toaddress this issue, the Company has hired a number of senior members of itsfinance team, including a Corporate Controller, a Manager of Finance, a Managerof Accounting Operations as well as several staff accountants. In addition, theCompany has retained the services of several financial consultants.

 

•      InadequateInternal Process of Review for Account Reconciliations

•      In order toaddress this issue, the Company has hired a number of senior members of itsfinance team as described above. As a result of these additional resources, theCompany has instituted a more formal general ledger close process whichincludes the preparation and review of reconciliations with material activity.

 

•      InadequateDocumentation of Internal Controls

•      In conjunctionwith the assistance of certain consultants, the Company is in the process ofidentifying its key internal controls. These controls will then be documentedand used as a starting point to comply with Section 404 of the Sarbanes-OxleyAct.

 

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

•      In order toaddress this issue, the Company, in addition to hiring the senior members ofits finance team above, has increased certain responsibilities of its AuditCommittee including oversight of disclosure and reporting processes and is nowusing a formal disclosure checklist.

 

### **Evaluation of DisclosureControls and Procedures as of December 31, 2005**

### ** **

An evaluation of the effectiveness of theCompany’s “disclosure controls and procedures” (as such term is defined inRules 13a-15(e) or 15d-15(e) of the Securities Exchange Act of1934, as amended (the “Exchange Act”)) as of December 31, 2005,was carried outby the Company under the supervision and with the participation of the Company’sCo-Chief Executive Officers (“Co-CEOs”) and Chief Financial Officer (“CFO”).

 

As noted above, the Company has identifiedfour areas of material weakness in its internal controls systems. Whilesignificant progress was made in 2005 to correct these weaknesses, we believethat all four areas still constitute material weaknesses. Based upon theirevaluation of these conditions, the Company’s CO-CEOs and CFO concluded that,as of December 31, 2005, the Company’s disclosure controls and procedures werenot effective to provide reasonable assurance that information the Company isrequired to disclose in reports that it files or submits under the Exchange Actis recorded, processed, summarized and reported within the time periodsspecified in the Securities and Exchange Commission rules and forms.

 

The Company intends to continue to implementchanges to 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**

 

Notapplicable.

 

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**PART III**

 

**ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS ANDCONTROL PERSONS; COMPLIANCE WITH SECTION 16(a) OF THE 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) From April 2004 toFebruary 2005, Mr.Romeo was employed by the Company.

 

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

 

**THOMAS J.COLATOSTI**has servedas a Director of the Company since September 2002 and as Chairman of the Boardsince January 3, 2003. He has served as Co-Chief Executive Officer sinceJuly 2005. Mr. Colatosti also currently serves as the Chief ExecutiveOfficer of American Security Ventures, a Lexington, Massachusetts basedconsulting firm he founded which specializes in providing strategic managementconsulting services to emerging and developing companies in the homelandsecurity industry. From 1997 through June 2002, Mr. Colatosti servedas the Chief Executive Officer of Viisage Technology, Inc., a publiclytraded biometric technology company focusing on biometric face-recognitiontechnology and delivering highly secure identification documents and systems.Between 1995 and 1997, Mr. Colatosti served as President and ChiefExecutive Officer of CIS Corporation, a higher education industry leader thatdesigned and implemented integrated and flexible systems solutions to manageentire university administrative operations. Prior to CIS, Mr. Colatostihad a 20-year career with Digital Equipment Corporation. His most recent responsibilitywas Vice President and General Manager, Northeast Area, where he wasresponsible for a business unit with annual revenues of more than$1.2 billion and 3,000 people. Mr. Colatosti is an active industrysecurity spokesperson testifying before Congressional Committees and advisingthe White House and other Federal security agencies on homeland securityissues. Since August 18, 2005, Mr. Colatosti has served as a Director and ChiefFinancial Officer of Good Harbor Partners Acquisition Corp., a publicly-tradedblank check company 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.

 

**MICHAEL W.DEPASQUALE**has servedas the Chief Executive Officer and a Director of the Company sinceJanuary 3, 2003. He has served as Co-Chief Executive Officer since July2005. Mr. DePasquale brings more than 20 years of executivemanagement, sales and marketing experience to the Company. Prior to joining theCompany, Mr. DePasquale served as the President and Chief ExecutiveOfficer of Prism eSolutions, Inc., a Pennsylvania based provider ofprofessional consulting services and online solutions for ISO-9001/14000 certificationfor customers in manufacturing, healthcare and government markets, sinceFebruary 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. FromJanuary 1996 until December 1999, Mr. DePasquale served asSenior Vice President of Jostens Learning Corp., a California based provider ofmulti media curriculum. Prior to Jostes, Mr. DePasquale held sales andmarketing management positions with McGraw-Hill and Digital EquipmentCorporation. Mr. DePasquale earned a Bachelor of Science degree from theNew Jersey Institute of Technology.

 

**JEFFREY J.MAY**has served as aDirector of the Company since October 29, 2001. Since 1997, Mr. Mayhas served as the President of Gideons Point Capital, a Tonka Bay Minnesotabased financial consulting firm and angel investor focusing on assisting andinvesting in start-up technology companies. In 1983, Mr. May co-foundAdvantek, Inc., a manufacturer of equipment and materials which facilitatethe automatic handling of semi-conductors and other electrical components whichwas sold in 1993. Mr. May continued to serve as a director andVice-President of Operations of Advantek until 1997, at which time it had over600 employees and sales in excess of $100 million. Mr. May earned aBachelor of Science degree in Electrical Engineering from the University ofMinnesota in 1983.

 

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**CHARLES P.ROMEO**has served as adirector of the Company since February 28, 2005 and from January 29,2003 to April 19, 2004. From April 2004 until February 2005, heserved as Vice President of Sales, Public Safety Division of the Company. FromSeptember 2002 until April 2004 Mr. Romeo has served as thePresident and Chief Executive Officer of FreedomBridge Technologies, Inc.,a Rhode Island based consulting firm to technology companies in the homelandsecurity industry specializing in implementing direct and channel selling programs,strategic alliances and partnerships in the law enforcement market. Prior tofounding FreeedomBridge, Mr. Romeo had a 33 year sales and marketingmanagement career with Digital Equipment Corporation, Compaq ComputerCorporation and Hewlett Packard. During his career, Mr. Romeo served asVice President of Service Sales for a $500 million business unit, andDirector of Public Sector Sales, a $275 million division of HewlettPackard. Mr. Romeo authored *The SalesManager’s Troubleshooter,*Prentice Hall 1998, which was namedas one of the “top 10 must reads” by Sales and Marketing Magazine.Mr. Romeo earned a Bachelor of Science degree in Mathematics and Economicsfrom the University of Massachusetts and an Executive MBA from Babson College.

 

**JOHNSCHOENHERR**has servedas a Director of the Company since December 30, 2004. Mr. Schoenherrserves as Vice President of Corporate Performance Management for OracleCorporation, and has served as an Oracle Vice President for over five years.Mr. Schoenherr has over 25 years of experience in the area ofbusiness intelligence. His career includes a number of product development andmanagement positions.

 

**FRANCIS J.CUSICK** has served asthe Chief Financial of the Company since February 28, 2005. Mr. Cusick joinedthe Company as the Corporate Controller in September 2004. Mr. Cusick served asan independent business consultant to public and private companies in a varietyof strategic and financial executive roles from March 2002 until September 2004.From January 2001 through February 2002, Mr. Cusick was Chief Financial Officerfor SANgate Systems, a multi-national provider of storage hardware and software.Between November 1999 and December 2000, Mr. Cusick served as CorporateController for Equipe Communications Corporation and was responsible for allaccounting and finance functions. Prior to Equipe, Mr. Cusick held seniorfinancial management positions at Parametric Technology Corp., CascadeCommunications Corp. and Synernetics Inc.

 

**RANDYFODERO**has served asthe Vice President of Sales since February 1, 2006. From July 22, 2005 untilFebruary 1, 2006, he was a sales consultant to the Company. Between July 18,2003 and July 22, 2005, Mr. Fodero was the Vice President of Sales andMarketing of the Company. Mr. Fodero joined the Company as a member of thesales organization in March 2003. Mr. Fodero brings more than20 years of successful executive and sales management experience to theCompany. Prior to joining the Company, Mr. Fodero served as director ofGlobal Accounts from Veritas Software from February 2002 untilJanuary 2003. Between 1999 and February 2002, Mr. Fodero servedin executive sales capacities with both companies in the enterprise softwareindustry, including Agile Software. From 1998 to 1999, Mr. Fodero servedas Regional Vice President of Sales for Memco Software, a leading provider ofinformation security software to Fortune 1000 companies, where he wasinstrumental in increasing sales and enhancing shareholder value in connectionwith the sale of Memco to Platinum Technology. From 1990 through 1998,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.

 

**KENNETH S.SOUZA**has served asChief Technology Officer of the Company since October 4, 2004 and theGeneral Manager, Law Enforcement since October 18, 2005. Prior to joining theCompany, Mr. Souza was Vice President of Industry Solutions for EMCCorporation. Prior to joining EMC, he was Vice President for e-CommerceEnterprise Systems Solutions for Compaq Computer Corporation. His 25-yeartechnology and market career includes serving in a number of executivepositions with Digital Equipment Corporation including Vice President WorldwideSolutions Services and Training, and Director of Workstations Marketing. In theearly 1980’s, Mr. Souza held technical sales management positions withHewlett Packard and Burroughs. Mr. Souza also held executive positionswith a venture funded MRP software company.

 

**Directors’Terms of Office**

 

Mr. May was initiallyelected to serve as a director in 2001, and was re-elected in 2004.Mr. Colatosti was initially elected to serve as a director in 2002, andwas re-elected in 2004. Mr. DePasquale was initially elected as a directorin 2003, and was re-elected in 2004. Mr. Schoenherr was initially electedas a director in 2004. Mr. Romeo was initially elected as a director in2005. Each such director was elected to serve until the Company’s next annualmeeting or until his successor is duly elected and qualified in accordance withthe By-laws of the Company.

 

**Board ofDirectors and Audit Committee 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.

 

43

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**DirectorsCompensation**

 

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)Beneficial Ownership Reporting Compliance**

 

Section 16(a) of theU.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 to furnishthe Company with copies of all forms filed with the SEC pursuant toSection 16(a) of the Exchange Act. Based solely on its review of thecopies of such forms received by it, or written representations from suchpersons that no other reports were required for such persons, the Company believesthat during the fiscal year ended December 31, 2005, allSection 16(a) filing requirements applicable to the Company’s officers,directors and ten percent (10%) stockholders were satisfied in a timelyfashion.

 

**ITEM 10. EXECUTIVE COMPENSATION**

 

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 endedDecember 31, 2003, 2004 and 2005:

 

**SUMMARY COMPENSATION 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                         |       | —                               |       | — |   | — |   | — |   | — |   | — |   | — |   |

 

44

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(1)  Mr. DePasquale became employed as ourChief Executive Officer on January 3, 2003.

 

(2)  Mr. Cusick became our Chief Financial Officeron February 28, 2005.

 

(3)  Mr. Fodero became Vice President of Saleson February 1, 2006. He was a sales consultant to the Company from July 22,2005 until February 1, 2006. Between July 18, 2003 and July 22, 2005, Mr.Fodero was the Senior Vice President of Sales and Marketing of the Company.

 

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

 

(5)  These options expired unexercised on October20, 2005.

 

(6)  Mr. Souza became an executive officer ofthe Company on October 4, 2004.

 

**OPTION GRANTS IN YEAR ENDED DECEMBER 31, 2005**

 

The following table setsforth all options granted during the year ended December 31, 2005 to eachof the named executive officers.

 
| **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                               |       | 11/10/12             |       |
|                       |            |                                                                  |            |                                                                                                   |            |                                    |            |                      |            |  |

 

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(1)   Options vested in three (3) annualinstallments commencing February 28, 2006.

 

(2)   Options vest 33.3% upon grant and thereafterat 22.2222% in three (3) annual installments commencing November 11, 2006.

 

**AGGREGATED OPTION EXERCISES IN THE YEAR ENDED**

**DECEMBER 31, 2005 AND FISCAL YEAR-END OPTION VALUE**

 

The following table setsforth for each named executive officer, information regarding stock optionsexercised by such officer during the year ended December 31, 2005,together with the number and value of stock options held at December 31,2005, each on an aggregated 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                                                                                                                          |       |

 

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(1) The last sales price ofthe Company’s Common Stock as reported on the OTC Bulletin Board onDecember 30, 2005 was $0.69.

 

45

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**EmploymentAgreements**

 

**MICHAEL W.DEPASQUALE.**   OnMarch 28, 2006, the Company entered into a two-year employment agreement withMichael 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 performance on anannual basis in the sole discretion of the Board of Directors. The employment agreement also provides forthe grant of options to purchase up to 400,000 shares of Company common stockpayable at the discretion of the Board of Directors.

 

In the event that Mr. DePasquale is terminated without 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 prohibitsMr. DePasquale from doing business with any current or prospective customerof the Company or engaging in a business competitive with that of the Companyduring the term of his employment and for the one year period thereafter. TheCompany may terminate the agreement at any time with or without cause. In theevent of termination without cause, Mr. DePasquale shall continue to bepaid his then current base salary for the greater of six months from the dateof such termination or the number of months remaining until the end of the termof the employment 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) year employment agreement with Kenneth S. Souza. The employmentagreement provides for an annual base salary of $200,000 and a performancebonus in the amount of up to $76,000 payable upon achievement of certainperformance criteria. Unless notice of non-renewal is provided toMr. Souza at least two months prior to the end of the term, the employmentagreement automatically renews for successive one year terms. In the event thatMr. Souza is terminated without cause, Mr. Souza will receiveseverance payment equal to his base salary for the greater of 6 months andthat number of months remaining until the end of the term. The employmentagreement contains standard and customary confidentiality, non-compete and workmade 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 its solediscretion.

 

**Change inControl 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 the Company;(iii) a merger or consolidation to which the Company is a party and afterwhich the prior shareholders of the Company hold less than 50% of the combinedvoting power of the surviving corporation’s outstanding securities;(iv) the incumbent directors cease to constitute at least a majority ofthe Board of Directors; or (v) a change in control of the Company whichwould otherwise be reportable under Section 13 or 15(d) of the ExchangeAct.

 

In the event of a “Change InControl” 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 theirrespective terms and permits the Company to make a cash payment to any or alloptionees equal to the difference between the exercise price of any or all suchoptions and the fair market value of the Company’s common stock immediatelyprior to the Change In Control. The 2004 Plan enables the Board to provide thatall outstanding 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 to executiveofficers outside of the Plans contain change in control provisionssubstantially similar to those contained in the 1999 Plan.

 

**Code of Ethics**

 

We haveadopted a Code of Ethics that applies to our principal executive officer,principal financial officer, principal accounting officer or controller, orpersons performing similar functions. Our Code of Ethics is designed to deterwrongdoing and promote: (i) honest and ethical conduct, including the ethicalhandling of actual or apparent conflicts of interest between personal andprofessional relationships; (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 internal reportingof violations of the code to an appropriate person or persons identified in thecode; and (v) accountability for adherence to the code. Any person may obtain acopy of our Code of Ethics free of charge by sending a written request for suchto the attention of the Chief Financial Officer of the Company.

 

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

 

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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* Less than 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, may includesecurities owned by or for, among others, the spouse and/or minor children ofan individual and any other relative who has the same home as such individual,as well as, other securities as to which the individual has or shares voting orinvestment power or which each person has the right to acquire within60 days through the exercise of options or otherwise. Beneficial ownershipmay be disclaimed as to certain of the securities. This table has been preparedbased 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)  Includes 66,666shares issuable upon exercise of options. Does not include 133,334 sharesissuable upon exercise of options subject to vesting.

 

(5)  Consists ofshares 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)  Includes200,000 shares issuable upon exercise of options. Does not include 400,000shares issuable upon exercise of options subject to vesting.

 

(9)  Includes100,000 shares issuable upon exercise of options. Does not include 200,000shares issuable 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.

 

**EQUITY COMPENSATION 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 of Directors and stockholders of the Company adopted the 1996 StockOption 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 termof stock options granted 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 a change in control, asdefined, all options outstanding vest immediately.  The Plan 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 is currentlyadministered by the Board of Directors of the Company (the “Plan Administrator”).The Plan Administrator is authorized to construe the 1999 Plan and any optionissued under the 1999 Plan, select the persons to whom options may be granted,and determine the number of shares to be covered by any option, the exerciseprice, vesting schedule and other material terms of such option.

 

The 1999 Plan provides forthe issuance of options to purchase up to 2,000,000 shares of common stock toofficers, 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 provides forthe immediate vesting of all options in the event of a “Change In Control” ofthe 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 December31, 2005, there were outstanding options under the 1996 Plan to purchase150,000 shares 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 1,062,125 sharesof common stock, and options to purchase an aggregate of 647,132 shares wereavailable for future grants.

 

On October 12, 2004, theBoard of Directors of the Company approved the 2004 Stock Option Plan (the 2004Plan). The 2004 Plan has not yet been presented to stockholders for approvaland thus incentive stock options are not available under this plan. Under theterms of this plan, 4,000,000 shares of common stock are reserved for issuanceto employees, officers, directors, and consultants of the Company at exerciseprices which may not be below 85% of fair market value. The term of stockoptions granted may not exceed ten years. Options issued under the 2004 Planvest pursuant to the terms of stock option agreements with the recipients. Inthe 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 2,052,860 sharesof common stock, and options to purchase an aggregate of 1,947,140 shares wereavailable 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 under the nonplan to purchase 3,082,850 shares of common stock. The terms of these optionsare substantially similar to the provisions of the 1999 Plan and optionsissued thereunder. 

 

48

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

 

**EmploymentArrangements**

 

The Companyhas entered into an employment agreements with Michael W. DePasquale andKenneth S. Souza. See **“EXECUTIVE COMPENSATION—EmploymentAgreements.”**

 

**OptionsGranted to Executive Officers and Directors**

 

During 2002,the Company issued options to purchase 200,000 shares of common stock to ThomasJ. Colatosti upon his appointment as a director of the Company. During 2003,2004 and 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, and vest over aone to three year period. 

 

**ConsultingArrangement with Thomas J. Colatosti**

 

In connectionwith his 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 December2003 and 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. The committeealso issued options to Mr. Colatosti to purchase 200,000 shares of common stockat an exercise price of $1.32 per share, the closing price of the Company’scommon stock on the date of grant, for serving as Chairman. Effective November1, 2004, Mr. Colatosti’s monthly consulting fee was increased to $14,500. Mr.Colatosti has substantial experience in the biometric industry and in additionto his role as the Chairman of the Board of Directors of the Company, providesextensive service to the Company in the areas of strategic planning andcorporate finance.

 

In March 2004,Mr. Colatosti entered into a three year consulting arrangement with the ShaarFund Ltd., a principal creditor and shareholder of the Company. Under the termsof the arrangement, The Shaar Fund transferred $375,000 principal amount of oursecured convertible notes due October 1, 2005 to Mr. Colatosti. On April 28,2004 the Company issued 3,750 shares of the Company’s Series A 7% convertiblepreferred stock to Mr. Colatosti in conversion of the $375,000 securedconvertible 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 provide services tothe Company and its subsidiaries and affiliates for the year ending December31, 2006, at a rate of $14,500 per month.

 

49

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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) Financial statements filed as part of this Report:

 

Report of Independent Certified Public Accountants

 

Balance Sheets at December 31, 2005 and 2004 and 2003

 

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

 

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

 

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

 

Notes to Financial Statements—December 31, 2005, 2004and 2003

 

(2) The exhibits listed in the Exhibits Index immediately precedingsuch exhibits are filed as part of this Report

 

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

 

Thefollowing table presents fees for professional audit services by DS&B, Ltd.for the audit of the Company’s annual financial statements for 2005 and 2004,and fees 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 |   |

 

*Audit Fees*consist of fees billed for professional services rendered for the auditof our financial statements and review of the interim financial statementsincluded in quarterly reports and services that are normally provided by DS&B,Ltd. in connection with statutory and regulatory filings or engagements. Auditfees also include fees for services provided in connection with businessacquisitions and registration of securities.

 

*Tax Fees*consists of fees billed for professional services for tax compliance,tax advice and tax planning. These services include assistance regardingfederal and state tax compliance, tax audit defense, customs and duties, andmergers and acquisitions.

 

**AuditCommittee Pre-Approval Procedures**

 

TheAudit Committee of our Board of Directors, which consists of John Schoenherrand Jeffrey 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.

 

50

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**ITEM7—FINANCIAL STATEMENTS**

 

Thefollowing financial statements of BIO-key International, Inc. are includedherein at the indicated page numbers:

 
| Report of Independent  Certified Public Accountants                                                      | 52     |
|----------------------------------------------------------------------------------------------------------|--------|
| Balance Sheets at December 31,  2005, 2004 and 2003                                                 | 53     |
| Statements of Operations—Years ended December 31,  2005, 2004 and 2003                         | 54     |
| Statement of Stockholders’  Equity (Deficit)—Years ended December 31, 2005, 2004 and 2003 | 55     |
| Statements of Cash Flows—Years ended December 31,  2005, 2004 and 2003                         | 56     |
| Notes to the Financial  Statements—December 31, 2005, 2004 and 2003                            | 57-141 |

 

51

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**Report of Independent Certified Public Accountants**

 

Board of Directors andStockholders

BIO-key International, Inc.

