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

**WASHINGTON,D.C. 20549**

** **

**FORM 10-KSB**

** **

**AnnualReport Pursuant to Section 13 or 15(d)of the Securities Exchange Act of 1934**

** **

**Forthe Fiscal Year Ended December 31, 2007**

** **

**CommissionFile Number 1-13463**

 

**BIO-KEY INTERNATIONAL, INC.**

(Nameof small business issuer in its charter)

 

| **DELAWARE**                     |   | **41-1741861**         |
|----------------------------------|--------|------------------------|
| (State or other  jurisdiction of |   | (IRS Employer          |
| Incorporation or  organization)  |   | Identification Number) |

 

| **3349  HIGHWAY 138, BUILDING D, SUITE B, WALL, NJ  07719** |
|-----------------------------------------------------------------------|
| (Address of Principal  Executive Offices) (Zip Code)                  |

 

**(732)359-1100**

Issuer’s telephonenumber, including area code.

 

Securities registered pursuant to Section 12(b) of the Act:

 

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

 

Securities registeredunder Section 12(g) of the Exchange Act

**None**

** **

Check whether theissuer is not required to file reports pursuant to Section 13 or 15(d) ofthe Exchange Act. o

 

Check whether theissuer (1) filed all reports required to be filed by Section 13 or 15(d) ofthe Exchange Act during the preceding 12 months (or for such shorterperiod that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past90 days. Yes x   No o

 

Check if there isno disclosure of delinquent filers in response to Item 405 ofRegulation S-B contained in this form, and no disclosure will becontained, to the best of registrants knowledge, in definitive proxy orinformation statements incorporated by reference in Part III of this Form 10—KSBor any amendment to this form 10—KSB. x

 

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act).

 

Yes o   No x

 

State issuer’srevenues for its most recent fiscal year: $9,988,456

 

The aggregatemarket value of the voting and non-voting common equity held by non-affiliatesof the registrant based on the closing sale price of the registrant’ commonstock as reported on the OTC Bulletin Board on March 1, 2008 was$7,501,341. The information provided shall in no way be construed as anadmission that any person whose holdings are excluded from the figure is anaffiliate or that any person whose holdings are included in the figure is notan affiliate, and any such admission is hereby disclaimed. The informationprovided is solely for the record keeping purposes of the Securities andExchange Commission.

 

As of March 1,2008, 62,511,172 shares of the registrant’s common stock were outstanding.

 

Transitional SmallBusiness Disclosure Formats (check one):

 

Yes o   No x

** **

** **

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**DOCUMENTS INCORPORATED BY REFERENCE**

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None.

** **

**TABLE OFCONTENTS**

 
| ** ** |   |                                                                                                              |   |
|------------|--------|-------------------------------------------------------------------------------------------------------------------|--------|
|       |   |                                                                                                              |   |
|       |   | PART I                                                                                                            | 1      |
|       |   |                                                                                                              |   |
| Item 1.    |   | Description of Business                                                                                           | 1      |
| Item 2     |   | Description of Property                                                                                           | 17     |
| Item 3     |   | Legal Proceedings                                                                                                 | 17     |
| Item 4     |   | Submission of Matters  to a Vote of Security Holders                                                              | 17     |
|       |   |                                                                                                              |   |
|       |   | PART II                                                                                                           | 18     |
|       |   |                                                                                                              |   |
| Item 5     |   | Market for Common  Equity and Related Stockholder Matters                                                         | 18     |
| Item 6     |   | Management’s Discussion  and Analysis or Plan of Operation                                                   | 21     |
| Item 7     |   | Financial Statements                                                                                              | 32     |
| Item 8     |   | Changes in and  Disagreements with Accountants on Accounting and Financial Disclosure                             | 33     |
| Item 8A(T) |   | Controls and Procedures                                                                                           | 34     |
| Item 8B    |   | Other Information                                                                                                 | 34     |
|       |   |                                                                                                              |   |
|       |   | PART III                                                                                                          | 35     |
|       |   |                                                                                                              |   |
| Item 9     |   | Directors, Executive  Officers, Promoters and Control Persons; Compliance with Section 16(a) of the  Exchange Act | 35     |
| Item 10    |   | Executive Compensation                                                                                            | 40     |
| Item 11    |   | Security Ownership of  Certain Beneficial Owners and Management and Related Stockholder Matters                   | 45     |
| Item 12    |   | Certain Relationships  and Related Transactions                                                                   | 47     |
| Item 13    |   | Exhibits                                                                                                          | 48     |
| Item 14    |   | Principal Accountant  Fees and Services                                                                           | 48     |
|       |   | Signatures                                                                                                        | 80     |

 

 

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**PRIVATE SECURITIES LITIGATION REFORM ACT**

 

All statements other than statements of historical facts contained inthis Annual Report on Form 10-KSB, including statements regarding ourfuture financial position, business strategy and plans and objectives of managementfor future operations, are forward-looking statements. The words “anticipate,” “believe,”“estimate,” “will,” “may,” “future,” “plan,” “intend” and “expect” and similarexpressions generally identify forward-looking statements. Although we believeour plans, intentions and expectations reflected in the forward-lookingstatements are reasonable, we cannot be sure they will be achieved. Actualresults may differ materially from the forward-looking statementscontained herein due to a number of factors. Many of these factors are setforth under the caption “Risk Factors” in Item 1 of this Annual Report andother filings with the Securities and Exchange Commission. These factors arenot intended to represent a complete list of the general or specific factorsthat may affect us. It should be recognized that other factors, includinggeneral economic factors and business strategies, may be significant,presently or in the future. Except as required by law, we undertake noobligation to update any forward-looking statement, whether as a result of newinformation, future events or otherwise.

 

 

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**PART I**

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**ITEM 1.**                    DESCRIPTION OF BUSINESS

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BIO-key International, Inc., a Delawarecorporation (the “Company,” “BIO-key,” “we,” or “us), was founded in 1993 todevelop and market proprietary biometric technology and software solutions.Biometric technology is the science of analyzing specific human characteristicswhich are unique to each individual in order to identify a specific person froma broader population. Firstincorporated as BBG Engineering, the company became SAC Technologies in1994.  The BIO-key name was introduced in2002.

 

We develop and market proprietary fingerprintidentification biometric technology and software solutions. We also deliveradvanced identification solutions and information services to law enforcementdepartments, public safety agencies and other government and private sectorcustomers. Our mobile wireless technology provides first responders withcritical, reliable, real-time data and images from local, state and nationaldatabases.

 

We were among the initial pioneers in developingautomated, finger identification technology that can be used without the aid ofnon-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 substantialtime and effort in completing the development of what we believe is the mostdiscriminating and effective commercially available finger-based biometrictechnology. During the past four years, our primary focus has shifted tomarketing and selling this technology and completing strategic acquisitionsthat can help us leverage our capability to deliver identification solutions.We have built a direct sales force of professionals with substantial experiencein selling technology solutions to government and corporate customers.

 

On March 30, 2004,BIO-key acquired Public Safety Group, Inc. (PSG), a privately held companythat is a leader in wireless solutions for law enforcement and public safetymarkets. PSG’s primary technology is PocketCopTM, a handheld solution thatprovides mobile officers, such as detectives who are not typically in theirvehicles, a hand-held mobile information software solution.

 

On September 30,2004, BIO-key completed a transaction with Aether Systems, Inc. topurchase its Mobile Government Division (“Mobile Government” or “AMG”), aleading provider of wireless data solutions for use by public safetyorganizations, primarily state, local police, fire and rescue and emergencymedical services organizations. Our 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.

 

On May 22, 2007, BIO-key competed a transactionwith ZOLL Data Systems, Inc. (“ZOLL”), a subsidiary of ZOLL MedicalCorporation, in which ZOLL acquired substantially all of the assets related tothe Company’s Fire/EMS Services division.

 

As a result of these transactions, and as discussed inNote M to the Consolidated Financial Statements included in this report,we have organized the Company into two reporting segments:  Law Enforcement, and Biometrics. During theyear ended December 31, 2007 the Company continued to focus on its primaryobjectives of increasing revenue and managing expenses.

 

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**Markets**

 

***Finger-based BiometricIdentification***

 

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 (VST) is the foundation for these solutions.BIO-key’s WEB-key ® is acost-effective, easy-to-deploy, fingerprint-based, strong authenticationsystem. This unique solution allows users to positively identify themselves toany application with the simple scan of their finger. This capability is asignificant improvement in both convenience and security over otheralternatives and provides companies with a cost-effective solution to thwartphishing attacks and comply with government regulations and legislation such asFFIEC compliance, HIPAA, HSPD-12, and the Electronic SignaturesAct. BIO-key couples these capabilities with device interoperability,system flexibility and scalability. BIO-key enables the use of 40 differentfingerprint sensor technologies to enroll and identify employees, customers orbusiness partners. Most recently, BIO-key integrated its biometric capabilitieswith its public safety mission with the introduction of IdentityMatch, areal-time, in-station solution that allows law enforcement professionals tomanage the identity of a suspect simply by using their fingerprint. BIO-key hasalso formed relationships with providers of biometric logon software likeIdentiPHI, Softex, and Computer Associates to provide enterprise-readySingleSignOn systems to many large companies in the US and abroad. Also,BIO-key has integrated VST to a pure physical access solution in NextGenID, whichhas been deployed across the US at many leading companies.

 

·                  *Growthpotential* — As the provider of the core technology, BIO-key’sgreatest growth potential for this market is as a partner with companies thatoffer applications that address growing concerns particularly about identitytheft and anti-terrorism.

 

Forexample, BIO-key has implemented programs that will enable biometric logicaland physical access. These include working with IdentiPHI to provide strongnetwork based authentication on BIO-key technology; and with the PegasusProgram to authenticate users accessing a nationwide information-sharing system designed byand for the nation’s sheriffs. These represent the kind of partnership-basedopportunities BIO-key may see in the finger-based biometric market.

 

Inparallel, BIO-key is both strengthening security and improving user and systemadministrator convenience by integrating biometric log-in, as well astwo-factor authentication, with its law enforcement suite of solutions.  These capabilities provide BIO-key with theability to address the latest CJIS security requirements providing marketleadership in this critical area . This is a true differentiator to potentialnew customers, and creates add-on opportunities with existing customers.  Fingerprint identification of FirstResponders has been identified as a way to facilitate disaster recoveries andthese integrated projects have been receiving funding from the Department ofHomeland Security.  By promoting ourintegration of fingerprints for this use, we can capitalize on our vastcustomer base and drive new revenue.

 

***Law Enforcement***

 

BIO-key’sInfoServer, MobileCop and PocketCop law enforcementproducts are a leading wireless mobile data communications client/serversolution, implemented in more than 750 agencies in 43 states. Providingimmediate access to mission-critical data and enabling in-field reporting,BIO-key software keeps officers on the street, improving their productivity andenhancing officer safety. BIO-key solutions are able to run across any and allwireless infrastructures and integrate with virtually all computer-aideddispatch (CAD) and records management systems. This makes us a leader inmulti-agency cooperation and interoperability, which are absolutely critical intimes of large-scale natural and terrorist threats.

 

·                 *Growthpotential* — BIO-key’s large base of more than 750  law enforcement agencies continues to be astrength that helps leverage additional sales from both existing customers andnew customers.

 

Public Safety remains one of the largest areas ofstate and local government IT investment. A 2007 Gartner study entitled “Dataquest Insight: State and Local GovernmentMarket Environment, 2007”, reported total IT spending of  $7.4 billion in 2007, with an expected 18%growth over the next 3 years, and spending for voice/data communications forpublic safety — 

 

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the market segmentfor MobileCop and PocketCop and related add-on products —  expected to total  $5.5 billion over the next 5 years

 

Akey opportunity is the growing awareness of the need for multi-agencyinteroperability. In these situations, BIO-key offers:

 

o                   BIO-key’s LE products, whichcan run on any and all wireless infrastructures. BIO-key also has had successimplementing seamless roaming across multiple infrastructures for multi-agencyconsortiums.

 

o                 BIO-key’s open architecture.

 

o                 BIO-key’s experience inlarge, complex and multi-agency implementations, such as Hamilton County, OhioSheriff’s Office and Pennsylvania State Police.

 

o                 New add-on applications:

 

·                  Data sharing ofRMS information — InfoExchange

 

·                  GPS & AVL Mapping — MobileCopNavigator

 

·                  Handheld Mobile Solutions for BlackBerriesand PDA’s

 

·                   FieldReporting — Mobile Office

 

·                   New ease of use andadministration features for hosting multi agencies at lower costs

 

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

 

Anadditional growth area is the introduction of BIO-key’s finger-based biometricidentification to law enforcement. In addition to now offering biometric loginto our traditional InfoServer product, we have introducedthe IdentityMatch fingerprintidentification solution, which lets law enforcement personnel capture fingerprints in thefield. Using BIO-key’s patented Vector Segment Technology, IdentityMatchanalyzes and categorizes fingerprints the same way a fingerprint expert would —only faster. IdentityMatch also enables multiple law enforcement agencies toshare fingerprint data with other agencies. This powerful tool, built onBIO-key’s understanding of law enforcement requirements and its fingerprinttechnology, presents opportunities for the law enforcement business segment inthe coming year.

 

**Products**

 

BIO-key® operates in two major segments — biometricsand law enforcement. These segments are described below and a list of productsin each line is noted.

 

***Biometrics***

 

The Company’s biometric identification technologyimproves both the accuracy and speed of finger-based biometrics. The Company’sproprietary biometric technology extracts unique data from a fingerprint anduses it to positively identify an individual. The technology has been built to be completely scalable to handledatabases containing millions of fingerprints. BIO-key achieves the highestlevels of discrimination without requiring any other identifying data — like auserID, smart card, or token.  BIO-key’score technology supports interoperability on over 40 different commerciallyavailable readers.  This interoperabilityis a key differentiators for BIO-key in the biometric market.  BIO-key has full support for industrystandards and recently received National Institute of Standards and Techology (“NIST”)certification on its ability to support HSPD-12 supported INCITS-378templates.  Extending our products tosupport standards enables BIO-key to participate in large government projectslike Transportation Workers Identification Card(TWIC), Registered Travelerprojects, PIV initiatives, and FIXS consortium solutions. We believe ourfingerprint identification technology has a broad range of information securityand access control applications, including:

 

·              Securing Internet sites and electronictransactions

 

·              Securing access to logical networks andapplications

 

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·              Securing access to buildings andrestricted areas

 

·              Providing fast, accurate member identificationservices

 

·              Securing mobile devices such as biometricenabled handhelds and PDA’s

 

·                 Preventing identity theft through positive user identification andfalse alias validation

 

**BiometricProducts:**

 

BIO-key’s finger identification algorithm — Vector SegmentTechnology (VSTTM) is the core intellectual property behind its fullsuite of biometric products that include:

 

·                  **Vector SegmentTechnology SDK (VST)**— BIO-key’s biometric development kit that provides developers theability to take advantage of a highly accurate, device interoperable algorithm.VST is available as a low level SDK for incorporation into any applicationarchitecture to increase security while not sacrificing convenience. VST runson Windows, Linux or Solaris systems.

 

·                  **True User Identification**® — BIO-key’sbiometric identification solution that offers large scale one to many userlookup with nothing but a single fingerprint. This solution enables customersto perform false alias checks and manage fraudulent access to systems.  True User Identification leveragescommercially available databases, like Oracle, to scale the identificationcapabilities to millions of users.  Thesolution also runs on commercially available hardware making it truly scalablefor any size system.

 

·                  **WEB-key**® — BIO-key’s biometric securityplatform for managing fingerprint authentication across unprotectednetworks like the internet. It extends all features and functionalities of theVST algorithm to customers looking to add an enhanced level of security totheir thin client and client/server applications. WEB-key currently issupported by both Windows and Linux operating systems.

 

·                  **Biometric ServiceProviderTM**— BIO-key provides support for the BioAPI (a standards based solutionmeeting worldwide needs) for a compliant interface to applications usingbiometrics for verification and identification. BIO-key enhances thetraditional use of the BioAPI by adding support for CE devices, supportingidentification calls and also providing a single user interface for multiplefingerprint 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. ID Director can easily add a levelof security and convenience to the transaction level of any application.

 

***Law Enforcement***

 

·                 **MobileCopTM**— A complete wireless query and messagingapplication that puts the power of mobile and wireless technology to work foragencies of every size, MobileCopTM sets the standard for mobile lawenforcement. Providing real-time retrieval of motor vehicle, warrant andcriminal history information, powerful mobile integration capabilities, and anintuitive user interface, MobileCop delivers the most in performance and it’seasy to see why over 750 law enforcement agencies around the country havedeployed MobileCop for fast and secure access to critical information in thefield

 

·                 **PocketCop®**— PocketCopis a software solution that provides law enforcement personnel withinstantaneous access to criminal, civil, and local database information in awireless environment. PocketCop is a handheld application that provides accessto state and federal databases over the wireless network for Windows Mobile,and RIM OS devices. Using a portable wireless handheld device and the PocketCopapplication software, an authorized user can access suspect information such aswanted status, warrant status, vehicle registration and driver license status.PocketCop technology has been deployed in numerous police agencies in theUnited States,  including the OklahomaCounty (OK) Sheriff’s Office and the Franklin County (OH) Sheriff’s Office. We expect our PocketCop

 

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sales to benefit from the increase in the availability and use ofBlackBerry and Windows Mobile smartphones in public safety.

 

·                  **IdentityMatch**— ** **a web-based fingerprint biometricsolution that allows various criminal custody agencies to quickly identifycriminals at all points along the chain-of-custody throughout the criminaljustice process.  This solution enablesthe sharing of information between trusted entities and personnel, from the bookingagencies to parolee oversight. IdentityMatch allows law enforcement agencies to capture and storefingerprints locally and to identify subjects by matching their fingerprintagainst those stored in the database, securely and in real time. Fingerprintscan be captured using a live scan device from existing 10-print cards orthrough a wide variety of inexpensive commercially available fingerprintreaders. This is an AFIS companion, rather than a replacement  product, designed to maximize the value of fingerprintdata and also to provide a new level of safety for the law enforcementpersonnel.

 

ID-Match — is the webbased client front-end application for the IdentityMatch system solution.  It is a browser based application thatretrieves detailed fingerprint records such as LiveScan, Rolled 10-print andLatent fingerprint information and displays criminal aliases by fingerprintmatch along with detailed information of the actual fingerprint images.