 

We have audited theaccompanying consolidated balance sheets of BIO-key International, Inc. and Subsidiaryas of December 31, 2005, 2004 and 2003, and the related statements ofoperations, stockholders’ equity (deficit) and cash flows for each of the yearsin the three year period ended December 31, 2005. These financial statementsare the responsibility of the Company’s management. Our responsibility is toexpress an opinion on these financial statements based on our audits.

 

We conducted our audits inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether the financial statements are free ofmaterial misstatement. The Company is not required to have, nor were we engagedto perform, an audit of its internal control over financial reporting. Ouraudit included consideration of internal control over financial reporting as abasis for designing audit procedures that are appropriate in the circumstances,but not for the purpose of expressing an opinion on the effectiveness of theCompany’s internal control over financial reporting. Accordingly, we express nosuch opinion. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement as well as evaluating the overall financial statement presentation.We believe our audits provide a reasonable basis for our opinion.

 

As described in Note B to theconsolidated financial statements, the Company restated its 2004 and 2003consolidated financial statements.

 

In our opinion, the financialstatements referred to above present fairly, in all material respects, thefinancial position of BIO-key International, Inc. and Subsidiary as of December31, 2005, 2004 and 2003, and the results of its operations and its cash flowsfor each of the years in the three year period ended December 31, 2005, inconformity with accounting principles generally accepted in the United States.

 

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. However, as discussed in note A to the financialstatements, the Company has only recently begun to generate significantrevenues, has suffered recurring losses from operations and has a workingcapital deficit. These aforementioned issues, among others, raise substantialdoubt about the Company’s ability to continue as a going concern. The financialstatements do not include any adjustments that might result front this uncertainty.Management’s plans in regard to these matters are also discussed in Note A.

 
| /s/  DS&B, Ltd.    |   |
|------------------------|--------|
|                   |   |
| Minneapolis  Minnesota |   |
| March 29,  2006        |

 

52

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**BIO-key International, Inc and Subsidiary**

**Consolidated Balance Sheets**

 
| ** **                                                                                                                                                                                                   | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                   | ** ** | **2005**              | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                                                                                                                                   | ** ** | ** **            | ** ** | **(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                                                                                                                                                        |       | 4,864,161             |       | 5,037,415 |   | 150,206 |   |
| 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                                                                                                                                                |       | $                     | 1,201,207  |   | $ | 3,078,037 |   | $ | — |   |
| 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                                                                                                                                                                                   |       | 11,295,601            |       | 13,356,705 |   | 551,308 |   |
| Long-term  obligations, net of discount and current maturities                                                                                                                                               |       | 3,723,017             |       | 10,848,304 |   | 10,373,680 |   |
| Deferred rent                                                                                                                                                                                                |       | 867,850               |       | 1,311,454 |   | — |   |
| Deferred  revenue                                                                                                                                                                                            |       | 1,163,738             |       | 71,203 |   | — |   |
| Total  non-current liabilities                                                                                                                                                                               |       | 5,754,605             |       | 12,230,961 |   | 10,373,680 |   |
| **TOTAL  LIABILITIES**                                                                                                                                                                                       |       | 17,050,206            |       | 25,587,666 |   | 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                                                                                                                                                                                  |       | 51,529,332            |       | 47,996,243 |   | 18,327,992 |   |
| Accumulated  deficit                                                                                                                                                                                         |       | (42,226,240           | )          | (42,452,248 | ) | (27,909,129 | ) |
| **TOTAL  STOCKHOLDERS’ EQUITY (DEFICIT)**                                                                                                                                                               |       | 9,307,728             |       | 5,951,426 |   | (9,368,866 | ) |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)**                                                                                                                                               |       | $                     | 26,357,934 |   | $ | 31,539,092 |   | $ | 1,556,122 |   |

 

The accompanying notes are an integral part ofthese statements.

 

53

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**BIO-key International, Inc. and Subsidiary**

**STATEMENTS OF OPERATIONS**

 
| ** **                                     | ** ** | **Years ended December 31,** | ** ** |
|------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                     | ** ** | **2005**                          | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                     | ** ** | ** **                        | ** ** | **(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                              |       | (6,548,130                        | )          | (1,916,558 | ) | (1,909,788 | ) |
| Derivative  and warrant fair value adjustments |       | 15,213,186                        |       | (6,003,137 | ) | 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)               |       | 8,646,247                         |       | (7,908,171 | ) | (1,048,098 | ) |
| **NET INCOME (LOSS)**                          |       | $                                 | 358,065    |   | $ | (14,345,632 | ) | $ | (4,058,950 | ) |
| ** **                                     |       |                              |       |   |   |   |   |
| **Earnings (Loss) Per Share:**                 |       |                              |       |   |   |   |   |
| **Basic**                                      | ** ** | $                                 | 0.00       |   | $ | (0.42 | ) | $ | (0.24 | ) |
| **Diluted**                                    | ** ** | $                                 | (0.17      | ) | $ | (0.42 | ) | $ | (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 |   |

 

The accompanying notes are an integral part of these statements.

 

54

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**BIO-key International, Inc. and Subsidiary**

**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                             |       | —                |       | —                |       | —                |       | —            |       | —          |       | —          |       | 24,221     |       | 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     |           | 2,513,086 |   | — |   | 2,547,644 |   |
| 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 |   |
| Reclassification of  Warrants from liability to equity                                                                                |       | —                |       | —                |       | —                |       | —            |       | —          |       | —          |       | —     |       | —     |           | 2,847,019 |   | — |   | 2,847,019 |   |
| Net loss                                                                                                                              |       |                  |       |                  |       |                  |       |              |       |            |       |            |       |       |       |       |           |   |   | (14,345,632 | ) | (14,345,632 | ) |
| **Balance  as of December 31, 2004 (Restated)**                                                                                  | ** ** | **—**            | ** ** | **$**                 | **—** | ** **            | **—** | ** **        | **$**      | **—**      | ** ** | **62,182**      | ** ** | **$**      | **623**    | ** ** | **40,680,692** | ** ** | **$** | **406,808** | ** ** | **$** | **47,996,243** | ** ** | **$** | **(42,452,248** | **)** | **$** | **5,951,426** | ** ** |
| 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        |           | 889,845 |   | — |   | 890,003 |   |
| 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 income                                                                                                                            |       | —                |       | —                |       | —                |       | —            |       | —          |       | —          |       | —     |       | —     |           | — |   | 358,065 |   | 358,065 |   |
| **Balance  as of December 31, 2005**                                                                                             | ** ** | **44,557**            | ** ** | **$**                 | **4**      | ** **            | **—** | ** **        | **$**      | **—**      | ** ** | **—**      | ** ** | **$**      | **—** | ** ** | **46,306,589** | ** ** | **$** | **4,632** | ** ** | **$** | **51,529,332** | ** ** | **$** | **(42,226,240** | **)** | **$** | **9,307,728** | ** ** |

 

The accompanying notes are an integral part of these statements.

 

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**BIO-key International, Inc. and Subsidiary**

**STATEMENTS OF CASH FLOWS**

 
| ** **                                                                                  | ** ** | **Years ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                  | ** ** | **2005**                          | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                  | ** ** | ** **                        | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
|                                                                                        |       |                              |       |   |   |   |   |
| **CASH  FLOW FROM OPERATING ACTIVITIES:**                                                   |       |                              |       |   |   |   |   |
| Net Income  (Loss)                                                                          |       | $                                 | 358,065    |   | $ | (14,345,632 | ) | $ | (4,058,950 | ) |
| **Adjustments  to reconcile net income (loss) to net cash used   in operating activities:** |       |                              |       |   |   |   |   |
| Derivative  and warrant fair value adjustments                                              |       | (15,213,186                       | )          | 6,003,137 |   | (857,545 | ) |
| Depreciation                                                                                |       | 244,450                           |       | 77,912 |   | 6,386 |   |
| Amortization                                                                                |       |                              |       |   |   |   |   |
| Intangible  assets                                                                          |       | 1,509,880                         |       | 550,421 |   | — |   |
| Discounts on  convertible debt related to warrants and beneficial conversion features       |       | 4,124,759                         |       | 1,258,341 |   | 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 of these statements.

 

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**BIO-key International, Inc. and Subsidiary**

**NOTES TO THE FINANCIAL STATEMENTS**

**December 31, 2005, 2004 and 2003**

 

**NOTE A—THECOMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

*Change inName of Company and State of Incorporation*

 

EffectiveJanuary 1, 2005, BIO-key International, Inc., a Minnesota corporation(“Old BIO-key”), reincorporated as BIO-key International, Inc., a Delawarecorporation (the “Company,” “BIO-key”,). The reincorporation was effected pursuantto an Agreement and Plan of Merger (the “Merger Agreement”); whereby OldBIO-key was merged with and into the Company, its wholly owned subsidiary, inorder to reincorporate in the State of Delaware (the “Reincorporation”). As aresult of the Reincorporation, the legal domicile of the registrant is nowDelaware.

 

*Nature ofBusiness*

 

TheCompany, founded in 1993, made two strategic acquisitions in 2004. The Companyacquired Public Safety Group Inc. (“PSG”) in March, 2004, and the MobileGovernment division of Aether Systems, Inc. (“AMG” or “Mobile Government”)in September, 2004. The Company is now focused on delivering advanced fingerbased biometric identification and security solutions and information servicesto law enforcement, fire service and emergence medical service agencies as wellas other 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.

 

*Basis ofPresentation*

 

Broadcommercial acceptance of the Company’s technology is critical to the Company’ssuccess and ability to generate revenues. As a result of two acquisitions, theCompany’s only significant revenues to date have began in the fourth quarter of2004. The Company recorded approximately $14,226,000 in revenues in 2005. TheCompany has accumulated losses during 2003 and 2004 of approximately $ 18,405,000,of which approximately $ 14,346,000 was incurred during 2004. The Companyreported a profit of approximately $358,000 in 2005. As of December 31,2005, there was a working capital deficit of approximately $3,600,000.

 

TheCompany issued notes in 2004 as well as 2005 in amount of approximately $10,101,000and $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.

 

Theaccompanying financial statements have been prepared in conformity withaccounting principles generally accepted in the United States, whichcontemplate continuation of the Company as a going concern. The mattersdescribed in the preceding paragraphs raise substantial doubt about the Company’sability to continue as a going concern. Recoverability of a major portion ofthe recorded asset amounts shown in the accompanying balance sheet is dependentupon the Company’s ability to obtain additional funding, meet its fundingrequirements on a continuing basis, and succeed in its future operations. Theaccompanying financial statements do not include any adjustments that might benecessary should the Company be unable to continue in existence.

 

*Summary ofSignificant Accounting Policies*

 

Asummary of the significant accounting policies consistently applied in thepreparation of the accompanying 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*

 

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 may includesoftware license fees, usage fees and services or various combinations thereof.For each arrangement, revenues will be recognized when evidence of an agreementhas been documented, the fees are fixed or determinable, collection of fees isprobable, delivery of the product has occurred and no other significantobligations 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 sold separately(i.e., software license fees charged when consulting or other services are notprovided, hourly rates charged for consulting services when sold separatelyfrom a software license or usage fees). If vendor specific objective evidenceof fair value does not exist for any undelivered elements, all revenue isdeferred and recognized ratably over the service period if the undeliveredelement is services, or until sufficient objective evidence of fair valueexists 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 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.

 

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 of activityused by the customer or, in the case of fixed-fee arrangements, ratably overthe arranged time period.

 

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

 

3.             *Cash and Cash Equivalents*

 

Cashequivalents consist of certificates of deposit and all other liquid investmentswith original maturities of three months or less. The Company maintains itscash balances in a financial institution in Nevada. These balances are insuredby the 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.

 

58

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5.             *Accounting for Acquisitions*

 

TheCompany completed 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 intangible assets.Our accounting for these acquisitions involves significant judgments andestimates regarding fair values of acquired intangible assets, which are basedon 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 andAmortization*

 

Depreciationis provided for in amounts sufficient to relate the cost of depreciable assetsto operations 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 financing fees are amortized on the straight-line method overtheir expected useful lives. Financing fees related to the issuance oflong-term obligations are capitalized and amortized to interest expense overthe lives of the related debt using the effective interest rate method. Patentcosts are capitalized until patents are awarded. Upon award, such costs areamortized over their respective lives. If a patent is denied, all costs arecharged to operations in that year.

 

Theestimated useful lives used to compute depreciation and amortization forfinancial reporting purposes 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            |
| Financing fees                          |     | 3 years            |
| Patents                                 |     | life               |

 

Theestimated aggregate amortization expense of intangible assets for the fiveyears following 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*

 

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.

 

59

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8.             *Derivative and Warrant FinancialInstruments*

 

Inconnection with the sale of debt or equity instruments, we may selloptions or warrants to purchase our common stock. In certain circumstances,these options or warrants may be classified as derivative liabilities,rather than as equity. Additionally, the debt or equity instruments may containembedded derivative 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 or liability.

 

Theidentification of, and accounting for, derivative instruments is complex. Ourderivative instrument liability is re-valued at the end of each reporting period,with changes in the fair value of the derivative liability recorded as chargesor 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 financial statements.

 

9.             *Goodwill and IntangibleAssets*

 

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 30thof each year using a number of criteria, including the value of the overallenterprise. As of December 31, 2005, the Company believes that no materialimpairment exists. Future impairment charges from previous or futureacquisitions, if any, will be reflected as an operating expense in thestatement of operations.

 

10.           *Impairment of Long-LivedAssets*

 

TheCompany has adopted SFAS No. 144, Accounting for the Impairment orDisposal of Long-Lived Assets. In accordance with SFAS No. 144, long-livedassets subject to depreciation and amortization are reviewed for impairmentwhenever events or changes in circumstances indicate the carrying amount of anasset may not be recoverable. The Company’s long-lived assets consistprimarily of its equipment and leasehold improvements and its intangibleassets. Upon indication of possible impairment, the Company evaluates therecovery of held-for-use long-lived assets by measuring the carrying value ofthe assets against the related estimated undiscounted future cash flows. Whenan evaluation indicates that the future undiscounted cash flows are notsufficient to recover the carrying value of the asset, the asset is adjusted toits estimated fair value. The following circumstances would be consideredimportant and could lead to an impairment review; significant changes in the mannerof our using the asset, negative industry or economic trends andunderperformance relative to projected operating results.

 

11.           *Advertising Expense*

 

TheCompany expenses the costs of advertising as incurred. Advertising expenses forthe years ended December 31, 2005, 2004, and 2003, were approximately $108,000,$146,000, and $18,000, respectively.

 

12.*          **Deferred Revenue*

 

Deferredrevenue includes 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*

 

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.

 

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14.           *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,“Earnings Per Share of Common Stock,” for additional information.

 

15.           *Accounting for Stock-BasedCompensation*

 

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.

 

OnDecember 31, 2005, the Company accelerated the vesting of certain of theoutstanding options to purchase shares of the Company’s common stock withoption exercise prices greater than the fair market value of the Company’scommon stock on such date. The acceleration applies to all such optionsoutstanding as of December 31, 2005 under the Company’s 1996 Stock OptionPlan, 1999 Stock Option Plan and 2004 Stock Option Plan, except for optionsheld by the Company’s executive officers subject to Section 16(b) ofthe Securities Exchange Act of 1934, as amended, and the members of the Company’sBoard of Directors. Options to purchase up to 897,614 shares of the Company’scommon stock, or 14% of the total shares of the Company’s common stock subjectto outstanding options, with a weighted average exercise price of approximately$1.09 and varying remaining vesting schedules, are subject to this accelerationand become immediately vested and exercisable as of December 31, 2005. Thenumber of shares, exercise prices and other terms of the options subject to theacceleration remain unchanged.

 

Asa result of this acceleration, the Company expects to reduce its exposure tothe effects of the Financial Accounting Standards Board’s Statement ofFinancial Accounting Standards No. 123 (revised 2004), Share-Based Payment(FAS 123R), which requires companies to recognize stock-based compensationexpense associated with stock options based on the fair value method. TheCompany currently expects reductions in stock-based compensation expenseassociated with this acceleration of approximately $330,000 for fiscal year2006 and approximately $225,000 for fiscal year 2007.

 

*Proforma Compensation Disclosure*

 

InDecember 2002, the Financial Accounting Standards Board (FASB) issued SFASNo.148, Accounting for Stock-Based Compensation-Transition and Disclosure. SFASNo. 148 amends SFAS No. 123, Accounting for Stock-Based Compensation,to provide alternative methods of transition for a voluntary change to the fairvalue based method of accounting for stock-based employee compensation. Inaddition, SFAS No. 149 requires expanded, more prominent disclosure inboth annual and interim financial statements about the method of stock-basedemployee compensation 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 measurement provisionsof APB Opinion No. 25, Accounting for Stock issued to Employees, andrelated interpretations 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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Ifcompensation expense for the stock options granted had been determined based onthe fair value at the grant dates consistent with the method of SFAS No. 123,the Company’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)** | ** ** |
| Net income  (loss) available to common shareholders                         |       | 44,548                            |       | (14,730,987 | ) | (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                        |       | (1,451,538                        | )          | (14,998,987 | ) | (4,331,705 | ) |
| Basic income  (loss) per common shares                                      |       | 0.00                              |       | (0.42 | ) | (0.24 | ) |
| Basic loss  per common shares - pro forma                                   |       | (0.03                             | )          | (0.43 | ) | (0.25 | ) |
| Diluted loss  per comon shares                                              |       | (0.17                             | )          | (0.42 | ) | (0.24 | ) |
| Diluted loss  per comon shares - pro forma                                  |       | (0.20                             | )          | (0.43 | ) | (0.25 | ) |

 

Indetermining the proforma compensation cost of the options granted, the fairvalue of each grant was estimated on the date of grant using the Black-Scholesoption pricing model. The assumptions used to determine the fair value of eachgrant included the 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*

 

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 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’s historicalperformance and estimated future taxable income a full valuation allowance hasbeen established.

 

17.           *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, in the opinion of management are used in accounting for, amongother things, long-term contracts, allowances for uncollectible receivables,recoverability of goodwill and other long-lived assets, depreciation andamortization, valuation of deferred income taxes, convertible notes and relateddiscounts, embedded derivates, preferred stock, stock options, and warrantsoutstanding.

 

62

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18.           *Recent AccountingPronouncements*

 

InNovember 2005, FASB issued FSP FAS 115-1 and FAS 124-1, “TheMeaning of Other-Than-Temporary Impairment and Its Application to CertainInvestments” (“FSP FAS 115-1”), which provides guidance on determiningwhen investments in certain debt and equity securities are considered impaired,whether that impairment is other-than-temporary, and on measuring suchimpairment loss. FSP FAS 115-1 also includes accounting considerationssubsequent to the recognition of an other-than temporary impairment andrequires certain disclosures about unrealized losses that have not beenrecognized as other-than-temporary impairments. FSP FAS 115-1 is requiredto be applied to reporting periods beginning after December 15, 2005. Weare required to adopt FSP FAS 115-1 in the first quarter of fiscal 2006. We donot expect that the adoption of the statement will have a material impact onour consolidated results or financial condition.

 

InMay 2005, FASB issued SFAS 154, “Accounting Changes and ErrorCorrections—a replacement of APB Opinion No. 20 and FASB Statement No. 3”.SFAS 154 changes the requirements for the accounting for and reporting of achange in accounting principle, and applies to all voluntary changes in accountingprinciple. It also applies to changes required by an accounting pronouncementin the unusual instance that the pronouncement does not include specifictransition provisions. This statement requires retrospective application toprior periods’ financial statements of changes in accounting principle, unlessit is impracticable to determine either the period-specific effects or thecumulative effect of the change. SFAS 154 is effective for accountingchanges made in fiscal years beginning after December 15, 2005. We do notexpect that adoption of this statement will have a material impact on ourresults of operations or financial condition.

 

InMarch 2005, the FASB issued FASB Interpretation No. 47, *Accounting for Conditional Asset RetirementObligations – an interpretation of FASB Statement No. 143*(FIN47), which requires companies to recognize a liability for the fair value of alegal obligation to perform asset retirement activities that areconditional on a future event if the amount can be reasonably estimated. Weadopted the provisions of FIN 47 on December 31, 2005. No conditionalasset retirement obligations were recognized and, accordingly, the adoption ofFIN 47 had no effect on our financial statements.

 

InDecember 2004, the FASB issued SFAS No. 123 (revised 2004), *Share-Based Payment*(SFAS 123R). Thisstatement replaces SFAS No. 123 and supersedes *APB Opinion No. 25, Accounting for Stock Issued to Employees.*SFAS 123Rrequires all share-based payments to employees, including grants of employee stockoptions, 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 new awardsand to awards modified, repurchased, or cancelled after the required effectivedate. Additionally, compensation cost for the unvested portion of awardsoutstanding 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.

 

InNovember 2004, the FASB issued Statement No. 151,*Inventory Costs—an amendment of ARB No. 43,Chapter 4*, which amends and clarifies existing accounting literatureregarding abnormal amounts of idle facility expense, freight, handling costs,and wasted material (spoilage). This statement is effective for inventory costsincurred during fiscal years beginning after June 15, 2005, with earlierapplication permitted. The provisions of this statement are to be appliedprospectively. The adoption of this standard is not expected to have a materialeffect on the Company’s financial position, results of operations, orliquidity.

 

63

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**NOTEB—Restatement of Previously Issued Financial Statements**

 

RESTATEMENT

 

In the process of reviewingour registration statement for the securities issued in our June 2005financing, the Securities and Exchange Commission (“SEC”) raised questions withregard to our convertible term notes suggesting that we consider EITF 00-19 “Accountingfor Derivative 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 also commented that the Company shouldreview the convertible notes issued in fiscal 2003 and 2004. The SEC staff alsoasked us to review adjustments to revenue made in the fourth quarter of 2004.The SEC staff raised the question of whether the transactions had a materialimpact on previously filed Exchange Act reports and would be bettercharacterized as restatements.

 

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

 

•              *Revenue Recognition*

TheCompany reviewed contracts and purchase agreements related to certainnon-governmental customers and identified specific contracts for which theinitial accounting inflated annual and quarterly revenues and earnings inviolation of generally accepted accounting principles (“GAAP”). These practiceswere primarily the result of recognizing revenue on transactions with customersthat were not creditworthy and recognizing revenue when the earnings processhad not been completed. The revenue and related cost has been adjusted on theincome statement as well as the related balance sheet accounts.

 

•              *Accounting for Convertible Financing Arrangements*

TheCompany reviewed the initial accounting for the 7% Convertible Notes issued in2003, the Senior and Subordinated Convertible Term Notes issued in 2004 and theSenior and Subordinated Convertible Term Notes issued in 2005. During thereview the company identified that EITF 00-19 should be applied to evaluatewhether any 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 12 to 32and determined that these instruments would not be classified as components ofstockholders equity. The instruments have been deemed liabilities, and as suchwill be subject to SFAS 133 and should be recorded at fair value. Features thathave been evaluated and determined to require such treatment include:

 

•      The principal conversion option

 

•      The monthly payments conversion option

 

•      The interest 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. Thecorrection of prior errors affected the subsequent accounting for debt conversionsto equity as well as the amortization of related discounts and deferred financecharges associated with the above financings.

 

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 our previouslyreported financial information, and the failure to prevent them or detect themin our financial reporting process, were largely attributable to weak internalcontrols and an inadequate staff of competent accounting personnel with anappropriate 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 and 2004 and our previously reported unaudited financial statements forthe 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.

 

64

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For the quarterly impact ofthe restatement and the restated financial results for the first, second and thirdquarters of 2003, 2004, and 2005, see Note X, Results by Quarter.

 

The following tables summarize the impact of all ofthese adjustments on previously reported revenue, and assets, liabilities, andretained stockholders’ equity (deficit) for the years ended December 31,2004 and 2003.

 
| ** **                 | ** ** | **Impact of Adjustments on  Revenue**     | ** ** |
|----------------------------|------------|-------------------------------------------|------------|
| ** **                 | ** ** | **For the Years Ended December 31,** | ** ** |
| ** **                 | ** ** | **2004**                                  | ** ** | **2003** | ** ** |
|                       |       |                                      |       |   |   |
| **As previously reported** |       | $                                         | 5,558,231  |   | $ | 524,101 |   |
| Revenue recognition        |       | 162,720                                   |       | (308,620 | ) |
| **As restated**            |       | $                                         | 5,720,951  |   | $ | 215,481 |   |

 
| ** **                                        | ** ** | **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                                                           |       | 5,340,573 |   | (4,524,072 | ) | — |   | (57,543 | ) | 57,543 |   |
| Total Adjustments                                 |       | 694,411                                                           |       | 5,364,383 |   | (4,669,972 | ) | (308,620 | ) | (75,743 | ) | (232,877 | ) |
| **As  restated**                                  |       | $                                                                 | 31,539,092 |   | $ | 25,587,666 |   | $ | 5,951,426 |   | $ | 1,556,122 |   | $ | 10,924,988 |   | $ | (9,368,866 | ) |

 

65

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The following tables present the effect of therestatement adjustments on the consolidated Statement of Operations for theyears ended December 31, 2004 and 2003.

 
| ** **                                                                 | ** ** | **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                               | )          | (1,249,550 | ) | (1,916,558 | ) |
| Derivative  and warrant fair value adjustments                             |       |                                   |       | (6,003,137 | ) | (6,003,137 | ) |
| Gain on sale  of marketable securities                                     |       | —                                 |       |   |   | — |   |
| Other  expense                                                             |       | (55,300                                | )          | — |   | (55,300 | ) |
| Total other  income (deductions)                                           |       | (655,484                               | )          | (7,252,687 | ) | (7,908,171 | ) |
| **NET LOSS**                                                               |       | $                                      | (7,237,465 | ) | $ | (7,108,167 | ) | $ | (14,345,632 | ) |
|                                                                       |       |                                   |       |   |   |   |   |
| **Basic Loss per Share:**                                                  |       |                                   |       |   |   |   |   |
| *Numerator*                                                                | * *   |                                   |       |   |   |   |   |
| Net loss                                                                   |       | $                                      | (7,237,465 | ) | $ | (7,108,167 | ) | $ | (14,345,632 | ) |
|                                                                       |       |                                   |       |   |   |   |   |
| Convertible  preferred stock dividends and accretion                       |       | (414,240                               | )          | 28,885 |   | (385,355 | ) |
|                                                                       |       |                                   |       |   |   |   |   |
| Net loss  attributable to common shareholders                              |       | $                                      | (7,651,705 | ) | $ | (7,079,282 | ) | $ | (14,730,987 | ) |
|                                                                       |       |                                   |       |   |   |   |   |
| *Denominator*                                                              | * *   |                                   |       |   |   |   |   |
| Weighted  average common shares outstanding                                |       | 34,806,201                             |       | 34,806,201 |   | 34,806,201 |   |
| ***Basic Loss per Share***                                                 |       | $                                      | (0.22      | ) | $ | (0.20 | ) | $ | (0.42 | ) |
|                                                                       |       |                                   |       |   |   |   |   |
| **Diluted Loss per Share:**                                                |       |                                   |       |   |   |   |   |
| *Numerator*                                                                | * *   |                                   |       |   |   |   |   |
| Net loss  attributable to common shareholders                              |       | $                                      | (7,651,705 | ) | $ | (7,079,282 | ) | $ | (14,730,987 | ) |
|                                                                       |       |                                   |       |   |   |   |   |
| Effect of  Dilutive Securities:                                            |       | —                                 |       | — |   | — |   |
| Convertible  Debentures                                                    |       |                                   |       |   |   |   |   |
|                                                                       |       |                                   |       |   |   |   |   |
| Net loss  attributable to common shareholders and assumed conversions      |       | $                                      | (7,651,705 | ) | $ | (7,079,282 | ) | $ | (14,730,987 | ) |
|                                                                       |       |                                   |       |   |   |   |   |
| *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      | ) | $ | (0.20 | ) | $ | (0.42 | ) |

 

66

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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 | ) |

 

67

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The following tables present the effect of therestatement adjustments on the Consolidated Balance Sheet as of December 31,2004 and 2003.

 

**CONSOLIDATEDBALANCE SHEET**

 
| ** **                                                                                                                                                                       | ** ** | **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                        |       | 860,136 |   | 5,037,415 |   |
| 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  |   | $ | (177,145 | ) | $ | 3,078,037 |   |
| 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                       |       | (196,970 | ) | 13,356,705 |   |
| Long-term  obligations, net of discount and current maturities                                                                                                                   |       | 5,286,951                        |       | 5,561,353 |   | 10,848,304 |   |
| Deferred  rent                                                                                                                                                                   |       | 1,311,454                        |       | — |   | 1,311,454 |   |
| Deferred  revenue                                                                                                                                                                |       | 71,203                           |       | — |   | 71,203 |   |
| Total  non-current liabilities                                                                                                                                                   |       | 6,669,608                        |       | 5,561,353 |   | 12,230,961 |   |
| TOTAL  LIABILITIES                                                                                                                                                               |       | 20,223,283                       |       | 5,364,383 |   | 25,587,666 |   |
| **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                       |       | 2,671,071 |   | 47,996,243 |   |
| Accumulated  deficit                                                                                                                                                             |       | (35,111,205                      | )          | (7,341,043 | ) | (42,452,248 | ) |
| TOTAL  STOCKHOLDERS’ EQUITY (DEFICIT)                                                                                                                                       |       | 10,621,398                       |       | (4,669,972 | ) | 5,951,426 |   |
| TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)                                                                                                                       |       | $                                | 30,844,681 |   | $ | 694,411 |   | $ | 31,539,092 |   |

 

68

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**CONSOLIDATEDBALANCE 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                                                                                                                           |       | 150,206                          |       | — |   | 150,206 |   |
| 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 |   |

 

69

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**NOTEC—ACQUISITIONS**

 

*Acquisitionof Public Safety Group, Inc.*

 

OnMarch 30, 2004, we acquired all of the outstanding capital stock of PublicSafety Group, Inc. (PSG), a privately-held leader in wireless solutionsfor law enforcement and public safety markets based in Winter Park, Florida.The acquisition was completed pursuant to the terms of an Agreement and Plan ofMerger (the Merger Agreement) by and among the Company, BIO-Key AcquisitionCorp., a wholly-owned subsidiary of the Company, PSG and all of theshareholders of PSG. As a result of this transaction PSG became a wholly-ownedsubsidiary of the Company and now constitutes a division of our businessspecializing in the law enforcement and public safety markets (the PublicSafety Division). The business combination was accounted for using the purchasemethod.

 

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 shares issuedto the PSG shareholders (the Merger Shares) are subject to escrow provisionscontained in the Merger Agreement and a related escrow agreement, which providefor 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, withoutlimitation, the right to vote and receive dividends. The principal terms of theescrow arrangement are as follows:

 

•      One-twelfth (1/12 ) of the Merger Shareswere held in escrow for the purpose of securing certain prior obligations ofPSG to Harward.

 

•      The remaining eleven-twelfths (11/12) of theMerger Shares will be released to the former shareholders of PSG at quarterlyintervals, on a distribution schedule determined by the revenues achievedby the Public Safety Division during 2004. According to the distributionschedule, all of the Merger Shares will be released as early as September 30,2006 but no later than December 31, 2007.

 

•      Of the remaining eleven-twelfths (11/12) of theMerger Shares, those shares owned by former employees of PSG who became ouremployees by virtue of the merger transaction are subject to repurchase by usunder certain circumstances involving the termination of such employee’semployment. Shares remaining in escrow may also be used to fundindemnification obligations of the former PSG shareholders pursuant to theMerger 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 the estimated fair value of the netassets 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 Liabilites     |   | (332,307  | )         |
| Long-term obligations  |   | (400,000  | )         |
| Purchase price         |   | $         | 4,108,941 |   |

 

70

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*Acquisitionof Mobile Government*

 

OnSeptember 30, 2004, we acquired certain assets and assumed certainliabilities of the Mobile Government division of Aether Systems, Inc (Aether).The aggregate purchase price of the acquisition was $12,198,171, which includesa $311,537 post closing reduction in deferred rent and a working capitaladjustment payment of $341,878 made to Aether during December 2004. TheCompany did not finalize the purchase price of Aether Mobile Government until September 30,2005.

 

Asummary of the adjusted estimated fair value of the net assets acquired andliabilities 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 |   |

 

Thecomponents of the adjusted purchase price are as follows:

 

| 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 |   |

 

Inconnection with this acquisition, the Company issued a subordinated securedpromissory note to Aether in the face amount of $6,884,588 (the “Aether Note”).The Aether Note evidences a contingent reimbursement obligation of the Companyto Aether and a surety fee payable by the Company to Aether, in each case withrespect to a letter of credit maintained by Aether for the Company’s benefit inconnection with the acquisition. The Company’s obligations under the AetherNote are secured by a security interest granted to Aether in all orsubstantially all of the Company’s assets subordinate to the security interestdescribed in the Long-Term Obligations footnote.

 

Inconjunction with the acquisition of the Mobile Government division, the companywas required to place approximately $2,750,000 in escrow as of September 30,2004, for the following:

 

$1,000,000in escrow deposit supporting a $6,884,588 subordinated secured promissory noteissued to Aether to secure performance obligations assumed under a contractwith Hamilton County, Ohio. The obligation is expected to extend for one yearafter final acceptance of the system by the customer. Acceptance is expected tooccur in 2006.

 

$1,000,000in escrow available to Lockheed Martin in the event of non-payment ofliabilities for work performed on a contract with the Pennsylvania StatePolice. The escrow is available to Lockheed Martin until conditional acceptanceof certain defined milestones. During 2005, the entire escrow was returned tothe Company upon successful completion of a project milestone.

 

Thereis approximately $750,000 in escrow which is available to the landlord of a subleasedfacility in the event the company defaults on a lease. The funds will not beavailable for use by the company until the termination of the lease in August 2008.

 

71

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The acquisitions of theMobile Government Division from Aether Systems, Inc., (“Mobile Government”) andof Public Safety Group (“PSG) required a significant increase in accountingoperations on the part of the Company. At the time of the acquisitions the Companyreceived some detailed information, however the period that was required toidentify and measure the fair value of all of the assets acquired and theliabilities assumed through the acquisition was not feasible given the existingstaffing constraints of the organization. In order to comply with the fairvalue requirement noted in paragraph 6 of EITF 01-03, the Company conductedit’s review of the acquired net assets of both PSG and Mobile Government as ofthe dates of acquisition, March 30, 2004 and September 30, 2004 respectively,and determined an initial price allocation. The Company, subsequent to thisinitial price allocation and through the course of ongoing reviews andassessments of the assets acquired and the liabilities assumed through the acquisition,determined that there were several adjustments that were required. Theinformation that helped determine these adjustments became available andobtainable subsequent to the acquisition date. Thus, the Company has madeadjustments accordingly subsequent to the acquisition date in accordance withthe definition of “allocation period” in Appendix F of FAS 141. Theseadjustments 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, 2005and September 30, 2005, respectively.

 

*LiquidatedDamages*

 

The Company may have to payliquidated damages to customers in certain circumstance, including instanceswhere its sub-contractors do not perform on time. In addition, the Companysometimes indemnifies certain of its customers against damages, if any, theymight incur as a result of a claim brought against them related to third partysoftware 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. 

 

*WarrantyReserve*

 

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 ofOperations*

 

A summary of the aggregateoperating results of the two acquired businesses for the year endedDecember 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 | ) |

 

 

72

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*Pro FormaInformation*

 

The following unauditedfinancial data reflects revenue, loss from continuing operations, net loss andloss applicable per common share of the Company for the years endedDecember 31, 2004 and 2003 as though the PSG and Mobile Governmenttransactions had occurred as 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 approximately 11%,27%, and 82% of the company's outstanding accounts receivable balance,respectively. As of December 31, 2005 and 2004 one customer accounted for approximately86% of the costs and earnings in excess of billings on uncompleted contracts.For the years ended December 31, 2005, 2004 and 2003, two, one, and onecustomer(s) accounted for approximately 16%, 21% and 46%  of the Company's revenue, respectively. 

 

For the yearsended December 31, 2005 and 2004 the customers generating 16% and 21% of the Company'srevenue, respectively, were customers of the Law Enforcement segment. For theyear ended December 31, 2003, the customer generating 46% of the companiesrevenue was a customer of the Biometrics segment.

 

For the years ended December31, 2005 and 2004 sales to governmental entities amounted to approximately 79%and 89% of total revenue.  As of December31, 2005 and 2004 governmental customers amounted to approximately 74% and 62%of total accounts receivable.

 

**NOTEE—COSTS AND EARNINGS IN EXCESS OF BILLINGS ON UNCOMPLETED CONTRACTS**

** **

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

 

| ** **                                                         | ** ** | **2005**    | ** ** | **2004**     | ** ** |
|--------------------------------------------------------------------|------------|-------------|------------|--------------|------------|
| ** **                                                         | ** ** | ** **  | ** ** | **Restated** | ** ** |
| Cost and Earnings incured 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 |   |

 

73

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**NOTEF—PREPAID EXPENSES**

** **

Prepaid expenses consistedof the following as of December 31: 

 

| ** **          | ** ** | **2005**   | ** ** | **2004**     | ** ** | **2003**     | ** ** |
|---------------------|------------|------------|------------|--------------|------------|--------------|------------|
| ** **          | ** ** | ** ** | ** ** | **Restated** | ** ** | **Restated** | ** ** |
| ** **          | ** ** | ** ** | ** ** | ** **   | ** ** | ** **   | ** ** |
| 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 expiredOctober 31, 2004. 

 

**NOTEG—EQUIPMENT AND LEASEHOLD IMPROVEMENTS**

 

Equipment and leaseholdimprovements consisted of the following as of December 31:

 

| ** **                                      | ** ** | **2005**   | ** ** | **2004**     | ** ** | **2003**     | ** ** |
|-------------------------------------------------|------------|------------|------------|--------------|------------|--------------|------------|
| ** **                                      | ** ** | ** ** | ** ** | **Restated** | ** ** | **Restated** | ** ** |
| ** **                                      | ** ** | ** ** | ** ** | ** **   | ** ** | ** **   | ** ** |
| 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 |   |

 

**NOTEH—OTHER ASSETS**

 

*IntangibleAssets and Deferred Charges*

 

Intangible assets anddeferred changes consisted of the following as of December 31: 

 

| ** **                    | ** ** | **2005**   | ** ** | **2004**     | ** ** | **2003**     | ** ** |
|-------------------------------|------------|------------|------------|--------------|------------|--------------|------------|
| ** **                    | ** ** | ** ** | ** ** | **Restated** | ** ** | **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       |       |
| Finance fees and other        |       | 2,327,042  |       | 1,056,201    |       | 81,900       |       |
|                          |       | 6,924,462  |       | 5,587,836    |       | 150,206      |       |
|                          |       |       |       |         |       |         |       |
| Less Accumulated Amortization |       | (2,060,301 | )          | (550,421     | )          | —       |       |
|                          |       |       |       |         |       |         |       |
| Total                         |       | $          | 4,864,161  |         | $          | 5,037,415    |       | $ | 150,206 |   |

 

74

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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 |   |

 

*DeferredOffering Costs*

 

In March 2002, theCompany engaged an investment banking firm to advise the Company regardingraising additional capital through the potential future issuance of theCompany's equity, debt or convertible securities. The firm received anonrefundable retainer fee of $50,000, out of pocket costs of $14,900 and hasbeen granted a warrant to purchase 25,000 shares of the Company's common stockat an exercise price of $1.00 per share through March 22, 2006. Theestimated value of the warrant is $17,000. These deferred costs were charged tooperations in 2004 when this engagement terminated. 

 

The Company also engaged theservices of an investment banking firm in connection with the issuance of theCompany’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 620,667 warrantswith a fair market value of $534,201. These warrants have an exercise price of$1.55 and are exercisable through September 29, 2009. On June 8, 2005, theCompany issued the investment firm 248,615 warrants with a fair market value of$211,310. The warrants have an exercise price of $1.35 and are exercisablethrough June 8, 2009. Finally, on July 14, 2005 the Company issued theinvestment firm 23,333 warrants with a fair market value of $22,839. Thesewarrants have an exercise price of $1.35 and are exercisable through July 14,2009. The fair market value of the warrants is amortized over the life of theassociated debt. As of December 31, 2004, the 2004 warrants have a fair marketvalue $474,478 and $59,723 has been charged to non cash interest expense in2004. As of December 31, 2005, the 2004 and 2005 warrants have a combined fairmarket value of $442,248 and $266,379 has been charged to non cash interestexpense in 2005.

 

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*Deposits*

* *

Deposits consisted of thefollowing as of December 31: 

 

| ** **                                         | ** ** | **2005**   | ** ** | **2004**     | ** ** | **2003**     | ** ** |
|----------------------------------------------------|------------|------------|------------|--------------|------------|--------------|------------|
| ** **                                         | ** ** | ** ** | ** ** | **Restated** | ** ** | **Restated** | ** ** |
| ** **                                         | ** ** | ** ** | ** ** | ** **   | ** ** | ** **   | ** ** |
| 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    |       | $ | — |   |

 

**NOTEI—ACCRUED LIABILITIES**

 

Accrued liabilities consistedof 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**

 

**ConsultingArrangement with Thomas J. Colatosti**

 

In connection with hisappointment to the Board of Directors in September 2002, the Company enteredinto a consulting arrangement with Thomas J. Colatosti. Under the arrangement,the Company paid Mr. Colatosti $4,000 per month through December 2003 andissued him options to purchase 150,000 shares of common stock at an exerciseprice of $0.31 per share, the closing price of the Company's common stock onthe date of grant. In December 2003, a committee of independent directorsrenewed this arrangement through December 31, 2004. The committee also issuedoptions to Mr. Colatosti to purchase 200,000 shares of common stock at anexercise price of $1.32 per share, the closing price of the Company's commonstock on the date of grant, for serving as Chairman. Effective November 1,2004, Mr. Colatosti's monthly consulting fee was increased to $14,500. Mr.Colatosti has substantial experience in the biometric industry and in additionto his role as the Chairman of the Board of Directors of the Company, providesextensive service to the Company in the areas of strategic planning andcorporate finance. During the year ended December 31, 2005 and 2004, approximately$102,000 and $69,000 was paid, respectively. Mr. Colatosti agreed to waive hisfees for five months in 2005.