 

ID-Mobile — provides forwireless in the field identification of suspects.  This application can be used in mobile laptopcomputers or a convenient handheld device. The features and functionality ofthis application are ideal for law enforcement patrol, transport vehicles,motorcycle and bike patrols, mounted and foot patrols, as well as waterpatrols; wherever a versatile handheld biometric reader would be essential fortrue suspect identification.

 

ID-Track — ensures thetrue identification, tracking and management of criminals once they enter thecriminal handling continuum. From pre-booking to parolee management ID-Trackprovides true suspect identification. In addition to validating true criminalidentity it archives data for a historical review of enrollments and inmateactivity for report query (under development).

 

ID-Visit — verifies theidentity of visitors registered for visitation rights to incarceratedcriminals. ID-Visit can greatly reduce registration time for subsequent visitsand ensures compliance with a facility’s visitor policy.  A history of visitor activity is maintainedfor historical review and report query. This application is also helpful toidentify the access of pre-approved personnel such as volunteers, Chaplains,teachers, etc. (under development).

 

BIO-key also provides a number of optional featuresdesigned to augment the core Law Enforcement products. These include:

 

·                  **Field Interview TrackerTM****—** enablespersonnel to capture field contact information. The data is stored in asearchable database where it can be located quickly. Police agencies can createonline contact forms that meet their specific needs and multiple agencies canshare information while using their own forms and procedures.

 

·                  **Patrol JournalTM —**an automated system to electronically capture andrecord users’ daily activities, such as patrol area assignments. With PatrolJournal, statistical and summary management reports provide an accurate pictureof time spent by field personnel.

 

·                  **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 for future reportgeneration.

 

·                  **State Crash ReportTM** — enables personnel to use their mobilecomputer to collect data needed for their state’s crash report. This data canbe wirelessly transmitted to a server for supervisor review and approval. Oncecomplete the report can be printed in the state’s format. Selected states aresupported.

 

·                  **InfoServerTM  —**BIO-key’s solution for an agency’s central messagingswitch for application software service, State/NCIC interfaces, Computer AidedDispatch (CAD) and Records Management Software (RMS) interfaces, data 

 

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                        sharing and other applications.

 

·                  **Multiple Application ProgrammingInterface**(API) —allows an agency to have multiple ports to the server to accommodate disparateinterfaces. These multiple API ports are in addition to the one port that isinherent in the server as well as the State/NCIC interface.

 

·                  **InfoExchangeTM —**provides datafrom local records management system (RMS) and other databases directly to themobile data user.  Local RMS systemsoften contain information and images (such as mugshots) not available fromstate and federal databases.

 

·                  **MobileCop® Navigator —**Based onMicrosoft MapPoint, MobileCop Navigator provides easy-to-use mapping features,such as in-car display of location and driving directions generatedautomatically from CAD call information, without extensive map creation ormaintenance of a full scale GIS mapping system.

 

**Partner applications include:**

 

·                  ·***iPass EMP software***enables wireless, remote software updates to dramatically reduce administrativetime and expense, and eliminate version lags.

 

**CurrentBusiness Plan**

 

BIO-key’s current business plan is to:

 

·                  **License its coretechnology “VST” and True User Identification®**to original equipment manufacturers,systems integrators, and application developers who develop products andapplications that utilize its biometric finger matching solutions.

 

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

 

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

 

·                  **Integrate its coretechnology competencies**to leverage new business opportunities and develop new markets for itsinnovative products.

 

**Competition**

 

The markets for BIO-key products and technologies aredeveloping and are characterized by intense competition and rapid technologicalchange. No assurance can be given that our competitors will not develop new orenhanced technologies that will offer superior price, performance, or features,or render BIO-key products or technologies obsolete.

 

*Biometrics*

 

In addition to companies that provide existingcommonplace methods of restricting access to facilities and logical accesspoints such as pass cards, PIN numbers, passwords, locks and keys, there arenumerous companies involved in the development, manufacturing and marketing offingerprint biometrics products to commercial, government, law enforcement andprison markets. These companies include, but are not limited to, Cogent, NEC,L-1 Identity Solutions, Sagem-Morpho, and Bioscrypt.

 

The most recent automated fingerprint identificationproduct sales in the market have been deployed for government and lawenforcement applications, typically at more cost than BIO-key’s products andlicensing arrangements. Although most companies that target consumerapplication markets have completed development of their biometric products,such technologies have not been widely accepted in the commercial markets to date.Most companies competing for commercial opportunities are in the business ofselling scanning devices and tie their algorithm to a specific device. BIO-keyhas created a “device independent” algorithm that provides flexibility inchoosing the correct device and optical or tactile sense to fit the 

 

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applicationserved.

 

BIO-key has found that commercial markets have beenslow to widely purchase biometrics as a viable alternative to their currentsecurity methods. As a result, the primary competition for biometric technologyconsists of traditional security methods such as passwords, PINs, cards andtokens.

 

With respect to competing biometrics technologies,each has its strength and weaknesses and none has emerged as a market leader:

 

·                  *Fingerprintidentification*isgenerally viewed as inexpensive and non-intrusive.

 

·                  *Iris scanning*is viewed as accurate, but can beexpensive and 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.

 

The market for biometric technology is evolving.Computer breaches, identity theft, phishing and other events in the recent pastare driving a large-scale shift to biometric deployments. In addition,companies such as IBM, Dell, Gateway, MPC, Samsung and HP have all introducedcomputers with integrated finger scanning devices to complement theconventional username/password technique since it is highly susceptible tohackers and security breaches. BIO-key supports these integrated devices forbroader enterprise level security solutions.

 

*LawEnforcement*

 

The public safety market comprises agencies at allgovernment levels, with a range of users, from a few to many hundreds. BIO-keycompetitors in the mobile data market include Computer Aided Dispatch/RecordsManagement companies such as New World, Tiburon and Motorola. Each hascomprehensive CAD and/or RMS offerings and has augmented those with their ownmobile data and field reporting solutions. While these mobile data solutionsmay not be as functionally rich as the BIO-key suite of products,they are sometimes less expensive when bundled with the CAD/RMS offerings. Theyalso provide a complete solution from one vendor.

 

**Marketingand Distribution**

 

BIO-key’s marketing and distribution efforts comprisethe 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-businesssuite of applications and provides the biometric enabler for the OracleSingle Sign on product. As an Oracle development partner, BIO-key provides theunderlying database used for true user identification and on demand aliaschecking. As a development partner, BIO-key participates in Oracle Trade Showssuch as Oracle Open World and Oracle Apps World.

 

·                  BIO-key has strategic alliances withtechnology leaders including Oracle, Computer Associates, Hewlett Packard,Dell, Verizon, Sprint/Nextel, AT&T Wireless, 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,integrator and partner network as well as a direct sales team.

 

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**Addressingthe Market**

 

Following are thespecific marketing/sales programs in place:

 

·                  *Direct Selling Efforts*— BIO-key now has a base of area salesdirectors who are responsible for the law enforcement market. This team ofsales professionals brings extensive experience in technical solution andrelationship-based selling. They are supported by a pre-sales team thatincludes system engineering and proposal management and post-sales programmanagement, implementation and training professionals. Included in this teamare individuals who are themselves former police officers.

 

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

 

·                  *Conferences and Trade Shows*— BIO-key attends and activelyparticipates in various product-related conferences and trade shows in thetechnology and security industries to generate market awareness of biometricand wireless mobile data technology generally and our offerings specifically.BIO-key’s public safety software often is featured at our business partners’booths at these events, showcasing the interoperability of the 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:

 

o                 BIO-key is partnering with AT&TWireless, the largest wireless carrier in the country, to first responders in aseven-county Tennessee consortium of fire, police and EMS agencies in access tomission critical information using BIO-key’s MobileCop solution in conjunctionwith AT&T Wireless’s EDGE wireless data network

 

o                 BIO-key is partnering with Research inMotion (RIM) and Sprint to increase the market penetration of PocketCop onBlackBerry smartphones through a national educational campaign and apromotional offer.

 

o                 Silex Technology America, Inc.,which develops fingerprint reader products designed to support a variety ofsecure computing options, utilizes BIO-key’s VST and WEB-key technology.

 

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

 

**Licensing**

 

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

 

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

 

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

 

·                  *Education*— Educational Biometric Technologies,Lunch Byte Systems and Identimetrics have incorporated BIO-key 

 

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                        technology to enable school children topay for school lunch programs and checkout library books using theirfingerprints. VST technology enables schools to enroll these children andreduces the administrative costs of managing passwords and collecting payments.

 

·                  *Commerce:*ChoicePoint has implemented a checkcashing solution using BIO-key’s VST technology to reduce fraud and identitytheft.

 

·                  *Patient Records and InformationManagement:*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. Also, the IndianaBlood Center is incorporating BIO-key’s large scale identity assurance platformto provide a safe, secure and convenient means for donors to confirm theiridentity.

 

·                  *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 forinstitutional customers.

 

**Intellectual Property Rights**

 

We believe that ourintellectual property is important to our biometric and law enforcement segments:

 

·                  *Patents*— our biometrics segment uses patentedtechnology and trade secrets developed or acquired by us.

 

In May 2005, theU.S. Patent & Trademark Office issued us a patent for our VectorSegment fingerprint technology (VST), BIO-key’s core biometric analysis andidentification technology.