 

In March 2004, Mr. Colatostientered into a three year consulting arrangement with the Shaar Fund Ltd., aprincipal creditor of the Company. Under the terms of the arrangement, TheShaar Fund transferred $375,000 principal amount of our secured convertiblenotes due October 1, 2005 to Mr. Colatosti. On April 28, 2004 the Companyissued 3,750 shares of the Company's Series A 7% convertible preferred stock toMr. Colatosti in conversion of the $375,000 secured convertible note.

 

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**NOTE K - DEFERREDREVENUE**

** **

The components of Deferred Revenue are as followsas of December 31,

 

| ** **                                                   | ** ** | **2005**   | ** ** | **2004**     | ** ** | **2003**     | ** ** |
|--------------------------------------------------------------|------------|------------|------------|--------------|------------|--------------|------------|
| ** **                                                   | ** ** | ** ** | ** ** | **Restated** | ** ** | **Restated** | ** ** |
| ** **                                                   | ** ** | ** ** | ** ** | ** **   | ** ** | ** **   | ** ** |
| **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.

 

Fullydeferred systems, installation and acceptance revenue relates to projects thathave been billed per the contractual terms, however because of undeliveredelements or acceptance criteria revenue has not yet been recognized. Theseamounts are expected to be completed within the next 12 months and areclassified as current liabilities.

 

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**NOTEL—LONG-TERM OBLIGATIONS**

** **

Long-term obligationsconsisted of the following as of December 31: 

 
| ** **                             | ** ** | **2005**   | ** ** | **2004**     | ** ** | **2003**     | ** ** |
|----------------------------------------|------------|------------|------------|--------------|------------|--------------|------------|
| ** **                             | ** ** | ** ** | ** ** | **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                               |       | (5,202,465 | )          | (10,122,156  | )          | —       |       |
| FMV of embedded derivatives            |       | 1,183,988  |       | 14,084,060   |       | —       |       |
| **2005**                               |       |       |       |         |       |         |       |
| Convertible term notes                 |       | 5,284,723  |       | —       |       | —       |       |
| Discount                               |       | (4,613,507 | )          | —       |       | —       |       |
| FMV of embedded derivatives            |       | 1,623,765  |       | —       |       | —       |       |
| FMV of warrants                        |       | 655,416    |       | —       |       | —       |       |
| Long-term accrued interest payable     |       | —     |       | —       |       | 1,131,053    |       |
|                                   |       | 4,924,224  |       | 13,926,341   |       | 10,373,680   |       |
|                                   |       |       |       |         |       |         |       |
| Less current portion (net of discount) |       | 1,201,207  |       | 3,078,037    |       | —       |       |
|                                   |       |       |       |         |       |         |       |
| **Total**                              |       | $          | 3,723,017  |         | $          | 10,848,304   |       | $ | 10,373,680 |   |

 

Aggregate maturities oflong-term obligations for the years following December 31, 2005 are asfollows:

 
| ** **                                     | ** ** | **2006**   | ** **      | **2007**   | ** ** | **2008**        | ** ** | **2009**   | ** **      | **Total**  | ** ** |
|------------------------------------------------|------------|------------|-----------------|------------|------------|-----------------|------------|------------|-----------------|------------|------------|
| ** **                                     | ** ** | ** ** | ** **      | ** ** | ** ** | ** **      | ** ** | ** ** | ** **      | ** ** | ** ** |
| Senior  secured convertible term notes         |       | $          | 1,524,211       |       | $          | 3,048,421       |       | $          | 1,027,367       |       | $          | — |   | $ | 5,599,999 |   |
| Subordinated  unsecured convertible term notes |       | 18,750     |            | 14,063     |       | $               | —     |       | 5,644,215       |       | 5,677,028  |   |
|                                           |       |       |            |       |       |            |       |       |            |       |       |
| Total                                          |       | $          |  1,542,961 |       | $          |  3,062,484 |       | $          |  1,027,367 |       | $          | 5,644,215 |   | $ | 11,277,027 |   |

 

***SeniorConvertible Term Notes***

 

**2004 Notes**

 

On September 29, 2004,we entered into a Securities Purchase Agreement (the "Senior PurchaseAgreement") with Laurus Master Fund, Ltd. ("Laurus") andcertain other institutional and accredited investors (together with Laurus, the"Senior Investors"). Under the Senior Purchase Agreement, the Companyissued secured convertible term notes (the "Senior ConvertibleNotes") in the aggregate principal amount of $5,050,000, convertible intocommon stock of the Company at $1.35 per share, and issued warrants (the"Senior Warrants") to purchase an aggregate of 1,122,222 shares ofour common stock at an exercise price of $1.55 per share. 

 

The proceeds from thistransaction were used in part to finance the Company's acquisition of AetherMobile Government (the "Aether Acquisition"). The Company'sobligations under the Senior Purchase Agreement, the Senior Convertible Notesand the Senior Warrants are secured by a security interest in all orsubstantially all of the Company'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, commencingDecember 1, 2004. The Company made principal payments of $1,563 inDecember 2004 and $1,453,831 in 2005, $67,500 was also converted into commonstock during 2005. The Senior Convertible Notes bear interest at an initialrate equal to the prime rate plus two percent (2%), subject to a six percent(6%) floor. The interest rate on the Senior Convertible Notes is subject toreduction on a month-by-month basisif specified conditions are met. In particular, if (a) we register thecommon stock underlying the Senior Convertible Notes and Senior Warrants 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 an effectiveregistration statement, but (y) our common stock is trading at a 25% orgreater premium to the note conversion price, and then the interest rate willbe adjusted downward by 1.0% for each incremental 25% increase over the noteconversion price. The effective interest rate as of December 31, 2004 and2005 was 7.25%. 

 

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 closing price of our common stock(for the five trading days immediately preceding the payment date) is greaterthan $1.48 per share (which represents 110% of the note conversion price, basedon the initial conversion price of $1.35), 

 

•              Such amount being converted does not exceed25% of the aggregate dollar trading volume for such immediately precedingtwenty-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 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 SeniorInvestors a blanket security interest in all of our assets, and we entered intoa stock pledge with the Senior Investors for the capital stock in PSG. If anevent of default 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 pay interest and principalpayments under the Senior Convertible Notes within three days of when due; 

 

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

 

•              A breach by us of any material representationor warranty made in the Senior Convertible Notes or in any of the investmentagreements; 

 

•              If we make an assignment for the benefit ofour 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 or similarfinal process against us for more than $50,000, which remains unvacated,unbonded or

 

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unstayed for a period of30 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 shares ofcommon stock when due upon conversions of the Senior Convertible Notes. 

 

As of December 31, 2004 theCompany was in default of one of its December 1 principal payments. The Companycured this default on January 5, 2005 and has received a waiver from the SeniorInvestors, 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 with theSecurities and Exchange Commission for resale the shares of common stock thatare issuable upon conversion of the Senior Convertible Notes and upon exerciseof the Senior Warrants. If we fail to comply with our registration obligations,the Senior Investors will be entitled to certain specified remedies, includingmonetary liquidated damages. In particular, for each 30 days (or such pro ratednumber 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 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 a pershare 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 under theSenior 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, weare required to make monthly payments of accrued interest only beginning onJuly 1, 2005. In addition, the Senior Convertible Note provides formonthly payments of principal in equal 1/32 incrementsthereof, plus accrued interest, commencing October 1, 2005. The SeniorConvertible Note bears interest at an initial rate equal to the prime rate plustwo percent (2%), subject to a six percent (6%) floor. The interest rate on theSenior Convertible Note is subject to reduction on a month-by-month basis ifthe following 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:

 

•     theaverage closing price of our common stock (for the five trading daysimmediately preceding the payment date) is greater than $1.48 per share (whichrepresents 110% of the note conversion price, based on the initial conversionprice of $1.35),

 

•     suchamount being converted does not exceed 25% of the aggregate dollar tradingvolume for such immediately preceding twenty-two trading days, and

 

•      Theshares of common stock underlying the note are registered under an effectiveregistration statement with the Securities 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 due andLaurus 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 failureto pay interest and principal payments under the Senior Convertible Note withinthree days of when due;

 

•     a breachby us of any material covenant or term or condition of the Senior ConvertibleNote or in any of the investment agreements, if not cured within 30 days ofsuch breach;

 

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•     A breachby us of any material representation or warranty made in the Senior ConvertibleNote or in any of the investment agreements;

 

•     if we makean assignment 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 filingof any money judgment or similar final process against us for more than $50,000,which remains unvacated, unbonded or unstayed for a period of 30 days;

 

•     if ourcommon stock is suspended for five consecutive days or for five days during anyten consecutive days from a principal market or pursuant to a Securities andExchange Commission stop order; and

 

•     A failureby us to timely deliver shares of common stock when due upon conversions of theSenior Convertible Note.

 

Uponan event of default, Laurus will be entitled to specified remedies, includingremedies under the Uniform Commercial Code.

 

We have agreed to registerwith the Securities and Exchange Commission for resale the shares of commonstock that are issuable upon conversion of the Senior Convertible Note and uponexercise of the Senior Warrant. Under the registration rights agreement, we wereobligated to file a registration statement with the Securities andExchange Commission on or before July 8, 2005, and to use reasonablecommercial efforts to have the registration statement declared effective notlater 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 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 our common stock for as long as any Senior Convertible Notes held by itremain outstanding. "Short sales" are contracts for the sale of sharesof stock 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. 

 

***SubordinatedConvertible Term Notes***

 

**2004 Notes**

 

On September 29, 2004,we entered into a Securities Purchase Agreement (the "SubordinatedPurchase Agreement") with The Shaar Fund, Ltd. ("Shaar")and other existing shareholders of the Company and accredited investors(collectively, the "Subordinated Investors") for $4,950,000. Underthe Subordinated Purchase Agreement, the Company issued unsecured convertibleterm notes (the "Subordinated Convertible Notes") in the aggregateprincipal amount of $4,950,000, convertible into common stock of the Company incertain circumstances at $1.35 per share, and issued warrants (the"Subordinated Warrants") to purchase an aggregate of 1,099,997 sharesof our common stock at an exercise price of $1.55 per share. The proceeds fromthis transaction were used in part to finance a portion of the AetherAcquisition and will be used in part for working capital purposes. 

 

Under the terms of theSubordinated Convertible Notes, we are required to make monthly payments ofaccrued interest only beginning on November 1, 2004. In addition, theSubordinated ConvertibleNotes provide for monthly payments of principal in equal monthly increments of$154,688 thereof, plus accrued interest, commencing February 1, 2005,which payments may be made in shares of common stock at the option of each noteholder. The Subordinate Investors converted $135,000 of these notes in 2004 and$1,996,420 in 2005.  They also madeprincipal payments of $454,380 in 2005.  TheSubordinated Convertible Notes bear interest at an initial rate equal to theprime rate plus seven and one-half percent (7.5%), subject to an eleven 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 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 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 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 suchbreach; 

 

•              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 benefit ofour 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 or similarfinal process against us for more than $50,000, which remains unvacated,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 shares ofcommon stock when due upon conversions of the Subordinated Convertible Notes;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 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 with theSecurities and Exchange Commission for resale the shares of common stock thatare issuable upon conversion of the Subordinated Convertible Notes and uponexercise 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 "shortsales" of our common stock for as long as any Subordinated ConvertibleNotes held by it remain outstanding.

 

**2005 Notes**

 

We entered into a SecuritiesPurchase 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 a pershare 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 SubordinatedConvertible Notes were issued at a purchase price equal to $900 for each $1,000of principal 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 onJuly 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 common stockat the option of each note holder. The Subordinated Convertible Notes bearinterest at nine percent (9%) per annum. Each Subordinated Convertible Note wasissued at a purchase price equal to $900 for each $1,000 of principal amount ofthe Note.

 

We may prepay theSubordinated Convertible Notes at any time upon payment of an amount equal to120% of the then outstanding principal balance, plus accrued and unpaidinterest. Upon any such prepayment, the Senior Convertible Note 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.

 

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 additional defaultinterest 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 principal payments under the SubordinatedConvertible Notes within three days of when due;

 

•     a breach by us of any covenant, term or condition in any materialrespect of the Subordinated Convertible Notes or in any of the investmentagreements, if not cured within 30 days of such breach;

 

•     any representation or warranty made in the Subordinated ConvertibleNotes or in any of the investment agreements being false or misleading in anymaterial respect;

 

•     If we make an assignment for the benefit of our creditors, or areceiver or trustee is appointed for us, or any form of bankruptcy orinsolvency proceeding is instituted by us, or any involuntary proceeding isinstituted against us;

 

•     the filing of any money judgment or similar final process against usfor more than $50,000, which remains unvacated, unbonded or unstayed for a periodof 30 days;

 

•     if our common stock is suspended for five consecutive days or for fivedays during any ten consecutive days from a principal market or pursuant to aSecurities and Exchange Commission stop order;

 

•     A failure by us to timely deliver shares of common stock when due uponconversions of the Subordinated Convertible Notes; 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 to registerwith the Securities and Exchange Commission for resale the shares of commonstock that are issuable upon conversion of the Subordinated Convertible Notesand upon exercise of the Subordinated Warrants. 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 registration statementwas initially filed with the Securities and Exchange Commission on July 8, 2005for the shares underlying the Subordinated Convertible Notes and SubordinatedWarrants. If we fail to comply with our registration obligations, theSubordinated 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 the originalprincipal amount of the Subordinated Convertible Notes. As of December 31, 2005,this registration statement has not been declared effective, therefore, the Companyhas approximately $202,000 reserved for payment of liquidating damages.  These damages were limited by a portion thathad been waived by one of the Subordinated Investors during 2005.

 

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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"of our common stock for as long as any Subordinated Convertible Notes held byit remain outstanding. 

 

**2004 and 2005 Senior andSubordinate Notes             **

** **

The Senior Notes’ featuresdiscussed above; such as a variety of conversion options, a variable interestrate feature, events of default and a variable liquidated damages clause areconsidered embedded derivative financial instruments. These features aredescribed below, as follows:

 

•                  Principal’s conversion option:  The Notes are convertible at the Holder’soption at any time at the fixed conversion price of $1.35 per share. Thisconversion feature has been identified as an embedded derivative and has beenbifurcated and recorded on the Company's balance sheet at its fair value usingthe Binomial Option Pricing Model;

 

•                  Monthly Payments Conversion Option:  Holders have the option to convert the Notes’monthly payment at a $1.35 per share conversion price if the common stock priceis higher than 110% of the conversion price ($1.49), as long as the amountconverted is not higher than 25% of trading volume for the last 22 trading days.If the Notes’ monthly payments are not converted, the payments will be paid incash at 102% of such amount. This conversion feature has been identified as anembedded derivative and has been bifurcated and recorded on the Company'sbalance sheet at its fair value using binomial models;

 

•                  Interest Rate Adjustment provision:  For every 25% increase in common stock valueabove $1.35 per share, the interest will be reduced by 2%. The interest ratemay never be reduced below 0%. This conversion feature has been identified asan embedded derivative and has been bifurcated and recorded on the Company'sbalance sheet at its fair value by measuring the impact of the derivative onthe expected interest payment amount over the life of the Note;

 

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’s conversion option:  The Notes are convertible at the Holder’soption at any time at the fixed conversion price of $1.35 per share. Thisconversion feature has been identified as an embedded derivative and has beenbifurcated and recorded on the Company's balance sheet at its fair value;

 

•                  Monthly Payments Conversion Option:  Holders have the option to convert the Notes’monthly payment at a $1.35 per share conversion price if the common stock priceis higher than 110% of the conversion price ($1.49), as long as the amountconverted is not higher than 25% of trading volume for the last 22 trading days.If the Notes’ monthly payments are not converted, the payments will be paid incash at 102% of such amount. This conversion feature has been identified as anembedded derivative and has been bifurcated and recorded on the Company'sbalance 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 had incorrectly calculated certain interest obligations oncertain subordinated notes issued by the Company in September 2004.Accordingly, the Company has corrected the error, and as of December 31, 2005 iscurrent with respect to its obligations under the September 2004subordinated notes.

** **

The Company entered into anAmendment and Waiver with Laurus, dated as of August 31, 2005, pursuant towhich the Company was permitted to defer the payment of the monthly principalamounts 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 onSeptember 29, 2004 (the “September 2004 Note”), and (b) theSecured Convertible Term Note in the original principal amount of $2,000,000issued by the Company to Laurus on June 8, 2005 (the “June 2005Note”), such aggregate deferred principal amounts being equal to $625,000 and$187,500,respectively.  The deferred principal amount under theSeptember 2004 Note is now due on September 29, 2007, the maturitydate of that note, and will be paid at the same time the final payments duewith respect to that note upon maturity.  The deferred principal amountunder the June 2005 Note is now due on June 7, 2008, the maturitydate of that note, and will be paid at the same time the final payments duewith 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 Amendmentand Waiver, the Company issued an aggregate of 612,166 shares of its Common Stockas consideration for this principal payment deferral.  The Company enteredinto a Registration Rights Agreement dated as of August 31, 2005(the“Registration Rights Agreement”) pursuant to which the Company has agreed tofile a registration statement with the Securities and Exchange Commission(the“SEC”) covering the resale of these shares of Common Stock on or beforeAugust 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.  Thedeferred principal 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 Amendmentand Waivers, the Company issued an aggregate of 263,705 shares of its CommonStock to the Subordinated Investors as consideration for this principal paymentdeferral.  The Company entered into the Registration Rights Agreement witheach of the Subordinated Investors, pursuant to which the Company has agreed tofile a registration statement with the SEC covering the resale of these sharesof Common Stock on or before August 31, 2006.

 

On July 8, 2005, theCompany made a payment of $39,061 to a holder of a senior convertible noteissued by the Company on September 29, 2004 to fully pay all principal andinterest on the Note. In conjunction with this repayment, the holdersurrendered a warrant to purchase 11,111 shares of the Company’s $0.0001 parvalue common stock.

 

Certain holders ofconvertible term notes issued by the Company on September 29, 2004 andMay 31, 2005 did not permit the Company to defer such principal payments,but instead waived certain provisions of those notes, specifically regardinganti-dilution adjustments of the Fixed Conversion Price that would otherwisehave been triggered as a result of the issuance of the above described sharesin connection with the debt deferral.  In consideration of these waivers, thewarrants held by these note holders were modified to reflect an exercise priceof $1.35.

 

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The accounting treatment ofthe derivatives and warrants requires that the Company record the derivativesand the warrant 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 derivatives andwarrants is higher at the subsequent balance sheet date, the Company willrecord a non-operating, non-cash charge. If the fair value of the derivativesand warrants is lower at the subsequent balance sheet date, the Company willrecord non-operating, non-cash income. As of December 31, 2004 and 2005,respectively, the derivatives were valued at $14,084,060 and $2,807,753 for the2004 and 2005 notes. Conversion related derivatives were valued using theBinomial Option Pricing Model with the following assumptions: dividend yield of0%; annual volatility of 83% to 118%; and risk free interest rate of 2.89% to4.4% as well as probability analysis related to trading volume restrictions.The remaining derivatives were valued using other binomial models and measuringthe impact of the derivative on the expected interest payment amount over thelife of the Note. The Warrants issued with the 2004 Notes were reclassifiedfrom a liability to equity in the fourth quarter of 2004 when the registrationof the shares became effective. At the time of the reclassification, theWarrants had a fair market value of $2,847,019. The 2005 Warrants classified asliabilities were valued at $655,416 at December 31, 2005 using the BlackScholes Option Pricing model with the following assumptions: dividend yield of0%; annual volatility of 110% and risk-free interest rate of 4.4%. Both thederivatives and warrants, with the exception of the reclassified warrantsdiscussed above, were classified as long-term liabilities.

 

At the time of issuance, theinitial relative fair value assigned to the embedded derivatives was $8,895,741and $4,653,425 for the 2004 and 2005 notes, respectively. The initial relativefair value assigned to the warrants was $1,912,639 and $1,233,153 for the 2004and 2005 notes, respectively.

 

Both the derivatives and thewarrants 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 the Noteswas $5,202,465 and $4,613,507 for 2004 and 2005 notes, respectively. Theeffective interest rate on the Notes for the period ended December 31, 2005 and2004 ranged between 45% and 180% based on the frequency of principal paymentsas well as actual payments made. At December 31, 2004, the unamortized discounton the Notes was $10,122,156 for the 2004 and 2005 notes combined.

 

**Other Debt**

** **

The key provisions of theCompany's long-term notes and debentures issued prior to 2004 are as follows: 

 

**•****            ****10% Secured Convertible Note Issued in 2001:**During 2001, the Company had unsecuredshort-term notes from Shaar in the aggregate principal amount of $2,770,000.Shaar converted this amount and associated accrued interest of $257,920together with additional financing of $1,065,000 into a convertible note in theprincipal amount of $4,092,920 (the Convertible Note). During 2003, Shaarconverted $475,000 of this note along with accrued interest of $98,465 into764,620 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. DuringMarch 2004, the Company entered into a securities exchange agreement (theAgreement) with Shaar. Pursuant to the Agreement, Shaar converted the remaining$1,553,982 of this note into shares of the Company's Series A convertiblepreferred stock at the stipulated per share conversion price of $100 per share.