 

On August 29 2006,BIO-key announced that the Company’s patent for biometric identificationindexing, a core feature of its VSTTM software, has been granted in Europe. Inaddition, a WEB-key® authentication security patent for “Systems and Methods ofSecure Biometric Authentication” has been issued in South Africa. These patentsenhance the worldwide protection of BIO-key’s technology. The European patentfor VST, which provides BIO-key with protection of its intellectual property inEurope, was issued on March 29, 2006 and covers a similar set of claimsfor a patent BIO-key was granted in 2005 in the United States.  BIO-keyexpects the patent for Secure Biometric Authentication, issued in South Africaon April 26, 2006, to be issued in the United States in the near future.

 

On October 3, 2006,BIO-key announced that the Company’s patent for a biometric authenticationsecurity framework has been granted by the U.S. Patent & TrademarkOffice. The patent (No. 7,117,356) was issued to BIO-key for a biometricauthentication security framework that enhances commercial and civil biometricuse.  BIO-key’s authentication security framework  protects privacyand security while also facilitates ease of use of biometric systems.  Thetechnology that this patent is based on is the foundation for authenticationsecurity as incorporated in BIO-key’s WEB-key® product line.   WEB-key is a mature enterprise authentication solution that functions in a widevariety of application environments.  The solution supports a variety ofimplementation alternatives including card technologies for ‘two-factor’authentication and also supports  ‘single-factor’ authentication.  Partners and customers implementing BIO-key’sWEB-key software to provide convenient and secure user identity include anumber of institutions including the Allscripts Healthcare Solutions, AmericanAssociation of Medical Colleges, Empresa de Telecomunicaciones de Bogotá(Columbia) and Iomedex Corporation.

 

On January 11, 2007,BIO-key announced that the U.S. Patent & Trademark Office has issuedUS patent No. 7,155,040 covering BIO-key’s unique image processingtechnology, which is critical for enhancing information used in the extractionof biometric minutiae. The issued patent protects a critical part of aninnovative four-phase image enhancement process developed by BIO-key, andrepresents the third U.S. patent granted to the company for its biometrictechnology.

 

Additionally, we have anumber of U.S. and foreign patent applications in process related to thisintellectual property.

 

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·                  *Trademarks*— We have registered our trademarks (“BIO-key”,“True User Identification”, “WEB-key”, “PacketCluster”, “PacketCluster Patrol”,“PacketWriter”, “PocketCop”, “VirtualCop”, “MobileCop” and the design mark for “Cerulean”,with the U.S. Patent & Trademark Office. We have also applied fortrademarks for “Cerulean” and “MobileSRO, a mobile data solution for school andcampus security”.

 

·                  *Copyrights and trade secrets*— We take measures to ensure copyrightand license protection for our software releases prior to distribution. Whenpossible, the software is licensed in an attempt to ensure that only licensedand activated software functions to its full potential. We also take measuresto protect the confidentiality of our trade secrets.

 

**Research and Development**

 

Our research anddevelopment efforts are concentrated on enhancing the functionality,reliability and integration of our current products as well as developing newand innovative products for the biometrics and law enforcement. AlthoughBIO-key believes that its identification technology is one of the most advancedand discriminating fingerprint technologies available today, the markets inwhich BIO-key compete are characterized by rapid technological change andevolving standards. In order to maintain its position in the market, BIO-keywill continue to upgrade and refine its existing technologies. In 2006, BIO-keyannounced the launch of IdentityMatch, our fingerprint identification system.IdentityMatch offers a tool for agencies to store and search fingerprints andthe associated demographic data, the ability to compare new prints with thosepreviously captured as a low-cost AFIS alternative or to be used for a widevariety of routine identification transactions not supported by AFIS. IdentityMatchTMis currently being tested by a number of customers.

 

During the fiscal yearsended December 31, 2007 and 2006, BIO-key spent approximately $4,995,000and $5,372,000 respectively, on research, development and engineering. 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.

 

**Government Regulations**

 

BIO-key is not currentlysubject to direct regulation by any government agency, other than regulationsgenerally applicable to businesses or related to specific project requirements.In the event of any international sales, the company would be subject tovarious domestic and foreign laws regulating such exports and exportactivities.

 

**Environmental Regulations**

 

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

 

**Employees and Consultants**

 

As of March 1, 2008,BIO-key currently employed fifty-seven (57) individuals on a full-timebasis: thirty-three (33) in engineering, customer support, research anddevelopment; eleven (11) in finance and administration; and thirteen(13) in sales and marketing. BIO-key also uses the services of five (5) consultantswho provide engineering and technical services.

 

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**RISKFACTORS**

 

*The following material risk factors,among others, may affect the Company’s financial condition and results ofoperations.*

 

**Businessand Financial Risks**

 

**Based****on our lack ofsignificant revenue since inception and recurring losses from operations, ourauditors have included an explanatory paragraph in their opinion as to thesubstantial doubt about our ability to continue as a going concern.**

 

Due to, among otherfactors, our history of losses (excluding gains from valuation changes inembedded derivatives) and limited revenue, our independent auditors haveincluded an explanatory paragraph in their opinion for the year ended December 31,2007 as to the substantial doubt about our ability to continue as a goingconcern. Our financial statements have been prepared in accordance withaccounting principals generally accepted in the United States, whichcontemplate that we will continue to operate as a going concern. Our financialstatements do not contain any adjustments that might result if we are unable tocontinue as a going concern.

 

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

 

As of December 31,2007, we had negative working capital of approximately $5,796,000 and anaccumulated deficit of approximately $54,900,000. Since our inception, we havefocused almost exclusively on developing our core technologies and, until thefourth quarter of 2004 had not generated any significant revenue. In order toincrease revenue, we have developed a direct sales force and anticipate theneed to retain additional sales, marketing and technical support personnel andmay need to incur substantial expenses. We cannot assure you that we willbe able to secure these necessary resources, that a significant market for ourtechnologies will develop or that we will be able to achieve our targetedrevenue.

 

**Wehave previously identified material weaknesses in our internal control overfinancial reporting and have at times in the past failed to maintain aneffective system of disclosure controls and procedures. If we are unable tomaintain an effective system of disclosure controls and procedures, wemay not be able to accurately report our financial results or preventfraud. As a result, current and potential stockholders could lose confidence inour financial reporting; this would harm our business and the trading price ofour common stock.**

 

During the review of theCompany’s operating results for the period covered by this report, our CEO andCFO determined that, as of December 31, 2007, our disclosure controls andprocedures were effective in providing reasonable assurance that information weare required to disclose in reports we file or submit under the Exchange Act isrecorded, processed, summarized and reported within the time periods specifiedby the Securities and Exchange Commission rules and forms. Our managementreached this conclusion after identifying our system to capture disclosureitems, our internal process of review for account reconciliations, ourdocumentation of internal controls and our internal process for preparing ourannual report on Form 10-KSB for the fiscal year ended December 31,2007 as being adequate to provide such assurance.

 

Any failure to maintaineffective controls, or difficulties encountered in their implementation or inother effective improvement of our internal and disclosure controls couldmaterially harm our operating results or cause us to fail to meet our reportingobligations. If we are unable to adequately maintain our internal controls overfinancial reporting, or if we maintain an ineffective system of disclosurecontrols and procedures, our financial statements may not accurately reflectthe financial condition of the Company, and current and potential futureinvestors may not be able to rely upon our financial statements. 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 togain widespread market acceptance and we do not know how large of a market willdevelop for our technology.**

 

Biometric technology hasreceived only limited market acceptance, particularly in the private sector.Our technology represents a novel security solution and we have not yetgenerated significant sales. Although recent security concerns relating toidentification of individuals has increased interest in biometrics generally,it remains an undeveloped, evolving market. Biometric based solutions compete withmore traditional security methods including keys, cards, personal 

 

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identification numbers and security personnel.Acceptance of biometrics as an alternative to such traditional methods dependsupon a number of factors including:

 

· the reliabilityof biometric solutions

 

· publicperception regarding privacy concerns

 

· costs involvedin adopting and integrating biometric solutions

 

For these reasons, we are uncertain whether ourbiometric technology will gain widespread acceptance in any commercial marketsor that demand will be sufficient to create a market large enough to producesignificant revenue or earnings. Our future success depends, in part, uponbusiness customers adopting biometrics generally, and our solutionspecifically.

 

**Biometrictechnology is a new approach to Internet security****which****must be accepted inorder for our WEB-key**® **solution to generate significantrevenue.**

 

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

 

**Our softwareproducts may contain defects which will make it more difficult for us toestablish and maintain customers.**

 

Although we havecompleted the development of our core biometric technology, it has only beenused by a limited number of business customers. Despite extensive testingduring development, our software may contain undetected design faults andsoftware errors, or “bugs” that are discovered only after it has been installedand used by a greater number of customers. Any such defect 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.

 

While we have commenced asignificant sales and marketing effort, we have only begun to develop asignificant distribution channel and may not have the resources or abilityto sustain these efforts or generate any meaningful sales.

 

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

 

We market our technologythrough licensing arrangements with:

 

·                  Original equipment manufacturers, system integratorsand application developers which develop and market products and applicationswhich can then be sold to end users

 

·                  Companies which distribute goods, services or softwareapplications over the Internet

 

As a technology licensingcompany, our success will depend upon the ability of these manufacturers anddevelopers to effectively integrate our technology into products and serviceswhich they market and sell. We have no control over these licensees and can notassure you that they have the financial, marketing or technical resources tosuccessfully develop and distribute products or applications acceptable to endusers or generate any meaningful revenue for us. These third partiesmay also offer the products of our competitors to end users.