 

In conjunction with theissuance of the Convertible Note, the Company issued a warrant to the Shaar topurchase 4,000,000 shares of common stock at $1.00 per share throughNovember 26, 2006. The Convertible Note was recorded along with a$1,016,000 discount assigned to the fair value of the warrant. The valueassigned to the warrant was amortized as interest expense over the twenty-twomonth life of the Convertible Note. The fair value assigned to the warrant wasestimated on the grant date using the Black-Scholes pricing model. Theassumptions used to determine the fair value of the grant included the followingassumptions: risk-free interest rate of 3.5%, expected life of three years,stock price volatility of 175%, and expected dividends of zero. 

 

**•****            ****10% Secured Convertible Notes Issued in 2002:**As part of a recapitalization transaction,the Shaar agreed to provide additional financing in incremental monthlyinstallments during the six-month period commencing March 1, 2002, subjectto certain conditions. As of December 31, 2002, the Company has received$1,080,000 and issued notes payable to Shaar. The notes are convertible intoshares of the Company's common stock at a conversion price of $0.75 per share.The notes are collateralized by substantially all of the Company's assets.Pursuant to the Agreement entered into in March 2004, Shaar converted thisnote into shares of the Company's Series A convertible preferred stock atthe stipulated per share conversion price of $100 per share. 

 

**•****            ****7% Convertible Notes Issued in 2002:**As part of an August 2002 bridge noteagreement with Shaar, Shaar provided a total of $750,000 of additionalfinancing in incremental monthly installments during the four-month periodcommencing August 2002. The note, as amended, is due October 1, 2005along with accrued interest at 7% per annum. The bridge notes are convertibleat the option of Shaar into shares of the Company's common stock at aconversion 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 NotesIssued 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 beforeJune 30, 2004 the principal amount and accrued interest due under the noteis convertible, 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. 

 

During the quarter endedMarch 31, 2004, the Company received the final advances totaling$1,000,000, pursuant to this note agreement. In March 2004, at the requestof Shaar, the Company issued Thomas J. Colatosti, the chairman of the Board, a$375,000 note and Shaar a $2,125,000 note (collectively the Investors) inexchange for the October 31, 2003, $2,500,000 7% Secured ConvertiblePromissory Note due Shaar. The terms of the notes require the principal andaccrued interest at 7% to be repaid on October 1, 2005. In the event thatthe Company completes a private placement of equity securities resulting ingross proceeds of at least $5,000,000 on or before June 30, 2004 theprincipal amount and accrued interest due under the notes are convertible, atthe option of the Investors, into the securities sold in such transaction at aconversion price equal to the sale price of such securities. Upon completion ofsuch an equity transaction, the Investors also have the right to requestrepayment of the note. The Investors 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 Cpreferred stock at a conversion price of $100 per share. 

 

Pursuant to the Agreemententered into in March 2004, the Investors converted the remaining$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.

 

In 2005, it was determinedthat the Convertible Notes contained an embedded derivative known as aConversion Price Adjustment Provision which needed to be separated from thehost contract and accounted for separately. The derivative is known as theConversion Price Adjustment Provision and is described as follows:

 

If, prior to June 30, 2004,the Company completes a private placement of equity securities of the Companyfor an aggregate sale price of at least $5 million, upon the closing of thetransaction, the principal and the accrued interest of the Note, shall, at theoption of the holder, either (i) be converted into shares of the currentfinancing securities at a conversion price equal to the price per share atwhich the current financing securities are issued of (ii) immediately be paidin cash.

 

The accounting treatment ofthe derivative requires that the Company record the derivative at theirrelative fair value as of the inception date of the agreement, and at fairvalue as of each subsequent balance sheet date. Any change in fair value willbe recorded as non-operating, non-cash income or expense at each reportingdate. If the fair value of the derivative is higher at the subsequent balancesheet date, the Company will record a non-operating, non-cash charge. If thefair value of the derivatives and warrants is lower at the subsequent balancesheet date, the Company will record non-operating, non-cash income. As ofDecember 31, 2003, the derivative was valued at $310,603 and was recorded as aliability. As of December 31, 2004 and 2005, the derivative was valued at $0and $0 because the debt had been retired. The derivative was valued as ofDecember 31, 2003 using the Binomial Option Pricing Model with the followingassumptions: stock price of $.35 to $1.61; exercise price of $.75; annualvolatility of 87% to 141%; and risk free interest rate of 0.96% to 1.51%. Thederivative features are being accounted for properly as part of the currentyear restatement.

 

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On April 28, 2005, TheShaar Fund Ltd. loaned $250,000 to the Company. The loan allowed for interestat 10% per annum and was paid in full in June 2005 in conjunction with theCompany’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. 

 

The conversion and exerciseprices of the Company's convertible instruments, options and warrants discussedhere and elsewhere were determined by individual negotiation between theCompany and the individual security holders or grantees. 

 

Primarily all of theCompany's interest expense during 2005 and 2004 related to obligations dueShaar. During 2005 and 2004, interest expense to Shaar was approximately $226,000and $176,000, respectively.

 

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**NOTE M—SEGMENTINFORMATION**

** **

Inthe fourth quarter of fiscal year 2005, the Company’s consolidated operationswere divided into three segments: Law, Fire and Biometric.  Prior to thissegmentation of the business management evaluated the business as oneconsolidated operation.  For presentation and comparability purposes theallocation of costs between segments for prior periods have been estimated.

 

TheCompany evaluates performance and allocates resources based on revenues andoperating income (loss). Operating income (loss) for each segment includesselling, general and administrative expenses directly attributable to thesegment in addition to those allocated as a percentage based on the segmentsrevenues.  The segmentation of operating Income as noted above anddetailed below reflects how management now evaluates its business.  Assets for the company are commingled and are related to all operatingsegments.  Management does not evaluate or identify the operating assetsof the segments separately.

 

GeographicallyNorth American sales accounted for approximately 100% of the Company’s totalsales for fiscal years 2005, 2004 and 2003. 

 

Summarizedfinancial information concerning our reportable segments is shown in thefollowing table:

 

| ** **                        | ** ** | **For the Years Ended December 31,** | ** ** |
|-----------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                        | ** ** | **2005**                                                      | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                        | ** ** | ** **                                                    | ** ** | **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 Operaing Income     |       | (8,288,182                                                    | )          | (6,437,461 | ) | (3,010,852 | ) |
| **Reconciliation to net loss**    |       |                                                          |       |   |   |   |   |
| Interest expense                  |       | (6,548,130                                                    | )          | (1,916,558 | ) | (1,909,788 | ) |
| Ineterest income                  |       | 35,958                                                        |       | 66,824 |   | — |   |
| Non-cash interest income(expense) |       | 15,213,186                                                    |       | (6,003,137 | ) | 857,545 |   |
| Other expense                     |       | (54,767                                                       | )          | (55,300 | ) | 4,145 |   |
| **Net income (loss)**             |       | $                                                             | 358,065    |   | $ | (14,345,632 | ) | $ | (4,058,950 | ) |

 

**NOTE N—COMMITMENTSAND CONTINGENCIES**

 

*OperatingLeases*

 

The Company does not own anyreal estate but conducts operations from four leased premises. Thesenon-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. 

 

In connection with theCompany's acquisition of AMG in 2004, the Company entered into a sub-lease withAether, which requires monthly lease payments in excess of existing marketrates. Rent expense is recorded at market rate and charged on a straight- linebasis through August 31, 2008, the termination date of the lease. Thecompany has accrued a liability to reflect the net present value of the excessof cash payments over rent expense for the remaining term of the lease. 

 

88

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Minimum rental commitmentsof 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 wasapproximately $753,000, $258,000 and $60,000 during 2005, 2004 and 2003,respectively. 

 

*EmploymentAgreements*

 

The Company has employmentagreements with five employees. These agreements allow the continuation of theemployee's salary in the event of termination without cause. The agreementsalso acknowledge the employee's eligibility to participate in the Company'sbonus and option plans, the terms of which have not yet been established. Uponcompletion of one year of service during 2005, one employee is eligible foroptions for up to 300,000 shares. As of December 31, 2005, 2004 and 2003,the aggregate commitment under these agreements is approximately $275,000, $930,000and $90,000, respectively. 

 

*LegalProceeding*

 

Prior to our acquisition ofPSG in June 2003, PSG was named as a defendant in a civil action initiatedin the Superior Court Department in Hampden County, Commonwealth ofMassachusetts by The VinceGroup, Inc. ("TVG"). The case has since been removed to theUnited States District Court for the District of Massachusetts at the requestof the Parties. The complaint claims that PSG is obligated to pay a percentageof certain of its revenues to TVG in consideration for a strategic businessintroduction allegedly made by an agent of TVG. PSG has denied the allegationsand filed an answer in the litigation, and as of the date of this report theoutcome of the litigation is pending. The claim is for an unspecified amountincluding actual damages, interest, and attorney's fees. Management believesthe claim is without merit and will settle out of court for an amount whichwill not have a material adverse affect on our business, financial condition oroperating results.

 

*Accrued Royalties*

 

From time to time, theCompany licenses or sells products which may include technology obtained fromthird parties under a royalty agreement. These agreements obligate the companyto pay the third party a fixed fee, or in some instances, a percentage of theassociated revenue. The fees are generally due and payable only when softwarehas been installed and accepted by the customer. For the years ended December31, 2005 and 2004, royalty expense was approximately $178,000 and $23,000,respectively. 

 

**NOTE O—STOCKHOLDERS'EQUITY**

** **

*CommonStock*

* *

In August 2004, theCompany's shareholders approved amendments to its articles of incorporationwhich increased the number of authorized shares of common stock from 60,000,000to 85,000,000. 

 

During March 2004, thecompany entered into a securities purchase agreement with certain institutionaland accredited investors pursuant to which the Company issued and sold anaggregate of 8,888,928 shares of common stock and warrants to purchase anaggregate of 4,444,464 shares of common stock. The investors paid an aggregatepurchase price of $1.35 for each share of common stock and warrant to purchase0.5 of a share 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. 

 

89

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The Warrants issued inconjunction with the sale of common stock on March 31, 2004, may beexercised at any time prior to June 8, 2009. Each Warrant containsanti-dilution protection through March 31, 2005, which has resulted in areduction of the exercise price from $1.755 to $1.35 per share. Fifty percent(50%) of any unexercised portions of the Warrants are callable by the Companyif the volume weighted average trading price per share of our common stockexceeds $4.3875 per share for ten (10) consecutive trading days and theWarrants have not been exercised after forty-five (45) days' prior noticefrom the Company. 

 

Under the PurchaseAgreement, in the event that (i) an investor is not permitted to sell itssecurities hereunder for any reason for five (5) or more trading days(whether or not consecutive), (ii) any securities covered hereunder arenot listed on an eligible trading market or (iii) our common stock is notlisted or quoted, or is suspended from trading, on an eligible trading marketfor a period of three (3) trading days (whether or not consecutive), theCompany will be required to pay a cash amount to the investors equal to onepercent (1%) of the aggregate purchase price paid by the investors pursuant tothe Purchase Agreement for the first month that such event occurs and onepercent (1%) for each month thereafter in which such event remains uncured, ineach case prorated for any partial month. If the Company fails to make any suchpayment in a timely manner, such payment shall bear interest at the rate of onepercent (1%) per month (prorated for partial months) until paid in full. 

 

*Series A7% Convertible Preferred Stock*

 

On January 1, 2005, BIO-keyInternational, Inc., a Minnesota corporation (“BIO-key Minnesota”), consummateda merger (the “Reincorporation”) with and into its wholly owned subsidiary,BIO-key International, Inc., a Delaware corporation (“BIO-key Delaware”), inorder to reincorporate in the State of Delaware.  The Reincorporation waseffected pursuant to an Agreement and Plan of Merger dated as of December 30,2004 (the “Merger Agreement”) by and between BIO-key Minnesota and BIO-keyDelaware.  The Reincorporation was recommended was approved by the boardof directors of both BIO-key Minnesota and BIO-key Delaware,  Pursuant to the Merger Agreement, at theeffective time of the Reincorporation: (i) each outstanding share of CommonStock of BIO-key Minnesota, $0.01 par value per share, was automaticallyconverted into one share of Common Stock, $0.0001 par value per share, ofBIO-key Delaware; (ii) each outstanding share of Series C 7% ConvertiblePreferred Stock of BIO-key Minnesota, $0.01 par value per share, wasautomatically converted into one share of Series A 7% ConvertiblePreferred Stock, $0.0001 par value per share, of BIO-key Delaware, with suchSeries A 7% Convertible Preferred Stock containing substantially identicalterms and conditions as the Series C 7% Convertible Preferred Stock ofBIO-key Minnesota; (iii) each option to purchase shares of BIO-key Minnesota’sCommon Stock granted by BIO-key Minnesota under any warrant, stock option planor similar plan of BIO-key Minnesota outstanding immediately before theReincorporation was, by virtue of the Merger Agreement and without any actionon the part of the holder thereof, converted into and become an option topurchase, upon the same terms and conditions, the same number of shares ofBIO-key Delaware common stock at an exercise price per share equal to theexercise price per share thereunder immediately before the Reincorporation; and(iv) each warrant, option or stock option plan of BIO-key Minnesota was assumedby, and continues to be, a warrant, option or plan of BIO-key Delaware.

 

The Series A Preferred Stockaccrues dividends of 7% payable semi-annually on June 15th, December15th and on such date that the preferred stockholder elects toconvert preferred stock to common stock in additional shares of its commonstock. As of December 31, 2005, cumulative dividends in arrears wereapproximately $545,800.

 

*Series B9% Convertible Preferred Stock (**BIO-key Minnesota)*

 

The Series B PreferredStock accrues dividends of 9% payable semi-annually on June 15,December 15, and on such date that the preferred stockholder elects toconvert preferred stock to common stock, in cash, or at the option of theCompany, in additional shares of its common stock. As of December 31,2003, cumulative dividends in arrears were approximately $86,000. TheSeries B shares are redeemable at the option of the Company, so long asthe Company's common stock is eligible for quotation on the OTC Bulletin Boardand the shares issuable upon conversion are subject to an effectiveregistration statement. The Series B shares are convertible into shares ofthe Company's common stock at a per share conversion price equal to the lesserof $0.75 or a 22% discount to the average closing price of the common stockduring the five trading days preceding conversion. The Series B shareshave no voting rights. 

 

During March 2004, theInvestor converted the remaining 4,180 shares of Series B 9% convertiblepreferred stock and $107,693 of dividends and accrued interest thereon into5,257 shares of the Company's Series A preferred stock. All of theCompany's Series A preferred stock is convertible into shares of theCompany's common stock at a conversion price of $.75 per share. 

 

90

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*Series C7% Convertible Preferred Stock*

 

In March 2004, wedesignated 100,000 shares of preferred stock as Series C ConvertiblePreferred Stock (the "Series C Shares"), of which 62,182 areissued and outstanding at December 31, 2004. The Series C Sharesaccrue a cumulative annual dividend of 7% on the $100 face amount of suchshares payable in shares of common stock on June 15 and December 15each year, and on such date that the preferred stockholder elects to convertpreferred stock to common stock. As of December 31, 2004, cumulativedividends 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 obtainthe consent of the holders of a majority of the Series C Shares in orderto, among other things, issue any shares of preferred stock that are equal toor have a preference over the Series C shares or issue any shares ofpreferred stock, rights, options, warrants, or any other securities convertibleinto common stock of the Company, other than those issued to employees of theCompany in the ordinary course of their employment or to consultants or otherpersons providing services to the Company so long as such issuances do notexceed the conversion rights for more than 500,000 shares of common stock. Weare also required to obtain such consent in order to, among other things,complete a sale or other disposition of any material assets, complete anacquisition of a material amount of assets, engage in a merger, reorganizationor consolidation, or incur or 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                                 |       |

 

91

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The estimated fair value ofthe warrants granted during 2005, 2004 and 2003 was $1,467,302, $2,466,839 and$67,000, respectively. The estimated fair value of the warrants granted toconsultants and 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-BASEDCOMPENSATION**

** **

*1996 StockOption Plan*

 

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. 

 

*1999 StockOption Plan*

 

During 1999, the Board ofDirectors of the Company adopted the 1999 Stock Option Plan (the 1999 Plan).The 1999 Plan was not presented to stockholders for approval and thus incentivestock options are not available under the plan. Under the 1999 Plan, 2,000,000shares of common stock are reserved for issuance to employees, officers,directors, and consultants of the Company at exercise prices which may not bebelow 85% of fair market value. The term of nonstatutory stock options grantedmay not exceed ten years. Options issued under the Plan vest pursuant to theterms of stock optionagreements with the recipients. In the event of a change in control, asdefined, all options outstanding vest immediately. The 1999 Plan terminates inAugust 2009. 

 

*2004 StockOption Plan*

 

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 Planvest pursuant to the terms of stock option agreements with the recipients. Inthe event of a change in control, as defined, all options outstanding vestimmediately. The Plan terminates in October 2014. 

 

*Non-PlanStock Options*

 

Periodically, the Companyhas granted options outside of the 1996, 1999, and 2004 Plans to variousemployees and consultants. In the event of change in control, as defined,certain of the non-plan options outstanding vest immediately. 

 

92

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*Summary ofOption Information*

 

Information summarizing optionactivity 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 |   | 0.2-1.32 |   | 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 information regarding outstanding options as ofDecember 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-.40                                            |       | 837,456                                                          |       | 0.33 |   | 2.47 |   | 822,046 |   | 0.33 |   |
| 0.46-.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 fairvalue of options granted to employees and directors during 2005, 2004 and 2003were $0.85, $0.68, and $0.62 per share, respectively. The fair value of eachoption grant is estimated as of the date of the grant using the Black-Scholesoption-pricing model utilizing the same assumptions presented in the proformacompensation disclosure section below. 

 

Non-Plan options were grantedto consultants during 2005 and 2004 totaling 700,000 and 45,000 shares,respectively. Six hundred thousand of the options issued in 2005 vest ratablyover a three-year period commencing in November 2005. The remaining 100,000shares issued in 2005 vest ratably over a two-year period commencing inNovember 2005. The options issued in 2004 vest annually over a three-yearperiod commencing in July 2005. The estimated fair value of these Non-Planoptions granted to consultants in 2005 and 2004 were approximately $443,000 and$27,000 respectively.

 

InFebruary and March 2006, 1,798,000 Nonqualified Stock Options were granted toeligible employees

 

93

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**NOTE Q—INCOMETAXES**

** **

Deferred taxes are due toincome tax credits and net operating loss carryforwards and to the temporarydifferences between the carrying values of certain assets and liabilities forfinancial reporting and income tax purposes. 

 

Significant components ofdeferred taxes are as follows at December 31:

 

| ** **                             | ** ** | **2005**    | ** ** | **2004**     | ** ** | **2003**     | ** ** |
|----------------------------------------|------------|-------------|------------|--------------|------------|--------------|------------|
| ** **                             | ** ** | ** **  | ** ** | **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 theCompany has federal and state net operating loss carryforwards of approximately$47,122,000 and $16,491,000 respectively, subject to expiration between 2011and 2025. 

 

These net operating losscarryforwards are subject to the limitations under Section 382 of the InternalRevenue Code due to changes in the equity ownership of the Company.

 

A valuation allowance equalto the full amount of the deferred tax assets has been recorded due to theuncertainty of realization of the deferred tax assets due to operating losshistory of the Company. The valuation allowance could be reduced or eliminatedbased on future earnings and future estimates of taxable income. Similarly,income tax benefits related to stock options exercised have not been recognizedin 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** | ** ** | **Resated** | ** ** |
| US Federal statutory income tax rate                      |       | 34.0       | %          | 34.0         | %          | 34.0        | %          |
|                                                      |       |       |       |         |       |        |       |
| Federal income tax provision (benefit) at  statutory rate |       | $          | 122,000    |         | $          | (4,878,000  | )          | $ | (1,380,000 | ) |
| Derivative and warrant valuation  adjustments             |       | (5,172,000 | )          | 2,041,000    |       |        |       |
| Other                                                     |       | (585,000   | )          | 248,000      |       | 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         | %          |
|                                                           |            |            |            |              |            |             |            |  |  |  |  |

 

94

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**NOTE R—FAIRVALUES 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 includecertain conversion features and variable interest features. The Company alsoissued warrants to purchase shares of the Company’s Common stock as part of thedebt financing. The accounting treatment of derivatives and the warrantsrequires that the Company record the derivatives and the warrants as aliability at their relative fair values 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 derivatives or the warrantis higher at the subsequent balance sheet date, the Company will record anon-operating, non-cash charge. If the fair value of the derivatives or warrantis lower at the subsequent balance sheet date, the Company will recordnon-operating, non-cash income. As of December 31, 2005, the derivatives andwarrants classified as liabilities were valued at $2,807,753 and $655,416respectively. 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, the derivativesare classified as long-term liabilities due to the possible monetary penaltiesassociated with conversion features embedded within the debt instruments.

 

The Company also issuedwarrants to Investment Bankers as part of the debt financing which wereinitially recorded as a liability. The FMV of these warrants were adjusted on aquarterly basis. The FMV was reclassified to additional paid in capital withinthe Equity section once the registration of shares underlying the warrants becameeffective. Once classified in equity, the fair market value remains fixed. Atthe time they were reclassified and as of December 31, 2005, the warrantsclassified as equity were valued at $2,847,019.