 

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

 

Most of our business involvesproviding products and services under contracts with U.S. federal, state andlocal government agencies. Obtaining contracts from government agencies ischallenging, and government contracts often include provisions that are notstandard in private commercial transactions. For example, government contractsmay:

 

·                  include provisions that allow the government agency toterminate the contract without penalty under some circumstances;

 

·                  be subject to purchasing decisions of agencies thatare subject to political influence;

 

·                  contain onerous procurement procedures; and

 

·                  be subject to cancellation if government fundingbecomes unavailable.

 

Securing governmentcontracts can be a protracted process involving competitive bidding. In manycases, unsuccessful bidders may challenge contract awards, which can leadto increased costs, delays and possible loss of the contract for the winningbidder.

 

**We faceintense competition and may not have the financial and human resourcesnecessary to keep up with rapid technological changes, which may result inour technology becoming obsolete.**

 

The Internet, facilityaccess control and information security markets are subject to rapidtechnological change and intense competition. We compete with both establishedbiometric companies and a significant number of startup enterprises as well asproviders of more traditional methods of access control. Most of ourcompetitors have substantially greater financial and marketing resources thanwe do and may independently develop superior technologies, whichmay result in our technology becoming less competitive or obsolete. Wemay not be able to keep pace with this change. If we are unable to developnew applications or enhance our existing technology in a timely manner inresponse to technological changes, we will be unable to compete in our chosenmarkets. In addition, if one or more other biometric technologies such asvoice, face, iris, hand geometry or blood vessel recognition are widelyadopted, it would significantly reduce the potential market for our fingerprintidentification technology.

 

**Wedepend on key employees and members of our management team, including ourChairman of the Board and Chief Executive Officer, in order to achieve ourgoals. We cannot assure you that we will be able to retain or attract suchpersons.**

 

A loss of our currentChairman of the Board of Directors or Chief Executive Officer could severelyand negatively impact our operations. Our consulting contract with Thomas J.Colatosti, our Chairman of the Board, expired on December 31, 2007, andhas not been renewed. Mr Colatosti continues to assist the Company in the areasof strategic planning and corporate finance. In addition, we have an employmentcontract with Michael W. DePasquale, our Chief Executive Officer, through March 28,2008. Although the contract does not prevent him from resigning, it doescontain confidentiality and non-compete clauses which are intended to preventhim from working for a competitor within one year after leaving our Company. Oursuccess depends on our ability to attract, train and retain employees withexpertise in developing, marketing and selling software solutions. In order tosuccessfully market our technology, we will need to retain additionalengineering, technical support and marketing personnel. The market for suchpersons remains highly competitive and our limited financial resources willmake it more difficult for us to recruit and retain qualified persons.

 

**We cannot assure you that the limited intellectual property protection for our coretechnology provides a meaningful competitive advantage or barrier to entryagainst our competitors.**

 

Our success and abilityto compete is dependent in part upon proprietary rights to our technology.We rely primarily on a combination of patent, copyright and trademark laws,trade secrets and technical measures to protect our propriety rights. We havefiled a patent application relating to both the optic technology and biometricssolution components of our technology wherein several claims have been allowed.In May 2005, the U.S. Patent Office issued us a patent for our VectorSegment 

 

 

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fingerprint technology (VST), BIO-key’s core biometricanalysis and identification technology. We cannot assure you that anyadditional patents will be issued that we will have the resources to protectany patent from infringement. Although we believe our technology does notcurrently infringe upon patents held by others, we can not assure you that suchinfringements do not exist or will not exist in the future, particularly as thenumber of products and competitors in the biometric industry segment grows.

 

**Wemay need to obtain additional financing to execute our business plan, whichmay not be available. If we are unable to raise additional capital orgenerate significant revenue, we may not be able to continue operations.**

 

Since our inception, wehave not generated any significant revenue (other than revenue from acquiredbusinesses) and have experienced substantial losses, including an operatingloss of approximately $5,365,000 during 2007. In January 2006 we receivedapproximately $1,000,000 in a private placement convertible debt offering, andin August 2006 we raised approximately $2,000,000 in gross proceedsthrough a private issuance of equity securities, of which $1,500,000 wasreceived in cash and $500,000 was paid by an exchange of rights to declared andunpaid dividends. In May 2007 we received approximately $1,800,000 in netproceeds from the sale of our Fire/EMS Services division.

 

The Company’s Series AConvertible Preferred Stock is redeemable in cash by the stockholders within 10days after December 31, 2008, if certain stock price performance conditions arenot met. This date was deferred from March 31, 2008 by an agreement with theholders of the Series A Shares on March 24, 2008. In addition, theCompany’s Series B and Series C Convertible Preferred Stock isredeemable in cash by the stockholders during the first quarter of 2009, if similarstock price performance criterias are not met.

 

If we are unable togenerate sufficient revenue to meet our goals, we will need to obtainadditional third-party financing to (i) conduct the sales, marketing andtechnical support necessary to execute our plan to substantially growoperations, increase revenue and serve a significant customer base; and (ii) provideworking capital. Therefore, we will need to obtain additional financing throughthe issuance of debt or equity securities, or to restructure our financialposition through similar transactions to those consummated during 2006 and2007.

 

We cannot assure you thatwe will ever be able to secure any such financing on terms acceptable to us. Ifwe cannot obtain such financing, we may not be able to execute our businessplan or continue operations.

 

**Wemay not achieve profitability with respect to the law enforcement andbiometric components of our business if we are unable to maintain, improve anddevelop the wireless data services we offer.**

 

We believe that ourfuture business prospects depend in part on our ability to maintain andimprove our current services and to develop new ones on a timely basis. Ourservices will have to achieve market acceptance, maintain technologicalcompetitiveness and meet an expanding range of customer requirements. As aresult of the complexities inherent in our service offerings, major newwireless data services and service enhancements require long development andtesting periods. We may experience difficulties that could delay orprevent the successful development, introduction or marketing of new servicesand service enhancements. Additionally, our new services and serviceenhancements may not achieve market acceptance. If we cannot effectivelydevelop and improve services we may not be able to recover our fixed costsor otherwise become profitable.

 

**Our lawenforcement and biometric division depends upon wireless networks owned andcontrolled by others.**

 

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

 

 

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**New lawsand regulations that impact our law enforcement and biometric division couldincrease our costs or reduce our opportunities to earn revenue.**

 

We are not currently subjectto direct regulation by the Federal Communications Commission or any othergovernmental agency, other than regulations applicable to businesses ingeneral. However, in the future, we may become subject to regulation bythe FCC or another regulatory agency. In addition, the wireless carriers whosupply us airtime and certain of our hardware suppliers are subject toregulation by the FCC and regulations that affect them could increase our costsor reduce our ability to continue selling and supporting our services.

 

**If wefail to adequately manage our resources, it could have a severe negative impacton our financial results or stock price.**

 

We could be subject tofluctuations in technology spending by existing and potential customers.Accordingly, we will have to actively manage expenses in a rapidly changingeconomic environment. This could require reducing costs during economicdownturns and selectively growing in periods of economic expansion. If we donot properly manage our resources in response to these conditions, our resultsof operations could be negatively impacted.

 

**Ourobligations to the holders of our outstanding preferred stockmay adversely affect our ability to enter into potential significanttransactions with other parties.**

 

We will need to obtainthe consent of the holders of a majority of the then outstanding shares of ourconvertible preferred stock before we can take certain actions, including thefollowing:

 

·                  a sale or other disposition of any material assets;

 

·                  an acquisition of a material amount of assets;

 

·                  engaging in a merger, reorganization or consolidation;or

 

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

 

Accordingly, unless we obtain such consent, wemay not be able to enter into certain transactions.

 

**RisksRelated To Our Common Stock**

 

**We haveissued a substantial number of securities that are convertible into shares ofour common stock which will result in substantial dilution to the ownershipinterests of our existing shareholders.**

 

As of December 31,2007, approximately 57,388,000 shares of our common stock were reserved forissuance upon exercise or conversion of the following securities (at conversionprices applicable as at December 31, 2007):

 

·                  17,616,000 shares upon exercise ofoutstanding stock options and warrants;

 

·                  2,858,000 shares upon exercise of options availablefor future grant under our existing option plans; and

 

·                  36,914,000 shares or more upon conversion of our outstandingshares of Convertible Preferred Stock and cumulative dividends in arrears.

 

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

 

 

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**Asubstantial number of our convertible securities are convertible into shares ofcommon stock at a conversion price of $.30 per share. Most of these shares areeligible for public resale. The trading price of our common stock and ourability to raise additional financing may be adversely affected by the influxinto the market of such a substantial number of shares.**

 

Our outstanding shares ofSeries A Convertible Preferred Stock and cumulative dividends in arrearsare convertible into 10,998,843 shares of common stock as of December 31,2007 at a per share conversion price of $.30. 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 agreed to file a registration statement to cover the public resale ofall of these shares. This significant increase in the number of sharesavailable for public sale may have a negative impact on the trading price ofour shares and substantially dilute the ownership interests of our existingshareholders. In the event that our stock trades below $.30 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 $.30 per share. Anyissuance of shares at a purchase price of less than $.30 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 of ourcommon stock that could adversely affect the trading price of our common stock.