 

95

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**NOTES—SUPPLEMENTARY DISCLOSURES OF CASH FLOW INFORMATION **

 
| ** **                                                                                                                                             | ** ** | **Years ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                                             | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| **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 |   |
| Issuance of warrants for reduction in  payables                                                                                                        |       | —                                      |       | — |   | — |   |
| Securities transferred from  held-to-maturity to available-for-sale                                                                                    |       | —                                      |       | 1,000,000 |   | — |   |
| Cashless excersize 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 |   | — |   |
| Reclassification of warrants due to  activation of registration statement                                                                              |       | —                                      |       | 2,847,019 |   | — |   |
| Origination of embedded derivaties with  debt financing                                                                                                |       | 4,653,425                                   |       | 8,895,741 |   | — |   |
| Origination of debt discounts with debt  financing                                                                                                     |       | 6,540,109                                   |       | 11,749,540 |   | — |   |

 

**NOTE T—PROFITSHARING PLAN**

 

The Company has establisheda savings plan under section 401(k) of the Internal Revenue Code. Allemployees of the Company, after completing one day of service are eligible toenroll in the 401(k) plan. Participating employees may elect to defer a portionof their salary on a pre-tax basis up to the limits as provided by the IRSCode. The Company is not required to match employee contributions but may do soat its discretion. The Company made no contributions during the three yearsended December 31, 2005. 

 

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**NOTE U—EARNINGSPER SHARE “EPS”**

 

The Company’s basic EPS iscalculated using net earnings and the weighted-average number of sharesoutstanding during the reporting period. Diluted EPS includes the effect frompotential issuance of common stock, such as stock issuable pursuant to theexercise of stock options and warrants and the assumed conversion ofconvertible notes and preferred stock.

 

The reconciliation of thenumerators and denominators of the basic and diluted EPS calculations was asfollows for the following fiscal years ended December 31:

 
| ** **                                                    | ** ** | **2005**   | ** ** | **2004**     | ** ** | **2003**     | ** ** |
|---------------------------------------------------------------|------------|------------|------------|--------------|------------|--------------|------------|
| ** **                                                    | ** ** | ** ** | ** ** | **Restated** | ** ** | **Restated** | ** ** |
|                                                          |       |       |       |         |       |         |       |
| **Numerator:**                                                |       |       |       |         |       |         |       |
|                                                          |       |       |       |         |       |         |       |
| Net income (loss)                                             |       | 358,065    |       | (14,345,632  | )          | (4,058,950   | )          |
|                                                          |       |       |       |         |       |         |       |
| Dividends accumulated on cummulative  preferred stock         |       | (313,517   | )          | (385,355     | )          | (136,755     | )          |
| Income available to common shareholders  (basic eps)          |       | 44,548     |       | (14,730,987  | )          | (4,195,705   | )          |
|                                                          |       |       |       |         |       |         |       |
| Adjustment for interest expense and debt  conversion features |       | (8,795,834 | )          | —       |       | —       |       |
| Net earnings, adjusted (diluted eps)                          |       | (8,751,286 | )          | (14,730,987  | )          | (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                                                         |       | $          | 0.00       |         | $          | (0.42        | )          | $ | (0.24 | ) |
| Diluted                                                       |       | $          | (0.17      | )            | $          | (0.42        | )          | $ | (0.24 | ) |

 

The following tablesummarizes the potential weighted average shares of common stock that wereexcluded from the diluted per share calculation, because the effect ofincluding these potential shares was anitdilutive.

 

| ** **                  | ** ** | **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 thediluted per share calculation because the exercise price was greater than theaverage market price of the common shares:

 

97

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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 takenplace prior to the year-ended December 31, 2005, potential common shares wouldhave been increased by 1,428,571 shares. These shares would have beenant-dilutive and would have been excluded from the EPS calculation.

 

**NOTE V—RECLASSIFICATIONS**

 

Certain amounts in the 2004and 2003 financial statements have been reclassified to conform to the 2005 and2004 presentation. These reclassifications had no effect on the previouslyreported net loss or stockholders’ equity (deficit).

 

**NOTE W—EVENTSOCCURRING SUBSEQUENT TO DECEMBER 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 Notes Amendmentand Waiver, the Secured Notes issued by the Company to Laurus onSeptember 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) the maturity date of the June 2005 Note was extended toDecember 1, 2008, and (iii) the fixed conversion price under each ofthe Secured Notes was reset from $1.35 to $0.85 per share.  In addition,the exercise price of all warrants to purchase Common Stock of the Company heldby 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 ofJanuary 23, 2006, the Company also entered into an Amendment and Waiver(the “Subordinated Notes Amendment and Waiver”) with certain holders (“the “SubordinatedNote Holders”) of its Subordinated Convertible Promissory Notes (the “SubordinatedNotes”).

 

Under the Subordinated NotesAmendment and Waiver, the Subordinated Notes issued by the Company onSeptember 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 topurchase Common Stock held by the Subordinated Note Holders that currently havean exercise 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 theSeries B Preferred Stock of the Company, which shares are convertible intoshares of the Common Stock of the Company at an initial fixed conversion priceof $0.70 per share.

 

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 thistransaction will be used for general working capital purposes.

 

The Company entered into anAmendment No. 1 to Subordinated Secured Promissory Note, dated as ofJanuary 23, 2006 (the “Aether Note Amendment”), with AetherSystems, Inc. (“Aether”).  Pursuant to the Aether Note Amendment, theSubordinated Secured

 

98

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Promissory Note issued by the Company to Aether onSeptember 30,2004 in the aggregate maximum principal amount of $6,884,588(the “Aether Note”),was amended to increase such aggregate maximum principalamount 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 credit maintainedby 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, theCompany’s shareholders approved amendments to articles of incorporation whichincreased the number of authorized shares of common stock from 85,000,000 to170,000,000

 

OnMarch 28, 2006, the Company entered into a two-year employment agreement withMichael 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 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 prohibitsMr. DePasquale from doing business with any current or prospectivecustomer of the Company or engaging in a business competitive with that of theCompany during the term of his employment and for the one year periodthereafter. The Company may terminate the agreement at any time with or withoutcause. In the event of termination without cause, Mr. DePasquale shallcontinue to be paid his then current base salary for the greater of six monthsfrom the date of such termination or the number of months remaining until theend of the term of the employment agreement.

 

99

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**NOTE X—Resultsby Quarter (Unaudited)**

 

Thefirst set of tables below presents unaudited quarterly financial informationfor 2005 and 2004. The amounts presented have been restated from thosepreviously reported on Form 10-Q for the applicable periods and in our 2004annual report on Form 10-K. The second set of tables below sets forth, for eachof the quarters and for each of the interim balance sheet dates presented, theamounts of the restatement adjustments and a reconciliation from previouslyreported 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.

 

100

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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                                                      |       | (1,318,373                                       | )          | (367,044                                        | )          | (410,964 | ) | (1,357,964 | ) | (852 | ) | (484,733 | ) |
| Derivative and  warrant fair value adjustments                        |       | 6,554,565                                        |       | 323,128                                         |       | (119,247 | ) | 2,226,485 |   | — |   | 27,359 |   |
| Gain on sale of  marketable securities                                |       | (20,000                                          | )          | —                                          |       | — |   | — |   | — |   | — |   |
| Other income  (expense)                                               |       | —                                           |       | 2,348                                           |       | 554 |   | (532 | ) | 14,175 |   | 426 |   |
| Total other income  (deductions)                                      |       | 5,242,254                                        |       | (41,568                                         | )          | (529,657 | ) | 870,977 |   | 13,323 |   | (456,948 | ) |
| **NET  INCOME (LOSS)**                                                |       | $                                                | 3,096,730  |                                            | $          | (849,139 | ) | $ | (1,294,152 | ) | $ | (1,478,925 | ) | $ | (1,350,988 | ) | $ | (1,169,949 | ) |
|                                                                  |       |                                             |       |                                            |       |   |   |   |   |   |   |   |   |
| **Basic  Earnings (Loss) per Share:**                                 |       |                                             |       |                                            |       |   |   |   |   |   |   |   |   |
| *Numerator*                                                           |       |                                             |       |                                            |       |   |   |   |   |   |   |   |   |
| Net Income (loss)                                                     |       | $                                                | 3,096,730  |                                            | $          | (849,139 | ) | $ | (1,294,152 | ) | $ | (1,478,925 | ) | $ | (1,350,988 | ) | $ | (1,169,949 | ) |
|                                                                  |       |                                             |       |                                            |       |   |   |   |   |   |   |   |   |
| Convertivble  preferred stock dividends and accretion                 |       | (89,185                                          | )          | (11,103                                         | )          | — |   | (79,701 | ) | (127,765 | ) | — |   |
|                                                                  |       |                                             |       |                                            |       |   |   |   |   |   |   |   |   |
| Net Income (loss)  attributable to common shareholders                |       | $                                                | 3,007,545  |                                            | $          | (860,242 | ) | $ | (1,294,152 | ) | $ | (1,558,626 | ) | $ | (1,478,753 | ) | $ | (1,169,949 | ) |
|                                                                  |       |                                             |       |                                            |       |   |   |   |   |   |   |   |   |
| *Denominator*                                                         |       |                                             |       |                                            |       |   |   |   |   |   |   |   |   |
| Weighted average  common shares outstanding                           |       | 42,662,253                                       |       | 23,845,247                                      |       | 14,286,154 |   | 44,663,981 |   | 37,693,849 |   | 14,886,809 |   |
|                                                                  |       |                                             |       |                                            |       |   |   |   |   |   |   |   |   |
| ***Basic  Earnings (Loss) per Share***                                |       | $                                                | 0.07       |                                            | $          | (0.04 | ) | $ | (0.09 | ) | $ | (0.03 | ) | $ | (0.04 | ) | $ | (0.08 | ) |
|                                                                  |       |                                             |       |                                            |       |   |   |   |   |   |   |   |   |
| **Diluted Loss  per Share:**                                          |       |                                             |       |                                            |       |   |   |   |   |   |   |   |   |
| *Numerator*                                                           |       |                                             |       |                                            |       |   |   |   |   |   |   |   |   |
| Net income (loss)  attributable to common shareholders                |       | $                                                | 3,007,545  |                                            | $          | (860,242 | ) | $ | (1,294,152 | ) | $ | (1,558,626 | ) | $ | (1,478,753 | ) | $ | (1,169,949 | ) |
|                                                                  |       |                                             |       |                                            |       |   |   |   |   |   |   |   |   |
| Effect of  Dilutive Securities: Convertible Debentures                |       | (5,406,505                                       | )          | —                                          |       | — |   | (1,081,619 | ) | — |   | — |   |
|                                                                  |       |                                             |       |                                            |       |   |   |   |   |   |   |   |   |
| Net loss  attributable to common shareholders and assumed conversions |       | $                                                | (2,398,960 | )                                               | $          | (860,242 | ) | $ | (1,294,152 | ) | $ | (2,640,245 | ) | $ | (1,478,753 | ) | $ | (1,169,949 | ) |
|                                                                  |       |                                             |       |                                            |       |   |   |   |   |   |   |   |   |
| *Denominator*                                                         |       |                                             |       |                                            |       |   |   |   |   |   |   |   |   |
| Weighted average  shares outstanding                                  |       | 42,662,253                                       |       | 23,845,247                                      |       | 14,286,154 |   | 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                                      |       | 14,286,154 |   | 50,758,617 |   | 37,693,849 |   | 14,886,809 |   |
|                                                                  |       |                                             |       |                                            |       |   |   |   |   |   |   |   |   |
| ***Diluted  Loss per Share***                                         |       | $                                                | (0.05      | )                                               | $          | (0.04 | ) | $ | (0.09 | ) | $ | (0.05 | ) | $ | (0.04 | ) | $ | (0.08 | ) |

 

101

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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)** |   |
|                                                                  |       |                                   |       |                                  |       |   |   |   |   |   |   |   |   |
| **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 expense                                                      |       | (1,710,154                             | )          | 82,937                                |       | (546,195 | ) | (2,161,639 | ) | (1,631,599 | ) | (467,896 | ) |
| Derivative and  warrant fair value adjustments                        |       | 4,974,842                              |       | 940,716                               |       | 71,799 |   | 1,457,294 |   | (7,266,981 | ) | 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)                                       |       | 3,246,780                              |       | 1,066,633                             |       | (472,630 | ) | (713,765 | ) | (8,946,559 | ) | 411,137 |   |
| **NET  INCOME (LOSS)**                                                |       | $                                      | 1,213,055  |                                  | $          | (782,234 | ) | $ | (1,086,104 | ) | $ | (2,472,796 | ) | $ | (11,363,271 | ) | $ | (508,745 | ) |
|                                                                  |       |                                   |       |                                  |       |   |   |   |   |   |   |   |   |
| **Basic  Earnings (Loss) per Share:**                                 |       |                                   |       |                                  |       |   |   |   |   |   |   |   |   |
| *Numerator*                                                           |       |                                   |       |                                  |       |   |   |   |   |   |   |   |   |
| Net income (loss)                                                     |       | $                                      | 1,213,055  |                                  | $          | (782,234 | ) | $ | (1,086,104 | ) | $ | (2,472,796 | ) | $ | (11,363,271 | ) | $ | (508,745 | ) |
|                                                                  |       |                                   |       |                                  |       |   |   |   |   |   |   |   |   |
| Convertivble  preferred stock dividends and accretion                 |       | (72,632                                | )          | (126,801                              | )          | — |   | (71,999 | ) | (119,686 | ) | (136,755 | ) |
|                                                                  |       |                                   |       |                                  |       |   |   |   |   |   |   |   |   |
| Net income (loss)  attributable to common shareholders                |       | $                                      | 1,140,423  |                                  | $          | (909,035 | ) | $ | (1,086,104 | ) | $ | (2,544,795 | ) | $ | (11,482,957 | ) | $ | (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  Earnings (Loss) per Share***                                |       | $                                      | 0.03       |                                  | $          | (0.02 | ) | $ | (0.07 | ) | $ | (0.05 | ) | $ | (0.29 | ) | $ | (0.03 | ) |
|                                                                  |       |                                   |       |                                  |       |   |   |   |   |   |   |   |   |
| **Diluted Loss  per Share:**                                          |       |                                   |       |                                  |       |   |   |   |   |   |   |   |   |
| *Numerator*                                                           |       |                                   |       |                                  |       |   |   |   |   |   |   |   |   |
| Net income (loss)  attributable to common shareholders                |       | $                                      | 1,140,423  |                                  | $          | (909,035 | ) | $ | (1,086,104 | ) | $ | (2,544,795 | ) | $ | (11,482,957 | ) | $ | (645,500 | ) |
|                                                                  |       |                                   |       |                                  |       |   |   |   |   |   |   |   |   |
| Effect of  Dilutive Securities: Convertible Debentures                |       | (2,954,793                             | )          | (797,814                              | )          | — |   | — |   | — |   | — |   |
|                                                                  |       |                                   |       |                                  |       |   |   |   |   |   |   |   |   |
| Net loss  attributable to common shareholders and assumed conversions |       | $                                      | (1,814,370 | )                                     | $          | (1,706,849 | ) | $ | (1,086,104 | ) | $ | (2,544,795 | ) | $ | (11,482,957 | ) | $ | (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***                                         |       | $                                      | (0.03      | )                                     | $          | (0.04 | ) | $ | (0.07 | ) | $ | (0.05 | ) | $ | (0.29 | ) | $ | (0.03 | ) |

 

102

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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                                                                                                                                                     |       | 4,704,650          |       | — |   | — |   |
| 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                                                                                                                                                               |       | $                  | 2,566,473  |   | $ | — |   | $ | 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          |       | 119,658 |   | — |   |
| Total current liabilities                                                                                                                                                                                 |       | 14,449,963         |       | 1,239,958 |   | 7,623,694 |   |
| Long-term obligations, net of discount and  current maturities                                                                                                                                            |       | 4,247,968          |       | 375,000 |   | 1,218,866 |   |
| Deferred rent                                                                                                                                                                                             |       | 1,205,468          |       | — |   | — |   |
| Deferred revenue                                                                                                                                                                                          |       | 53,317             |       | 58,301 |   | — |   |
| Total non-current liabilities                                                                                                                                                                             |       | 5,506,753          |       | 433,301 |   | 1,218,866 |   |
| **TOTAL LIABILITIES**                                                                                                                                                                                     |       | 19,956,716         |       | 1,673,259 |   | 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                                                                                                                                                                                |       | 49,791,707         |       | 44,173,027 |   | 16,440,399 |   |
| Accumulated deficit                                                                                                                                                                                       |       | (39,427,704        | )          | (28,865,961 | ) | (24,899,556 | ) |
| **TOTAL STOCKHOLDERS’ EQUITY (DEFICIT)**                                                                                                                                                             |       | 10,368,442         |       | 15,666,848 |   | (8,315,199 | ) |
| **TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY  (DEFICIT)**                                                                                                                                            |       | $                  | 30,325,158 |   | $ | 17,340,107 |   | $ | 527,361 |   |

 

103

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**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                                                                                                                                                     |       | 4,856,214         |       | 4,593,692 |   | — |   |
| 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                                                                                                                                                               |       | $                 | 2,232,614  |   | $ | — |   | $ | 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                                                                                                                                                                                       |       | 5,151,042         |       | 266,994 |   | 907,846 |   |
| Deferred rent                                                                                                                                                                                             |       | 417,895           |       | — |   | — |   |
| Deferred revenue                                                                                                                                                                                          |       | 3,007,272         |       | 226,236 |   | — |   |
| Total current liabilities                                                                                                                                                                                 |       | 12,932,282        |       | 1,090,957 |   | 9,970,938 |   |
| Long-term obligations, net of discount and  current maturities                                                                                                                                            |       | 6,896,228         |       | — |   | — |   |
| Deferred rent                                                                                                                                                                                             |       | 1,096,271         |       | — |   | — |   |
| Deferred revenue                                                                                                                                                                                          |       | 53,317            |       | — |   | — |   |
| Total non-current liabilities                                                                                                                                                                             |       | 8,045,816         |       | — |   | — |   |
| **TOTAL LIABILITIES**                                                                                                                                                                                     |       | 20,978,098        |       | 1,090,957 |   | 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                                                                                                                                                                                |       | 50,582,811        |       | 44,408,954 |   | 16,480,472 |   |
| Accumulated deficit                                                                                                                                                                                       |       | (40,937,624       | )          | (30,234,847 | ) | (26,124,382 | ) |
| **TOTAL STOCKHOLDERS’ EQUITY (DEFICIT)**                                                                                                                                                             |       | 9,649,687         |       | 14,559,172 |   | (9,485,149 | ) |
| **TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY  (DEFICIT)**                                                                                                                                            |       | $                 | 30,627,785 |   | $ | 15,650,129 |   | $ | 485,789 |   |

 

104

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**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 |   | — |   |
| Deferred offering costs                                                                                                                                                                                   |       | —                 |       | — |   | — |   |
| Intangible assets—less accumulated  amortization                                                                                                                                                     |       | 5,322,028              |       | 17,324,815 |   | — |   |
| 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                                                                                                                                                               |       | $                      | 1,185,407  |   | $ | 998,520 |   | $ | 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                                                                                                                                                                                 |       | 11,969,607             |       | 12,392,222 |   | 11,002,863 |   |
| Long-term obligations, net of discount and  current maturities                                                                                                                                            |       | 3,938,870              |       | 6,901,815 |   | — |   |
| Deferred rent                                                                                                                                                                                             |       | 983,765                |       | 1,636,098 |   | — |   |
| Deferred revenue                                                                                                                                                                                          |       | 570,136                |       | 59,707 |   | — |   |
| Total non-current liabilities                                                                                                                                                                             |       | 5,492,771              |       | 8,597,620 |   | — |   |
| **TOTAL LIABILITIES**                                                                                                                                                                                     |       | 17,462,378             |       | 20,989,842 |   | 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                                                                                                                                                                                |       | 51,418,314             |       | 44,891,088 |   | 16,590,140 |   |
| Accumulated deficit                                                                                                                                                                                       |       | (39,753,445            | )          | (31,025,169 | ) | (27,255,719 | ) |
| **TOTAL STOCKHOLDERS’ EQUITY (DEFICIT)**                                                                                                                                                             |       | 11,669,503             |       | 14,256,279 |   | (10,495,252 | ) |
| **TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)**                                                                                                                                             |       | $                      | 29,131,881 |   | $ | 35,246,121 |   | $ | 507,611 |   |

 

105

----

 

**Resultsby Quarter (Continued)**

**(Unaudited)**

 
| ** **                                                                            | ** ** | **Three Months Ended March 31,** | ** ** |
|---------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                            | ** ** | **2005**                                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                            | ** ** | **(Restated)**                                       | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
|                                                                                  |       |                                                 |       |   |   |   |   |
| **CASH FLOW FROM OPERATING ACTIVITIES:**                                              |       |                                                 |       |   |   |   |   |
| Net Income (Loss)                                                                     |       | $                                                    | 3,096,730  |   | $ | (849,139 | ) | $ | (1,294,152 | ) |
| **Adjustments to reconcile net loss to cash  used in operating activities:**          |       |                                                 |       |   |   |   |   |
| Derivative and warrant fair value  adjustments                                        |       | (6,554,565                                           | )          | (323,128 | ) | 119,247 |   |
| Depreciation                                                                          |       | 58,590                                               |       | 6,995 |   | — |   |
| Amortization                                                                          |       |                                                 |       |   |   |   |   |
| Discounts on convertible debt related to  warrants and beneficial conversion features |       | 1,169,652                                            |       | — |   | 258,165 |   |
| Allowance for doubtful receivables                                                    |       | 19,790                                               |       | 2,000 |   | — |   |
| Gain on sale of marketable debt securities                                            |       | —                                               |       | — |   | — |   |
| Write down of deferred oferring 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 |   |

 

106

----

 

**Resultsby Quarter (Continued)**

**(Unaudited)**

 
| ** **                                                                            | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                            | ** ** | **2005**                                          | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                            | ** ** | **(Restated)**                                    | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
|                                                                                  |       |                                              |       |   |   |   |   |
| **CASH FLOW FROM OPERATING ACTIVITIES:**                                              |       |                                              |       |   |   |   |   |
| Net income (loss)                                                                     |       | $                                                 | 1,617,805  |   | $ | (2,200,127 | ) | $ | (2,464,101 | ) |
| **Adjustments to reconcile net loss to cash  used in operating activities:**          |       |                                              |       |   |   |   |   |
| Derivative and warrant fair value  adjustments                                        |       | (8,781,050                                        | )          | (323,128 | ) | 91,888 |   |
| Depreciation                                                                          |       | 115,618                                           |       | 17,015 |   | — |   |
| Amortization                                                                          |       |                                              |       |   |   |   |   |
| Intangible assets                                                                     |       | —                                            |       | 108,329 |   | — |   |
| Discounts on convertible debt related to  warrants and beneficial conversion features |       | 2,362,690                                         |       | 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 |   |

 

107

----

 

**Resultsby Quarter (Continued)**

**(Unaudited)**

 
| ** **                                                                            | ** ** | **Nine Months Ended September 30,** | ** ** |
|---------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                            | ** ** | **2005**                                                | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                            | ** ** | **(Restated)**                                          | ** ** | **(Restated)** | ** ** | **(Restated)** | ** ** |
|                                                                                  |       |                                                    |       |   |   |   |   |
| **CASH FLOW FROM OPERATING ACTIVITIES:**                                              |       |                                                    |       |   |   |   |   |
| Net income (loss)                                                                     |       | $                                                       | 2,830,860  |   | $ | (2,982,361 | ) | $ | (3,550,205 | ) |
| **Adjustments to reconcile net income (loss)  to cash used in operating activities:** |       |                                                    |       |   |   |   |   |
| Derivative and warrant fair value  adjustments                                        |       | (13,755,892                                             | )          | (1,263,844 | ) | 20,089 |   |
| Depreciation                                                                          |       | 179,642                                                 |       | 31,617 |   | 38,819 |   |
| Amortization                                                                          |       |                                                    |       |   |   |   |   |
| Intangible assets                                                                     |       | 1,504,600                                               |       | 216,658 |   | — |   |
| Discounts on convertible debt related to  warrants and beneficial conversion features |       | 2,461,638                                               |       | 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 |   |

 

108

----

 

The following tables setforth, for each of the quarters and for each of the interim balance sheet datespresented, the amounts of the restatement adjustments and reconciliation frompreviously reported amounts 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                                                                      | )          | (813,318 | ) | (1,318,373 | ) |
| Derivative and warrant fair value  adjustments                                 |       | —                                                                        |       | 6,554,565 |   | 6,554,565 |   |
| Gain on sale of marketable securities                                          |       | (20,000                                                                       | )          | — |   | (20,000 | ) |
| Total other income (deductions)                                                |       | (498,993                                                                      | )          | 5,741,247 |   | 5,242,254 |   |
| **NET INCOME (LOSS)**                                                          |       | $                                                                             | (2,683,717 | ) | $ | 5,780,447 |   | $ | 3,096,730 |   |
|                                                                           |       |                                                                          |       |   |   |   |   |
| **Basic Earnings (Loss) per Share:**                                           |       |                                                                          |       |   |   |   |   |
| *Numerator*                                                                    |       |                                                                          |       |   |   |   |   |
| Net income (loss)                                                              |       | $                                                                             | (2,683,717 | ) | $ | 5,780,447 |   | $ | 3,096,730 |   |
|                                                                           |       |                                                                          |       |   |   |   |   |
| Convertible preferred stock dividends and  accretion                           |       | (10,692                                                                       | )          | (78,493 | ) | (89,185 | ) |
|                                                                           |       |                                                                          |       |   |   |   |   |
| Net income (loss) attributable to common  shareholders                         |       | $                                                                             | (2,694,409 | ) | $ | 5,701,954 |   | $ | 3,007,545 |   |
|                                                                           |       |                                                                          |       |   |   |   |   |
| *Denominator*                                                                  |       |                                                                          |       |   |   |   |   |
| Weighted average common shares outstanding                                     |       | 42,662,253                                                                    |       | 42,662,253 |   | 42,662,253 |   |
|                                                                           |       |                                                                          |       |   |   |   |   |
| ***Basic Earnings (Loss) per Share***                                          |       | $                                                                             | (0.06      | ) | $ | 0.13 |   | $ | 0.07 |   |
|                                                                           |       |                                                                          |       |   |   |   |   |
| **Diluted Earnings (Loss) per Share:**                                         |       |                                                                          |       |   |   |   |   |
| *Numerator*                                                                    |       |                                                                          |       |   |   |   |   |
| Net income (loss) attributable to common  shareholders                         |       | $                                                                             | (2,694,409 | ) | $ | 5,701,954 |   | $ | 3,007,545 |   |
|                                                                           |       |                                                                          |       |   |   |   |   |
| Effect of Dilutive Securities:                                                 |       |                                                                          |       |   |   |   |   |
| Convertible Debentures                                                         |       | —                                                                        |       | (5,406,505 | ) | (5,406,505 | ) |
|                                                                           |       |                                                                          |       |   |   |   |   |
| Net income (loss) attributable to common shareholders  and assumed conversions |       | $                                                                             | (2,694,409 | ) | $ | 295,449 |   | $ | (2,398,960 | ) |
|                                                                           |       |                                                                          |       |   |   |   |   |
| *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      | ) | $ | 0.01 |   | $ | (0.05 | ) |

 

109

----

 
| ** **                                                                     | ** ** | **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                                                                  | )          | (782,204 | ) | (1,357,964 | ) |
| Derivative and warrant fair value  adjustments                                 |       | —                                                                    |       | 2,226,485 |   | 2,226,485 |   |
| Other expense                                                                  |       | (532                                                                      | )          | — |   | (532 | ) |
| Total other income (deductions)                                                |       | (573,304                                                                  | )          | 1,444,281 |   | 870,977 |   |
| **NET LOSS**                                                                   |       | $                                                                         | (2,944,226 | ) | $ | 1,465,301 |   | $ | (1,478,925 | ) |
|                                                                           |       |                                                                      |       |   |   |   |   |
| **Basic Earnings (Loss) per Share:**                                           |       |                                                                      |       |   |   |   |   |
| *Numerator*                                                                    |       |                                                                      |       |   |   |   |   |
| Net income (loss)                                                              |       | $                                                                         | (2,944,226 | ) | $ | 1,465,301 |   | $ | (1,478,925 | ) |
|                                                                           |       |                                                                      |       |   |   |   |   |
| Convertible preferred stock dividends and  accretion                           |       | (176,600                                                                  | )          | 96,899 |   | (79,701 | ) |
|                                                                           |       |                                                                      |       |   |   |   |   |
| Net income (loss) attributable to common  shareholders                         |       | $                                                                         | (3,120,826 | ) | $ | 1,562,200 |   | $ | (1,558,626 | ) |
|                                                                           |       |                                                                      |       |   |   |   |   |
| *Denominator*                                                                  |       |                                                                      |       |   |   |   |   |
| Weighted average common shares outstanding                                     |       | 44,663,981                                                                |       | 44,663,981 |   | 44,663,981 |   |
|                                                                           |       |                                                                      |       |   |   |   |   |
| ***Basic Earnings (Loss) per Share***                                          |       | $                                                                         | (0.07      | ) | $ | 0.03 |   | $ | (0.03 | ) |
|                                                                           |       |                                                                      |       |   |   |   |   |
| **Diluted Earnings (Loss) per Share:**                                         |       |                                                                      |       |   |   |   |   |
| *Numerator*                                                                    |       |                                                                      |       |   |   |   |   |
| Net income (loss) attributable to common  shareholders                         |       | $                                                                         | (3,120,826 | ) | $ | 1,562,200 |   | $ | (1,558,626 | ) |
|                                                                           |       |                                                                      |       |   |   |   |   |
| Effect of Dilutive Securities:                                                 |       |                                                                      |       |   |   |   |   |
| Convertible Debentures                                                         |       | —                                                                    |       | (1,081,619 | ) | (1,081,619 | ) |
|                                                                           |       |                                                                      |       |   |   |   |   |
| Net income (loss) attributable to common shareholders  and assumed conversions |       | $                                                                         | (3,120,826 | ) | $ | 480,581 |   | $ | (2,640,245 | ) |
|                                                                           |       |                                                                      |       |   |   |   |   |
| *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      | ) | $ | 0.01 |   | $ | (0.05 | ) |

 

110

----

 
| ** **                                                                     | ** ** | **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                                                                       | )          | (866,116 | ) | (1,710,154 | ) |
| Derivative and warrant fair value  adjustments                                 |       | —                                                                         |       | 4,974,842 |   | 4,974,842 |   |
| Other expense                                                                  |       | (24,816                                                                        | )          | — |   | (24,816 | ) |
| Total other income (deductions)                                                |       | (861,946                                                                       | )          | 4,108,726 |   | 3,246,780 |   |
| **NET INCOME (LOSS)**                                                          |       | $                                                                              | (2,957,541 | ) | $ | 4,170,596 |   | $ | 1,213,055 |   |
|                                                                           |       |                                                                           |       |   |   |   |   |
| **Basic Earnings (Loss) per Share:**                                           |       |                                                                           |       |   |   |   |   |
| *Numerator*                                                                    |       |                                                                           |       |   |   |   |   |
| Net income (loss)                                                              |       | $                                                                              | (2,957,541 | ) | $ | 4,170,596 |   | $ | 1,213,055 |   |
|                                                                           |       |                                                                           |       |   |   |   |   |
| Convertible preferred stock dividends and  accretion                           |       | (1,500                                                                         | )          | (71,132 | ) | (72,632 | ) |
|                                                                           |       |                                                                           |       |   |   |   |   |
| Net income (loss) attributable to common  shareholders                         |       | $                                                                              | (2,959,041 | ) | $ | 4,099,464 |   | $ | 1,140,423 |   |
|                                                                           |       |                                                                           |       |   |   |   |   |
| *Denominator*                                                                  |       |                                                                           |       |   |   |   |   |
| Weighted average common shares outstanding                                     |       | 45,476,802                                                                     |       | 45,476,802 |   | 45,476,802 |   |
|                                                                           |       |                                                                           |       |   |   |   |   |
| ***Basic Earnings (Loss) per Share***                                          |       | $                                                                              | (0.07      | ) | $ | 0.09 |   | $ | 0.03 |   |
|                                                                           |       |                                                                           |       |   |   |   |   |
| **Diluted Earnings (Loss) per Share:**                                         |       |                                                                           |       |   |   |   |   |
| *Numerator*                                                                    |       |                                                                           |       |   |   |   |   |
| Net income (loss) attributable to common  shareholders                         |       | $                                                                              | (2,959,041 | ) | $ | 4,099,464 |   | $ | 1,140,423 |   |
|                                                                           |       |                                                                           |       |   |   |   |   |
| Effect of Dilutive Securities:                                                 |       |                                                                           |       |   |   |   |   |
| Convertible Debentures                                                         |       | —                                                                         |       | (2,954,793 | ) | (2,954,793 | ) |
|                                                                           |       |                                                                           |       |   |   |   |   |
| Net income (loss) attributable to common shareholders  and assumed conversions |       | $                                                                              | (2,959,041 | ) | $ | 1,144,671 |   | $ | (1,814,370 | ) |
|                                                                           |       |                                                                           |       |   |   |   |   |
| *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      | ) | $ | 0.02 |   | $ | (0.03 | ) |

 

111

----

 
| ** **                                                                     | ** ** | **Three Months Ended March 31, 2004 (Unaudited)** | ** ** |
|--------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------|------------|
| ** **                                                                     | ** ** | **As Previously**                                                     | ** ** | **Effect of** | ** ** | **As** | ** ** |
| ** **                                                                     | ** ** | **Reported**                                                               | ** ** | **Restatement** | ** ** | **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 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 | ) |

 

112

----

 
| ** **                                                                 | ** ** | **Three Months Ended June 30, 2004 (Unaudited)** | ** ** |
|----------------------------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|
| ** **                                                                 | ** ** | **As Previously**                                                    | ** ** | **Effect of** | ** ** | **As** | ** ** |
| ** **                                                                 | ** ** | **Reported**                                                              | ** ** | **Restatement** | ** ** | **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 | ) |

 

113

----

 
| ** **                                                                     | ** ** | **Three Months Ended September 30, 2004 (Unaudited)** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------|------------|
| ** **                                                                     | ** ** | **As Previously**                                                         | ** ** | **Effect of** | ** ** | **As** | ** ** |
| ** **                                                                     | ** ** | **Reported**                                                                   | ** ** | **Restatement** | ** ** | **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 expense                                                               |       | (692                                                                           | )          | 83,629 |   | 82,937 |   |
| Derivative and warrant fair value  adjustments                                 |       | —                                                                         |       | 940,716 |   | 940,716 |   |
| Loss on sale of marketable securities                                          |       | 33,125                                                                         |       | — |   | 33,125 |   |
| Other income                                                                   |       | 9,855                                                                          |       | — |   | 9,855 |   |
| Total other income (deductions)                                                |       | 42,288                                                                         |       | 1,024,345 |   | 1,066,633 |   |
| **NET LOSS**                                                                   |       | $                                                                              | (1,860,164 | ) | $ | 1,077,930 |   | $ | (782,234 | ) |
|                                                                           |       |                                                                           |       |   |   |   |   |
| **Basic Earnings (Loss) per Share:**                                           |       |                                                                           |       |   |   |   |   |
| *Numerator*                                                                    |       |                                                                           |       |   |   |   |   |
| Net income (loss)                                                              |       | $                                                                              | (1,860,164 | ) | $ | 1,077,930 |   | $ | (782,234 | ) |
|                                                                           |       |                                                                           |       |   |   |   |   |
| Convertible preferred stock dividends and  accretion                           |       | (4,044                                                                         | )          | (122,757 | ) | (126,801 | ) |
|                                                                           |       |                                                                           |       |   |   |   |   |
| Net income (loss) attributable to common  shareholders                         |       | $                                                                              | (1,864,208 | ) | $ | 955,173 |   | $ | (909,035 | ) |
|                                                                           |       |                                                                           |       |   |   |   |   |
| *Denominator*                                                                  |       |                                                                           |       |   |   |   |   |
| Weighted average common shares outstanding                                     |       | 38,624,196                                                                     |       | 38,624,196 |   | 38,624,196 |   |
|                                                                           |       |                                                                           |       |   |   |   |   |
| ***Basic Earnings (Loss) per Share***                                          |       | $                                                                              | (0.05      | ) | $ | 0.02 |   | $ | (0.02 | ) |
|                                                                           |       |                                                                           |       |   |   |   |   |
| **Diluted Earnings (Loss) per Share:**                                         |       |                                                                           |       |   |   |   |   |
| *Numerator*                                                                    |       |                                                                           |       |   |   |   |   |
| Net income (loss) attributable to common  shareholders                         |       | $                                                                              | (1,864,208 | ) | $ | 955,173 |   | $ | (909,035 | ) |
|                                                                           |       |                                                                           |       |   |   |   |   |
| Effect of Dilutive Securities:                                                 |       |                                                                           |       |   |   |   |   |
| Convertible Debentures                                                         |       | —                                                                         |       | (797,814 | ) | (797,814 | ) |
|                                                                           |       |                                                                           |       |   |   |   |   |
| Net income (loss) attributable to common shareholders  and assumed conversions |       | $                                                                              | (1,864,208 | ) | $ | 157,359 |   | $ | (1,706,849 | ) |
|                                                                           |       |                                                                           |       |   |   |   |   |
| *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 |   | $ | (0.04 | ) |

 

114

----

 
| ** **                                                                 | ** ** | **Three Months Ended December 30, 2004 (Unaudited)** | ** ** |
|----------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------|------------|
| ** **                                                                 | ** ** | **As Previously**                                                        | ** ** | **Effect of** | ** ** | **As** | ** ** |
| ** **                                                                 | ** ** | **Reported**                                                                  | ** ** | **Restatement** | ** ** | **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                                                                      | )          | (1,102,755 | ) | (1,631,599 | ) |
| Derivative and warrant fair value  adjustments                             |       | —                                                                        |       | (7,266,981 | ) | (7,266,981 | ) |
| Gain on sale of marketable securities                                      |       | (33,125                                                                       | )          | — |   | (33,125 | ) |
| Other expense                                                              |       | (81,678                                                                       | )          | — |   | (81,678 | ) |
| Total other income (deductions)                                            |       | (576,823                                                                      | )          | (8,369,736 | ) | (8,946,559 | ) |
| **NET LOSS**                                                               |       | $                                                                             | (3,204,715 | ) | $ | (8,158,556 | ) | $ | (11,363,271 | ) |
|                                                                       |       |                                                                          |       |   |   |   |   |
| **Basic Loss per Share:**                                                  |       |                                                                          |       |   |   |   |   |
| *Numerator*                                                                |       |                                                                          |       |   |   |   |   |
| Net loss                                                                   |       | $                                                                             | (3,204,715 | ) | $ | (8,158,556 | ) | $ | (11,363,271 | ) |
|                                                                       |       |                                                                          |       |   |   |   |   |
| Convertible preferred stock dividends and  accretion                       |       | (243,698                                                                      | )          | 124,012 |   | (119,686 | ) |
|                                                                       |       |                                                                          |       |   |   |   |   |
| Net loss attributable to common  shareholders                              |       | $                                                                             | (3,448,413 | ) | $ | (8,034,544 | ) | $ | (11,482,957 | ) |
|                                                                       |       |                                                                          |       |   |   |   |   |
| *Denominator*                                                              |       |                                                                          |       |   |   |   |   |
| Weighted average common shares outstanding                                 |       | 39,270,676                                                                    |       | 39,270,676 |   | 39,270,676 |   |
|                                                                       |       |                                                                          |       |   |   |   |   |
| ***Basic Loss Per Share***                                                 |       | $                                                                             | (0.09      | ) | $ | (0.20 | ) | $ | (0.29 | ) |
|                                                                       |       |                                                                          |       |   |   |   |   |
| **Diluted Loss per Share:**                                                |       |                                                                          |       |   |   |   |   |
| *Numerator*                                                                |       |                                                                          |       |   |   |   |   |
| Net loss attributable to common  shareholders                              |       | $                                                                             | (3,448,413 | ) | $ | (8,034,544 | ) | $ | (11,482,957 | ) |
|                                                                       |       |                                                                          |       |   |   |   |   |
| Effect of Dilutive Securities:                                             |       |                                                                          |       |   |   |   |   |
| Convertible Debentures                                                     |       | —                                                                        |       | — |   | — |   |
|                                                                       |       |                                                                          |       |   |   |   |   |
| Net loss attributable to common shareholders  and assumed conversions      |       | $                                                                             | (3,448,413 | ) | $ | (8,034,544 | ) | $ | (11,482,957 | ) |
|                                                                       |       |                                                                          |       |   |   |   |   |
| *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      | ) | $ | (0.20 | ) | $ | (0.29 | ) |

 

115

----

 
| ** **                                                                 | ** ** | **Three Months Ended March 31, 2003 (Unaudited)** | ** ** |
|----------------------------------------------------------------------------|------------|----------------------------------------------------------------------------|------------|
| ** **                                                                 | ** ** | **As Previously**                                                     | ** ** | **Effect of** | ** ** | **As** | ** ** |
| ** **                                                                 | ** ** | **Reported**                                                               | ** ** | **Restatement** | ** ** | **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                                 |       | 14,256,154                                                                 |       | 14,256,154 |   | 14,256,154 |   |
|                                                                       |       |                                                                       |       |   |   |   |   |
| ***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                                        |       | 14,256,154                                                                 |       | 14,256,154 |   | 14,256,154 |   |
|                                                                       |       |                                                                       |       |   |   |   |   |
| Effect of Dilutive Securities:                                             |       |                                                                       |       |   |   |   |   |
| Convertible Debentures                                                     |       | —                                                                     |       | — |   | — |   |
|                                                                       |       |                                                                       |       |   |   |   |   |
| Diluted weighted average common shares and  common equivalents outstanding |       | 14,256,154                                                                 |       | 14,256,154 |   | 14,256,154 |   |
|                                                                       |       |                                                                       |       |   |   |   |   |
| ***Diluted Loss per Share***                                               |       | $                                                                          | (0.07      | ) | $ | (0.02 | ) | $ | (0.09 | ) |

 

116

----

 
| ** **                                                                 | ** ** | **Three Months Ended June 30, 2003 (Unaudited)** | ** ** |
|----------------------------------------------------------------------------|------------|---------------------------------------------------------------------------|------------|
| ** **                                                                 | ** ** | **As Previously**                                                    | ** ** | **Effect of** | ** ** | **As** | ** ** |
| ** **                                                                 | ** ** | **Reported**                                                              | ** ** | **Restatement** | ** ** | **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 | ) |