 

In January 2006, theCompany issued Convertible Term Notes in the aggregate principal amount of$1,000,000 to certain investors. The Convertible Notes subsequently convertedinto shares of Series B Convertible Preferred Stock of the Company, whichshares and cumulative dividends are convertible into shares of our common stockat a fixed conversion of $.30 per share for an aggregate amount of 3,517,245shares as at December 31, 2007. 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 agreed tofile a registration statement to cover the public resale of all of theseshares. This significant increase in the number of shares available for publicsale may have a negative impact on the trading price of our shares andsubstantially dilute the ownership interests of our existing shareholders. Inthe event that our stock trades below $.30 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 $.30 per share. Any issuance ofshares at a purchase price of less than $.30 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 of ourcommon stock that could adversely affect the trading price of our common stock.

 

In August 2006,certain subordinated term notes were converted to shares of Series CConvertible Preferred Stock of the Company, which shares and cumulativedividends are convertible into shares of our common stock at an fixedconversion of $.30 per share per share for an aggregate amount of 22,398,042shares as at December 31, 2007. Although many of the shares issuable uponconversion of our Series C Convertible Preferred Stock are eligible forpublic resale under Securities Exchange Commission Rule 144, we agreed tofile a registration statement to cover the public resale of all of theseshares. This significant increase in the number of shares available for publicsale may have a negative impact on the trading price of our shares andsubstantially dilute the ownership interests of our existing shareholders. Inthe event that our stock trades below $.30 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 $.30 per share. Any issuance ofshares at a purchase price of less than $.30 per share would reduce theconversion price of our Series C Convertible Preferred Shares to suchlower price. This would require us to issue additional shares upon conversionof our Series C 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 of ourcommon stock that could adversely affect the trading price of our common stock.

 

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

 

Our common stockcurrently trades on the OTC Bulletin Board. Since our common stock continues totrade below $5.00 per share, our common stock is considered a “penny stock” andis subject to SEC rules and regulations, which impose limitations upon themanner in which our shares can be publicly traded. These regulations requirethe delivery, prior to any 

 

 

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transaction involving a penny stock, of a disclosureschedule explaining the penny stock market and the associated risks. Underthese regulations, certain brokers who recommend such securities to personsother than established customers or certain accredited investors must make aspecial written suitability determination regarding such a purchaser andreceive such purchaser’s written agreement to a transaction prior to sale.These regulations have the effect of limiting the trading activity of ourcommon stock and reducing the liquidity of an investment in our common stock.

 

**We donot intend to pay dividends in the foreseeable future.**

 

We have never declared orpaid a dividend on our common stock. In addition, the terms of our outstandingConvertible Preferred Shares preclude us from declaring or paying a dividend onour common stock unless a dividend is also declared or paid, as applicable, onour Convertible Preferred Shares. We intend to retain earnings, if any, for usein the operation and expansion of our business and, therefore, do notanticipate paying any dividends on our common stock in the foreseeable future.

 

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

 

The trading price of ourshares has from time to time fluctuated widely and in the future may besubject to similar fluctuations. The trading price may be affected by anumber of factors including the risk factors set forth in this Report as wellas our operating results, financial condition, announcements of innovations ornew products by us or our competitors, general conditions in the biometrics andaccess control industries, and other events or factors. Although we believe thatapproximately 15 registered broker dealers currently make a market in ourcommon stock, we can not assure you that any of these firms will continue toserve as market makers or have the financial capability to stabilize or supportour common stock. A reduction in the number of market makers or the financialcapability of any of these market makers could also result in a decrease in thetrading volume of and price of our shares. In recent years broad stock marketindices, in general, and the securities of technology companies, in particular,have experienced substantial price fluctuations. Such broad market fluctuationsmay adversely affect the future-trading price of our common stock.

** **

**ITEM 2.     DESCRIPTION OF PROPERTY**

** **

We do not own any realestate. We conduct operations from leased premises in Marlborough,Massachusetts (38,000 square feet), Eagan, Minnesota (6,800 square feet), Wall,New Jersey (2,180 square feet) and Fulton County, Georgia, (360 square feet).We believe our current facilities are adequate for the foreseeable future.

** **

**ITEM 3.     LEGALPROCEEDINGS**

** **

In the normal course ofbusiness, the Company periodically becomes involved in litigation. As of December 31,2007, in the opinion of management, the Company had no pending litigation thatwould have a material adverse effect on the Company’s financial position,results of operations or cash flows.

** **

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

** **

No matters were submittedto a vote of security holders in the fourth quarter of 2007.

 

 

 

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** **

** **

**PART II**

** **

**ITEM 5.     MARKETFOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS**

** **

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

 

| **2007:**                             | ** ** | **High**   | ** ** | **Low**    | ** ** |
|---------------------------------------|------------|------------|------------|------------|------------|
| ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Quarter ended December 31, 2007  |       | $          | 0.27       |       | $          | 0.10 |   |
| Quarter ended September 30, 2007 |       | 0.20       |       | 0.07       |       |
| Quarter ended June 30, 2007      |       | 0.30       |       | 0.17       |       |
| Quarter ended March 31, 2007     |       | 0.35       |       | 0.20       |       |
|                                       |            |            |            |            |            |  |  |

 

| **2006:**                             | ** ** | **High**   | ** ** | **Low**    | ** ** |
|---------------------------------------|------------|------------|------------|------------|------------|
| ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Quarter ended December 31, 2006  |       | $          | 0.53       |       | $          | 0.32 |   |
| Quarter ended September 30, 2006 |       | 0.49       |       | 0.39       |       |
| Quarter ended June 30, 2006      |       | 0.67       |       | 0.40       |       |
| Quarter ended March 31, 2006     |       | 0.94       |       | 0.58       |       |
|                                       |            |            |            |            |            |  |  |

 

**Holders**

 

As of March 1, 2008,the number of stockholders of record of our common stock was 182.

 

**Dividends**

 

We have not paid any cashdividends on our common stock to date, and have no intention of paying any cashdividends 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 on our common stock is also subject to the discretion of our Board ofDirectors and certain limitations imposed under the Delaware GeneralCorporation Law. The timing, amount and form of dividends, if any, willdepend on, among other things, our results of operations, financial condition,cash requirements and other factors deemed relevant by our Board of Directors.

 

**Convertible Preferred Stock**

 

Within the limits andrestrictions provided in the Company’s Certificate of Incorporation, the Boardof Directors has the authority, without further action by the shareholders, toissue up to 5,000,000 shares of preferred stock, $.0001 par value per share, inone or more series, and to fix, as to any such series, any dividend rate,redemption price, preference on liquidation or dissolution, sinking fund terms,conversion rights, voting rights, and any other preference or special rightsand qualifications.

 

**Series AConvertible Preferred Stock.**

 

In March 2004, wedesignated 100,000 shares of preferred stock as Series C ConvertiblePreferred Stock. In connection with the Company’s reincorporation in Delaware, eachshare of Series C Convertible Preferred Stock was automatically convertedinto one share of Series A Convertible Preferred Stock (the “Series AShares”), of which 30,557 were issued and outstanding December 31, 2007.The following describes the material provisions of the Series A Shareswhich are more fully set forth in the Certificate of Designation on file withthe Delaware Secretary of State.

 

The Series A Sharesaccrue a cumulative annual dividend of 7% on the $100 face amount of suchshares payable June 15 and December 15 each year in shares of commonstock. In the event of a liquidation, dissolution or winding up of the Company,the Series A shares have a liquidation preference of $100 per share (plusall accrued and unpaid dividends thereon) prior to any payment or distributionto holders of our common stock. The Series A Shares are convertible intocommon stock 

 

 

 

18

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at a conversion price of $.30 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 A Shares, the conversion priceshall be lowered to such lesser price. In the event that the average closingbid price of our common stock is less than $1.00 per share for thirty(30) consecutive trading days at any time after November 17, 2008, we willbe required to redeem the Series A Shares by payment of $100 per shareplus all accrued and unpaid dividends due thereon. This date was deferred from March 3,2008 to November 17, 2008 by an agreement with the holders of the Series AShares on March 24, 2008.

 

We are required to obtainthe consent of the holders of a majority of the Series A Shares in orderto, among other things, issue any shares of preferred stock that are equal toor have a preference over the Series A 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 500,000 shares of common stock. We are also required to obtain suchconsent in order to, among other things, complete a sale or other dispositionof any material assets, complete an acquisition of a material amount of assets,engage in a merger, reorganization or consolidation, or incur or guaranty anyindebtedness in excess of $50,000.

 

**Series BConvertible Preferred Stock.**

 

In January 2006, theCompany designated 1,000,000 shares of preferred stock as Series B ConvertiblePreferred Stock, 970,612 of which are issued and outstanding as of December 31,2007. 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.

 

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, or cash at the Company’selection. In the event of a liquidation, dissolution or winding up of theCompany, the Series B Convertible Preferred Shares have a liquidationpreference of $1 per share (plus all accrued and unpaid dividends thereon)prior to any payment or distribution to holders of our common stock. The Series BConvertible Preferred Shares are convertible into common stock at a conversionprice of $.30 per share. The conversion price is subject to proportionaladjustment in the event of stock splits, stock dividends or reclassifications.Subject to certain exceptions, in the event we issue additional shares ofcommon stock at a purchase price less than the conversion price of the Series BConvertible Preferred Shares, the conversion price shall be lowered to suchlesser price.

 

If during the thirty(30) consecutive trading day period occurring prior to January 1,2009, the average closing bid price for one share of Common Stock, as reportedby Bloomberg, L.P. is at least $1.10, all outstanding Series B sharesshall automatically be converted into Common Stock, at the then effectiveconversion rate. Upon conversion, all accrued or declared but unpaid dividendson the Series B shares shall be paid in shares of Common Stock. In theevent that the average closing bid price of our common stock is less than $1.10per share for thirty (30) consecutive trading days at any time after January 1,2009, we will be required to redeem the Series B Convertible PreferredShares by payment of $1 per share plus all accrued and unpaid dividends duethereon.

 

For as long astwenty-five percent (25%) of the Series B Convertible Preferred Stock areoutstanding, we are required to obtain the consent of the holders of a majorityof the Series B Convertible Preferred Shares in order to, among otherthings, issue any shares of preferred stock that are equal to or have apreference over the Series B Convertible Preferred Shares or issue anyshares of preferred stock, rights, options, warrants, or any other securitiesconvertible into common stock of the Company, other than those issued toemployees of the Company in the ordinary course of their employment or toconsultants or other persons providing services to the Company. We are alsorequired to obtain such consent in order to, among other things, complete asale or other disposition of any material assets, complete an acquisition of amaterial amount of assets, engage in a merger, reorganization or consolidation,or incur or guaranty any indebtedness in excess of $50,000.

 

**Series CConvertible Preferred Stock.**

 

In August 2006, theCompany designated 600,000 shares of preferred stock as Series CConvertible Preferred Stock, 592,032 of which are issued and outstanding, as ofDecember 31, 2007. The following describes the material provisions of 

 

 

19

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the Series CConvertible Preferred Shares, which are more fully set forth in the Certificateof Designation on file with the Delaware Secretary of State.

 

The Series CConvertible Preferred Shares accrue a cumulative annual dividend of 15% on the$10 face amount of such shares payable December 1, March 1, June 1and September 1 each year in shares of common stock, or cash at theCompany’s election. In the event of a liquidation, dissolution or winding up ofthe Company, the Series C Convertible Preferred Shares have a liquidationpreference of $10 per share (plus all accrued and unpaid dividends thereon)prior to any payment or distribution to holders of our common stock. The Series CConvertible Preferred Shares are convertible into common stock at a conversionprice of $.30 per share. The conversion price is subject to proportionaladjustment in the event of stock splits, stock dividends or reclassifications.Subject to certain exceptions, in the event we issue additional shares ofcommon stock at a purchase price less than the conversion price of the Series CConvertible Preferred Shares, the conversion price shall be lowered to suchlesser price.

 

If during the thirty(30) consecutive trading day period occurring prior to January 1,2009, the average closing bid price for one share of Common Stock, as reportedby Bloomberg, L.P. is at least $1.20, all outstanding Series C sharesshall automatically be converted into Common Stock, at the then effectiveconversion rate. Upon conversion, all accrued or declared but unpaid dividendson the Series C shares shall be paid in shares of Common Stock. In theevent that the average closing bid price of our common stock is less than $1.20per share for thirty (30) consecutive trading days at any time after January 1,2009, we will be required to redeem the Series C Convertible PreferredShares by payment of $10.00 per share plus all accrued and unpaid dividends duethereon.

 

For as long as any of theSeries C Convertible Preferred Stock are outstanding, we are required toobtain the consent of the holders of the Series C Convertible PreferredShares in order to, among other things, issue any shares of preferred stockthat are equal to or have a preference over the Series C 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.

 

 

20

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** **

** **

**ITEM 6.    MANAGEMENT’S DISCUSSION AND ANALYSIS OR PLANOF OPERATION**

** **

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

 

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

 

OVERVIEW provides adescription of our business, the major items that affected our business, andhow we analyze our business. It then provides an analysis of our overall 2007performance and a description of the significant events impacting 2007 andthereafter.

 

RESULTS OF OPERATIONSprovides an analysis of the consolidated and segment results of operations for2007 compared to 2006.

 

LIQUIDITY AND CAPITALRESOURCES provides an overview of our cash flows, financing, contractualobligations, and liquidity outlook.

 

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

 

RECENT ACCOUNTINGSTANDARDS by reference to Note 1 to the Consolidated Financial Statementsprovides a description of accounting standards which we have not yet beenrequired to implement and may be applicable to our operations, as well as thosesignificant accounting standards which were adopted during 2007.

 

**OVERVIEW**

 

Our Business

 

BIO-key develops anddelivers advanced identification solutions and information services tocustomers in both the private sector and government, including law enforcementdepartments, and public safety agencies. Our high-performance, yeteasy-to-deploy biometric finger identification technology accurately identifiesand authenticates users of wireless and enterprise data, improving security,convenience and privacy while reducing identity theft. Our mobile wirelesstechnology provides first responders with critical, reliable, real-time dataand images from local, state and national databases. Today, over 750 policedepartments in North America depend on BIO-key solutions, making us one of theleading supplier of mobile and wireless solutions for public safety worldwide

 

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

 

On September 30,2004, BIO-key acquired Aether Systems, Inc.’s Mobile Government Division (“MobileGovernment” or “AMG”), a leading provider of wireless data solutions for use bypublic safety organizations, primarily state, local police, fire and rescue andemergency medical services organizations. Our PacketCluster mobile informationsoftware, originally acquired as part of this transaction, is integrated with50 separate State/NCIC databases, as well as other state, local and federaldatabases. Its open architecture and its published Application ProgrammingInterface (API) make it easy to interface with a wide range of informationsources. PacketCluster products deliver real-time information in seconds,freeing dispatchers to handle more pressing emergencies.

 

 

21

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On May 22, 2007,BIO-key competed a transaction with ZOLL Data Systems, Inc. (“ZOLL”), asubsidiary of ZOLL Medical Corporation, in which ZOLL acquired substantiallyall of the assets related to the Company’s Fire/EMS Services division.

** **

**INTRODUCTION**

** **

Overthe past few years, the Company has integrated the products, operations andtechnology acquired from PSG and AMG, and restructured its operations intothree business segments: Biometrics, Law Enforcement and Fire Safety, the lastof which was sold in May 2007 to ZOLL. Our Biometrics and Law Enforcementsegments are headed by a General Manager and are organized to quickly respondto market needs as well as to drive down costs to achieve profitability.

 

Adetailed analysis of both segments can be found below.

 

**RESULTSOF OPERATIONS**

 

**Consolidated Results of Operations**

 

**Two Year % trend**

 

| ** **                                      | ** ** | **Years ended December 31,** | ** ** |
|-------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                      | ** ** | **2007**                                    | ** ** | **2006** | ** ** |
| **Revenues**                                    |       |                                        |       |   |   |
| Services                                        |       | 70                                          | %          | 72 | % |
| License fees and  other                         |       | 30                                          | %          | 28 | % |
|                                            |       | 100                                         | %          | 100 | % |
| **Costs and other expenses**                    |       |                                        |       |   |   |
| Cost of services                                |       | 15                                          | %          | 19 | % |
| Cost of license  fees and other                 |       | 3                                           | %          | 6 | % |
|                                            |       | 18                                          | %          | 25 | % |
| Gross Profit                                    |       | 82                                          | %          | 75 | % |
|                                            |       |                                        |       |   |   |
| **Operating expenses**                          |       |                                        |       |   |   |
| Selling, general  and administrative            |       | 86                                          | %          | 86 | % |
| Research,  development and engineering          |       | 50                                          | %          | 48 | % |
|                                            |       | 136                                         | %          | 134 | % |
| **Operating loss**                              |       | -54                                         | %          | -59 | % |
|                                            |       |                                        |       |   |   |
| **Other income (deductions)**                   |       |                                        |       |   |   |
| Total other  deductions                         |       | -2                                          | %          | -54 | % |
| **Net Loss from continuing operations**         |       | -56                                         | %          | -113 | % |
| **Net Income from discontinued operations**     |       | 4                                           | %          | 15 | % |
| **Gain on disposal of discontinued operations** |       | 41                                          | %          | 0 | % |
| **Net Loss**                                    |       | -11                                         | %          | -98 | % |

 

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 and other factors.The segmentation of operating income as noted above and detailed below reflectshow management now evaluates its business.  Assets for the Company arecommingled and are related to all operating segments. Management does not evaluateor identify the operating assets of the segments separately.