 

117

----

 
| ** **                                                                 | ** ** | **Three Months Ended September 30, 2003****(Unaudited)** | ** ** |
|----------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------|------------|
| ** **                                                                 | ** ** | **As Previously**                                                            | ** ** | **Effect of** | ** ** | **As** | ** ** |
| ** **                                                                 | ** ** | **Reported**                                                                      | ** ** | **Restatement** | ** ** | **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 | ) |

 

118

----

 
| ** **                                                                     | ** ** | **Three Months Ended December 31, 2003 (Unaudited)** | ** ** |
|--------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------|------------|
| ** **                                                                     | ** ** | **As Previously**                                                        | ** ** | **Effect of** | ** ** | **As** | ** ** |
| ** **                                                                     | ** ** | **Reported**                                                                  | ** ** | **Restatement** | ** ** | **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 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 | ) |

 

119

----

 
| ** **                                                                                                 | ** ** | **As of March 31, 2005 (Unaudited)** | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                                                                 | ** ** | **As Previously**                                   | ** ** | **Effect of** | ** ** | **As** | ** ** |
| ** **                                                                                                 | ** ** | **Reported**                                             | ** ** | **Restatement** | ** ** | **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                                                |       | 750,364 |   | 4,704,650 |   |
| 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  |   | $ | (688,038 | ) | $ | 2,566,473 |   |
| 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                                               |       | (707,863 | ) | 14,449,963 |   |
| Long-term obligations, net of discount and  current maturities                                             |       | 2,696,322                                                |       | 1,551,646 |   | 4,247,968 |   |
| Deferred rent                                                                                              |       | 1,205,468                                                |       | — |   | 1,205,468 |   |
| Deferred revenue                                                                                           |       | 53,317                                                   |       | — |   | 53,317 |   |
| Total non-current liabilities                                                                              |       | 3,955,107                                                |       | 1,551,646 |   | 5,506,753 |   |
| **TOTAL LIABILITIES**                                                                                      |       | 19,112,933                                               |       | 843,783 |   | 19,956,716 |   |
| **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                                               |       | 1,340,652 |   | 49,791,707 |   |
| Accumulated deficit                                                                                        |       | (37,867,108                                              | )          | (1,560,596 | ) | (39,427,704 | ) |
| **TOTAL STOCKHOLDERS’ EQUITY (DEFICIT)**                                                              |       | 10,588,386                                               |       | (219,944 | ) | 10,368,442 |   |
| **TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY  (DEFICIT)**                                             |       | $                                                        | 29,701,319 |   | $ | 623,839 |   | $ | 30,325,158 |   |

 

120

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| ** **                                                                                                 | ** ** | **As of June 30, 2005 (Unaudited)** | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                                                 | ** ** | **As Previously**                                  | ** ** | **Effect of** | ** ** | **As** | ** ** |
| ** **                                                                                                 | ** ** | **Reported**                                            | ** ** | **Restatement** | ** ** | **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                                               |       | 765,901 |   | 4,856,214 |   |
| 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  |   | $ | (1,094,803 | ) | $ | 2,232,614 |   |
| 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 | ) | 5,107,406 |   |
| Deferred rent                                                                                              |       | 417,895                                                 |       | — |   | 417,895 |   |
| Deferred revenue                                                                                           |       | 3,050,907                                               |       | — |   | 3,050,907 |   |
| Total current liabilities                                                                                  |       | 14,046,910                                              |       | (1,114,628 | ) | 12,932,281 |   |
| Long-term obligations, net of discount and  current maturities                                             |       | 5,347,335                                               |       | 1,548,893 |   | 6,896,228 |   |
| Deferred rent                                                                                              |       | 1,096,271                                               |       | — |   | 1,096,271 |   |
| Deferred revenue                                                                                           |       | 53,317                                                  |       | — |   | 53,317 |   |
| Total non-current liabilities                                                                              |       | 6,496,923                                               |       | 1,548,893 |   | 8,045,816 |   |
| **TOTAL LIABILITIES**                                                                                      |       | 20,543,833                                              |       | 434,265 |   | 20,978,097 |   |
| **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                                              |       | 321,426 |   | 50,582,811 |   |
| Accumulated deficit                                                                                        |       | (40,842,329                                             | )          | (95,294 | ) | (40,937,623 | ) |
| **TOTAL STOCKHOLDERS’ EQUITY (DEFICIT)**                                                              |       | 9,423,556                                               |       | 226,132 |   | 9,649,688 |   |
| **TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY  (DEFICIT)**                                             |       | $                                                       | 29,967,389 |   | $ | 660,396 |   | $ | 30,627,785 |   |

 

121

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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 |   |
| Marketable debt securities                                                                                 |       | —                                                       |       | — |   | — |   |
| 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                                                    |       | 569,978 |   | 5,322,028 |   |
| 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  |   | $ | (1,051,494 | ) | $ | 1,185,407 |   |
| 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                                                   |       | (759,319 | ) | 11,969,607 |   |
| Long-term obligations, net of discount and  current maturities                                             |       | 6,561,868                                                    |       | (2,622,998 | ) | 3,938,870 |   |
| Deferred rent                                                                                              |       | 983,765                                                      |       | — |   | 983,765 |   |
| Deferred revenue                                                                                           |       | 570,136                                                      |       |   |   | 570,136 |   |
| Total non-current liabilities                                                                              |       | 8,115,769                                                    |       | (2,622,998 | ) | 5,492,771 |   |
| **TOTAL LIABILITIES**                                                                                      |       | 20,844,695                                                   |       | (3,382,317 | ) | 17,462,378 |   |
| **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                                                   |       | (142,391 | ) | 51,418,314 |   |
| Accumulated deficit                                                                                        |       | (44,116,496                                                  | )          | 4,363,051 |   | (39,753,445 | ) |
| **TOTAL STOCKHOLDERS’ EQUITY (DEFICIT)**                                                              |       | 7,448,843                                                    |       | 4,220,660 |   | 11,669,503 |   |
| **TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY  (DEFICIT)**                                             |       | $                                                            | 28,293,538 |   | $ | 838,343 |   | $ | 29,131,881 |   |

 

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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 |   |
|                                                                                                           |            |                                                           |            |  |  |  |  |  |  |  |  |

 

123

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| ** **                                                                                               | ** ** | **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 |   |

 

124

----

 
| ** **                                                                                               | ** ** | **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                                                                                              |       | 3,489,028                                                     |       | (332,220 | ) | 3,156,808 |   |
| Billed, less  allowance for doubtful receivables of $1,014,161                                           |       |                                                          |       |   |   |   |   |
| 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                                                        |       | (80,000 | ) | — |   |
| Intangible  assets—less accumulated amortization                                                    |       | 16,268,614                                                    |       | 1,056,201 |   | 17,324,815 |   |
| 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  |   | $ | (1,160,609 | ) | $ | 998,520 |   |
| 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                                                    |       | (1,167,749 | ) | 12,392,222 |   |
| Long-term  obligations, net of discount and current maturities                                           |       | 5,880,871                                                     |       | 1,020,944 |   | 6,901,815 |   |
| Deferred  rent                                                                                           |       | 1,636,098                                                     |       | — |   | 1,636,098 |   |
| Deferred  revenue                                                                                        |       | 59,707                                                        |       | — |   | 59,707 |   |
| Total  non-current liabilities                                                                           |       | 7,576,676                                                     |       | 1,020,944 |   | 8,597,620 |   |
| **TOTAL  LIABILITIES**                                                                                   |       | 21,136,647                                                    |       | (146,805 | ) | 20,989,842 |   |
| **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                                                   | )          | 817,513 |   | (31,025,169 | ) |
| **TOTAL  STOCKHOLDERS’ EQUITY (DEFICIT)**                                                           |       | 13,497,493                                                    |       | 758,786 |   | 14,256,279 |   |
| **TOTAL  LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)**                                           |       | $                                                             | 34,634,140 |   | $ | 611,981 |   | $ | 35,246,121 |   |

 

125

----

 
| ** **                                                                                                | ** ** | **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 |   |

 

126

----

 
| ** **                                                                                                | ** ** | **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 |   |

 

127

----

 
| ** **                                                                                                 | ** ** | **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 |   |

 

128

----

 
| ** **                                                                            | ** ** | **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 | ) | $ | 5,780,447 |   | $ | 3,096,730 |   |
| **Adjustments  to reconcile net income (loss) to cash used in operating activities:** |       |                                                                        |       |   |   |   |   |
| Derivative  and warrant fair value adjustments                                        |       |                                                                        |       | (6,554,565 | ) | (6,554,565 | ) |
| 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                                                                     |       | 813,318 |   | 946,659 |   |
| 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 |   |

 

129

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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 | ) | $ | 7,245,748 |   | $ | 1,617,805 |   |
| **Adjustments  to reconcile net income (loss) to cash used in operating activities:** |       |                                                                     |       |   |   |   |   |
| Derivative and  warrant fair value adjustments                                        |       |                                                                     |       | (8,781,050 | ) | (8,781,050 | ) |
| 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                                                                  |       | 1,595,522 |   | 1,907,056 |   |
| 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 |   |

 

130

----

 
| ** **                                                                            | ** ** | **Nine Months Ended September 30, 2005  (Unaudited)** | ** ** |
|---------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------|------------|
| ** **                                                                            | ** ** | **As Previously**                                                         | ** ** | **Effect of** | ** ** | **As** | ** ** |
| ** **                                                                            | ** ** | **Reported**                                                                   | ** ** | **Restatement** | ** ** | **Restated** | ** ** |
| **Cash  flow from operating activities**                                              |       |                                                                           |       |   |   |   |   |
| Net income  (loss)                                                                    |       | $                                                                              | (8,716,279 | ) | $ | 11,547,139 |   | $ | 2,830,860 |   |
| **Adjustments  to reconcile net income (loss) to cash used in operating activities:** |       |                                                                           |       |   |   |   |   |
| Derivative  and warrant fair value adjustments                                        |       |                                                                           |       | (13,755,892 | ) | (13,755,892 | ) |
| 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 |       | —                                                                         |       | 2,408,338 |   | 2,408,338 |   |
| 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                                                                     | )          | (53,300 | ) | (4,585,792 | ) |
|                                                                                  |       |                                                                           |       |   |   |   |   |
| **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 |   |

 

131

----

 
| ** **                                                                            | ** ** | **Three Months Ended March 31, 2004  (Unaudited)** | ** ** |
|---------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|
| ** **                                                                            | ** ** | **As Previously  Reported**                                            | ** ** | **Effect of  Restatement** | ** ** | **As  Restated** | ** ** |
| **Cash  flow from operating activities**                                              |       |                                                                        |       |   |   |   |   |
| Net 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 |   |
|                                                                                       |            |                                                                             |            |  |  |  |  |  |  |  |

 

132

----

 
| ** **                                                                            | ** ** | **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 |   |
|                                                                                       |            |                                                                          |            |  |  |  |  |  |  |  |

 

133

----

 
| ** **                                                                            | ** ** | **Nine Months Ended September 30, 2004  (Unaudited)** | ** ** |
|---------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------|------------|
| ** **                                                                            | ** ** | **As Previously  Reported**                                               | ** ** | **Effect of  Restatement** | ** ** | **As  Restated** | ** ** |
| **Cash  flow from operating activities**                                              |       |                                                                           |       |   |   |   |   |
| Net loss                                                                              |       | $                                                                              | (4,032,750 | ) | $ | 1,050,389 |   | $ | (2,982,361 | ) |
| **Adjustments  to reconcile net loss to cash used in operating activities:**          |       |                                                                           |       |   |   |   |   |
| Derivative  and warrant fair value adjustments                                        |       |                                                                           |       | (1,263,844 | ) | (1,263,844 | ) |
| Depreciation                                                                          |       | 31,617                                                                         |       | — |   | 31,617 |   |
| Amortization                                                                          |       |                                                                           |       |   |   |   |   |
| Intangible  assets                                                                    |       | 216,658                                                                        |       | — |   | 216,658 |   |
| Discounts on  convertible debt related to warrants and beneficial conversion features |       | —                                                                         |       | 146,795 |   | 146,795 |   |
| 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                                                                     | )          | — |   | (3,474,815 | ) |
|                                                                                  |       |                                                                           |       |   |   |   |   |
| **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                                                                     |       | — |   | 20,047,486 |   |
|                                                                                  |       |                                                                           |       |   |   |   |   |
| **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 |   |
|                                                                                       |            |                                                                                |            |  |  |  |  |  |  |  |

 

134

----

 
| ** **                                                                            | ** ** | **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 |   |

 

135

----

 
| ** **                                                                            | ** ** | **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 |   |
|                                                                                       |            |                                                      |            |  |  |  |  |  |  |  |

 

136

----

 
| ** **                                                                            | ** ** | **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 |   |
|                                                                                       |            |                                                                                |            |  |  |  |  |  |  |  |

 

137

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The following tables summarize, for each of thequarters and for each of the interim balance sheet dates presented, the impactof each category of adjustment on previously reported revenue, and assets,liabilities and accumulated deficit.

 

**Impact of Adjustments on Revenue(Unaudited)**

 
| ** **                  | ** ** | **3/31/2005** | ** ** | **6/30/2005** | ** ** | **9/30/2005** | ** ** |
|-----------------------------|------------|---------------|------------|---------------|------------|---------------|------------|
| **As  previously reported** |       | $             | 3,900,391  |          | $          | 3,664,532     |       | $ | 3,202,601 |   |
| Revenue  recognition        |       | 39,200        |       | 21,020        |       | 29,870        |       |
| **As  restated**            |       | $             | 3,939,591  |          | $          | 3,685,552     |       | $ | 3,232,471 |   |

 
| ** **                  | ** ** | **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 |   |

 

138

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**Impact of Adjustments on Consolidated Balance Sheet Accounts(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 | ) | (320,386 | ) |
| Debt  financing                                   |       | 706,729                                      |       | 819,973                                      |       | (113,244 | ) |   |   | — |   | — |   |
| Total  Adjustments                                |       | 623,839                                      |       | 843,783                                      |       | (219,944 | ) | (399,645 | ) | (79,260 | ) | (320,386 | ) |
| **As  restated**                                  |       | $                                            | 30,325,158 |                                         | $          | 19,956,716 |   | $ | 10,368,442 |   | $ | 17,340,107 |   | $ | 1,673,258 |   | $ | 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 | ) |

 

139

----

 

**Impact of Adjustments on Consolidated Balance Sheet Accounts(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 | ) | (410,666 | ) |
| Debt  financing                                   |       | 722,266                                     |       | 410,455                               |       | 311,811 |   | — |   | — |   | — |   |
| Total  Adjustments                                |       | 660,396                                     |       | 434,265                               |       | 226,131 |   | (412,805 | ) | (2,140 | ) | (410,666 | ) |
| **As  restated**                                  |       | $                                           | 30,627,785 |                                  | $          | 20,978,098 |   | $ | 9,649,687 |   | $ | 15,650,129 |   | $ | 1,090,956 |   | $ | 14,559,172 |   |

 
| ** **                                        | ** ** | **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 | ) |

 

140

----

 

**Impact of Adjustments on Consolidated Balance Sheet Accounts(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                                          |       | (3,406,127                                 | )          | 4,244,470 |   | 976,201 |   | (139,665 | ) | 1,115,866 |   |
| Total  Adjustments                                |       | 838,343                                          |       | (3,382,317                                 | )          | 4,220,660 |   | 611,981 |   | (146,805 | ) | 758,786 |   |
| **As  restated**                                  |       | $                                                | 29,131,881 |                                       | $          | 17,462,378 |   | $ | 11,669,503 |   | $ | 35,246,121 |   | $ | 20,989,842 |   | $ | 14,256,279 |   |

 
| ** **                                        | ** ** | **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 | ) |

 

141

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**SIGNATURES**

 

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the Registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.

 
|                           | BIO-KEY INTERNATIONAL, INC. |
|--------------------------------|----------------------------------|
| Date: March 30, 2006 | By:                              |   |   | /s/   MICHAEL W.  DEPASQUALE |   |
|                           |                             |   |   | Michael W. DePasquale |
|                           |                             |   |   | Co-CHIEF EXECUTIVE OFFICER |

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons on behalf of the Registrant and inthe capacities on the dates indicated.

 
| **Signature**                         | ** ** | **Title**                                              | ** ** | **Date**            |
|---------------------------------------|------------|--------------------------------------------------------|------------|---------------------|
| /s/   MICHAEL W. DEPASQUALE |       | Co-Chief Executive Officer  and Director               |       | March 30, 2006 |
| Michael W. DePasquale                 |       |                                                   |       |                |
|                                  |       |                                                   |       |                |
| /s/   FRANCIS J. CUSICK     |       | Chief Financial Officer,  Principal Accounting Officer |       | March 30, 2006 |
| Francis J. Cusick                     |       |                                                   |       |                |
| /s/   THOMAS J. COLATOSTI   |       | Co-Chairman of the Board  of Directors                 |       | March 30, 2006 |
| Thomas J. Colatosti                   |       |                                                   |       |                |
| /s/   JEFFREY J. MAY        |       | Director                                               |       | March 30, 2006 |
| Jeffrey J. May                        |       |                                                   |       |                |
| /s/   CHARLES P. ROMEO      |       | Director                                               |       | March 30, 2006 |
| Charles P. Romeo                      |       |                                                   |       |                |
| /s/   JOHN SCHOENHERR       |       | Director                                               |       | March 30, 2006 |
| John Schoenherr                       |       |                                                   |       |                |

 

142

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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                                                                                                                                       |
|                      |            |                                                                                                                                                                                                                                              |  |

 

143

----

 
|      |   | Shaar Securities Purchase  Agreement                                                                                                                                                                                                                                                                  |
|-----------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 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(8)  |   | 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 CEO of  Registrant required under Rule 13a-14(a) under the Securities  Exchange Act of 1934, as amended                                                                                                                                                                      |
| 31.2(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 CEO of  Registrant required under Rule 13a-14(b) under the Securities  Exchange Act of 1934, as amended                                                                                                                                                                      |
| 32.2(8)   |   | Certificate of CFO of  Registrant required under Rule 13a-14(b) under the Securities  Exchange Act of 1934, as amended                                                                                                                                                                      |

 

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(1)                                  Filed as an exhibit to the registrant’scurrent report on Form 8-K filed with the Securities and ExchangeCommission on April 14, 2004 and incorporated herein by reference.

 

(2)                                  Filed as an exhibit to the registrant’scurrent report on Form 8-K filed with the Securities and ExchangeCommission on October 5, 2004 and incorporated herein by reference.

 

(3)                                  Filed as an exhibit to the registrant’scurrent report on Form 8-K filed with the Securities and ExchangeCommission on January 5, 2005 and incorporated herein by reference.

 

(4)                                  Filed as an exhibit to the registrant’sregistration statement on Form SB-2, File No. 333-16451 dated February 14,1997 and incorporated herein by reference.

 

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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 the registrant’scurrent report on Form 8-K filed with the Securities and ExchangeCommission on November 26, 2001 and incorporated herein by reference.

 

(7)                                  Filed as an exhibit to the registrant’sannual report on Form 10-KSB filed with the Securities and ExchangeCommission on March 26, 2004 and incorporated herein by reference.

 

(8)                                  Filed herewith.

 

(9)                                  Filed as an exhibit to the registrant’sannual report on Form 10-KSB filed with the Securities and ExchangeCommission on March 31, 2003 and incorporated herein by reference.

 

(10)                            Filed as an exhibit to the registrant’sregistration statement on Form SB-2, File No. 333-115037 dated April 30,2004 and incorporated herein by reference.

 

(11)                            Filed as an exhibit to the registrant’scurrent report on Form 8-K filed with the Securities and ExchangeCommission on April 5, 2004 and incorporated herein by reference.

 

(12)                            Filed as an exhibit to the registrant’sregistration statement on Form SB-2, File No. 333-120104 dated October 29,2004 and incorporated herein by reference.

 

(13)                            Filed as an exhibit to the registrant’scurrent report on Form 8-K filed with the Securities and ExchangeCommission on March 4, 2005 and incorporated herein by reference.

 

(14)                            Filed as an exhibit to the registrant’scurrent report on Form 8-K filed with the Securities and ExchangeCommission on June 14, 2005 and incorporated herein by reference.

 

(15)                            Filed as an exhibit to the registrant’scurrent report on Form 8-K filed with the Securities and ExchangeCommission on September 7, 2005 and incorporated herein by reference.

 

(16)                            Filed as an exhibit to the registrant’scurrent report on Form 8-K filed with the Securities and ExchangeCommission on January 25, 2006 and incorporated herein by reference.

 

(17)                            Filed as an exhibit to the registrant’scurrent report on Form 8-K filed with the Securities and ExchangeCommission on February 9, 2006 and incorporated herein by reference.

 

(18)                            Filed as an exhibit to the registrant’scurrent report on Form 8-K filed with the Securities and ExchangeCommission on March 29, 2006 and incorporated herein by reference.

 

(19)         Filed as an exhibitto the registrant’s proxy statement filed with the Securities and ExchangeCommission on January 18, 2006 and incorporated herein by reference.

 

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