 

 

22

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***Revenuesand Costs of goods sold***

 
| ** **                | ** ** | ** ** | ** ** | ** ** | ** ** | **2007 - 2006** | ** **     |
|---------------------------|------------|------------|------------|------------|------------|---------------------------|----------------|
| ** **                | ** ** | **2007**   | ** ** | **2006**   | ** ** | ** **                | **$ Chg** | ** ** | **%  Chg** | ** ** |
| ** **                | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                | ** **     | ** ** | ** ** |
| *Revenues*                | * *   | * *   | * *   | * *   | * *   | * *                  | * *       | * * | * * |
| **Law Enforcement**       | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                | ** **     | ** ** | ** ** |
| Service                   |       | $          | 6,904,856  |       | $          | 8,069,093                 |           | $ | (1,164,237 | ) | (14) | % |
| License &  other |       | 2,168,344  |       | 2,357,891  |       | (189,547                  | )              | (8) | % |
|                      |       | 9,073,200  |       | 10,426,984 |       | (1,353,784                | )              | (13) | % |
| **Biometrics**            | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                | ** **     | ** ** | ** ** |
| Service                   |       | 60,850     |       | 79,377     |       | (18,527                   | )              | (23) | % |
| License &  other |       | 854,406    |       | 781,677    |       | 72,729                    |           | 9 | % |
|                      |       | 915,256    |       | 861,054    |       | 54,202                    |           | 6 | % |
|                      |       |       |       |       |       |                      |           |   |   |
| *Total  Revenue*          |       | $          | 9,988,456  |       | $          | 11,288,038                |           | $ | (1,299,582 | ) | (12) | % |
|                      |       |       |       |       |       |                      |           |   |   |
| *Cost of goods sold*      | * *   | * *   | * *   | * *   | * *   | * *                  | * *       | * * | * * |
| **Law Enforcement**       | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                | ** **     | ** ** | ** ** |
| Service                   |       | $          | 1,397,888  |       | $          | 1,958,868                 |           | $ | (560,980 | ) | (29) | % |
| License &  other |       | 145,627    |       | 499,197    |       | (353,570                  | )              | (71) | % |
|                      |       | 1,543,515  |       | 2,458,065  |       | (914,550                  | )              | (37) | % |
| **Biometrics**            | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                | ** **     | ** ** | ** ** |
| Service                   |       | 95,453     |       | 208,981    |       | (113,528                  | )              | (54) | % |
| License &  other |       | 145,808    |       | 158,463    |       | (12,655                   | )              | (8) | % |
|                      |       | 241,261    |       | 367,444    |       | (126,183                  | )              | (34) | % |
|                      |       |       |       |       |       |                      |           |   |   |
| *Total  COGS*             |       | $          | 1,784,776  |       | $          | 2,825,509                 |           | $ | (1,040,733 | ) | (37) | % |

 

***Revenues***

 

*LawEnforcement*

 

Service revenue for thesegment for the year ended December 31, 2006 included approximately$1,409,000 from a long-term project that the Company had participated in as asubcontractor.  The amount resulted from a cash payment of approximately$571,000 along with approximately $838,000 of revenue that was previouslydeferred until evidence of full acceptance by the end user was received by theCompany.  In 2007, revenue from this project was $293,000 for servicerevenue and $310,000 for license revenue. License revenue for 2007 decreasedfrom 2006 due to a decline in the size and volume of orders.

 

*Biometrics*

 

License revenue included approximately $200,000 from alarge commercial biometrics order received in the fourth quarter of 2007.  However, revenue in this segment continues tobe inconsistent and unpredictable as the market for the Biometrics’ productscontinues to develop slowly.

 

***Costsof goods sold***

 

*LawEnforcement*

 

Costof services for the year ended December 31, 2007 decreased from the 2006period due to a reduction in payroll costs of approximately $350,000, and theassociated allocation of corporate overhead. Share-based compensation decreasedas well due to the majority of options granted becoming fully vested in 2006.

 

Costof licenses for the year ended December 31, 2007 decreased when comparedto the 2006 period due to the 

 

 

 

23

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Company lessening itsactivity with technology partners, leading to a reduction in royalty-bearinglicense sales. In addition, the 2006 period included approximately $205,000 ofhardware costs for long-term projects which were wound up during that year.

 

*Biometrics*

 

Costsof Services decreased for the year ended December 31, 2007 due to a 50%reduction in headcount within the segment compared to the corresponding 2006period.

 

Costsof License and other are primarily related to the hardware component for salesof biometric fingerprint readers. The margin for the hardware sales during the2007 year was higher than that achieved in the corresponding 2006 period due tothe Company moving to a newer fingerprint reader technology during thetimeframe, with an improved pricing structure.

*** ***

***Selling, general and administrative***

*** ***
| ** **          | ** ** | ** ** | ** ** | ** ** | ** ** | **2007 - 2006** | ** **     |
|---------------------|------------|------------|------------|------------|------------|---------------------------|----------------|
| ** **          | ** ** | **2007**   | ** ** | **2006**   | ** ** | ** **                | **$ Chg** | ** ** | **% Chg** | ** ** |
| ** **          | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                | ** **     | ** ** | ** ** |
| **Law Enforcement** |       | $          | 7,142,929  |       | $          | 7,972,645                 |           | $ | (829,716 | ) | (10) | % |
| **Biometrics**      |       | 1,430,934  |       | 1,790,106  |       | (359,172                  | )              | (20) | % |
|                |       |       |       |       |       |                      |           |   |   |
| **Total**           |       | $          | 8,573,863  |       | $          | 9,762,751                 |           | $ | (1,188,888 | ) | (12) | % |

 

For 2006, SG&A costswere allocated to segments based on several factors including managementestimates and percentage of revenue.  For2007, sales expenses and R&D management expenses are a direct cost to thesegment, while G&A costs are allocated between business segments on fixedpercentages that were established by management during the budgeting process.

 

The overall decline inthe total SG&A costs for the year ended December 31, 2007 as comparedto 2006 was primarily attributable to a reduction in headcount driven bycontinued focus on expense management. Payroll costs, which include permanent and temporary staff as well asthe associated benefits, and commissions, were reduced by approximately$740,000 in 2007. In addition, the Company was able to eliminate certainaccounting and consulting fees incurred during 2006 relating to reporting andcompliance issues that the Company experienced due to the restatement ofpreviously filed financial statements that occurred in 2006.  This resulted in professional fees droppingby approximately $670,000 throughout the 2007 year, offset by $426,000 inone-time legal and regulatory costs associated with our proposed acquisition ofa Canadian company.  Furthermore, theCompany reduced spending in air travel and advertising by approximately$220,000 as the sales and marketing functions were streamlined during the year.

*** ***

***Research, development and engineering***

*** ***
| ** **          | ** ** | ** ** | ** ** | ** ** | ** ** | **2007 - 2006** | ** **     |
|---------------------|------------|------------|------------|------------|------------|---------------------------|----------------|
| ** **          | ** ** | **2007**   | ** ** | **2006**   | ** ** | ** **                | **$ Chg** | ** ** | **% Chg** | ** ** |
| ** **          | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                | ** **     | ** ** | ** ** |
| **Law Enforcement** |       | $          | 3,997,678  |       | $          | 4,010,233                 |           | $ | (12,555 | ) | (0) | % |
| **Biometrics**      |       | 997,121    |       | 1,362,087  |       | (364,966                  | )              | (27) | % |
|                |       |       |       |       |       |                      |           |   |   |
| **Total**           |       | $          | 4,994,799  |       | $          | 5,372,320                 |           | $ | (377,521 | ) | (7) | % |

 

R&D expensesrepresent the costs of investing in products under development at a point intime and are mainly driven by headcount, facilities costs and share-basedcompensation.

 

 

 

 

24

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*LawEnforcement*

 

R & D costs havedecreased slightly for the year ended December 31, 2007 as compared to2006,  primarily due to staff and coststructure reductions, particularly at the contractor or temporary level.  Non-cash share-based compensation chargesrose during the year, as options predominately granted during 2006 were subjectto a full year of vesting during 2007. Due to greater personnel reductions inother cost centers the Law segment comprised a higher proportion of Companyheadcount, and so was allocated more of the facilities expenses, offsetting thepayroll reductions.

 

*Biometrics*

 

R & D costs havedecreased for the year ended December 31, 2007, as compared to 2006,mainly due to lower personnel costs, on both a permanent and temporarylevel.  This reduction also affected thesize of the allocation of facility charges, which also fell during the year.

*** ***

***Other income and expense***

*** ***
| ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** | **2007 - 2006** | ** **     |
|-----------------------------------------------|------------|------------|------------|------------|------------|---------------------------|----------------|
| ** **                                    | ** ** | **2007**   | ** ** | **2006**   | ** ** | ** **                | **$ Chg** | ** ** | **% Chg** | ** ** |
| ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** **                | ** **     | ** ** | ** ** |
| Interest income                               |       | $          | 3,097      |       | $          | —                    |           | $ | 3,097 |   | n/a |   |
| Interest expense                              |       | (832,457   | )          | (5,730,712 | )          | 4,898,255                 |           | (85) | % |
| Derivative and warrant fair value adjustments |       | 1,016,845  |       | 7,542,666  |       | (6,525,821                | )              | (87) | % |
| Loss on extinguishment of debt                |       | (403,940   | )          | (7,815,717 | )          | 7,411,777                 |           | (95) | % |
| Other income (expense)                        |       | 12,102     |       | (48,637    | )          | 60,739                    |           | (125) | % |
|                                          |       |       |       |       |       |                      |           |   |   |
|                                          |       | $          | (204,353   | )          | $          | (6,052,400                | )              | $ | 5,848,047 |   | (97) | % |

 

Forthe year ended December 31, 2007, the decrease in interest expense wasattributable to the expiration of the letter of credit arrangement with AetherSystems Inc. on December 31, 2006, and the repayment of all of the Company’ssenior and subordinated debt obligations in May 2007.  Interest expense includes actual cash paidfor interest as well as non-cash interest charges for the amortization of debtdiscounts, deferred charges, and deferred rent.

 

Forthe year ended December 31, 2007, derivative and warrant fair valueadjustments decreased, when compared to the 2006 period, due to changes in thefair market value of embedded derivatives and detachable warrants issued withconvertible debt in 2004 and 2005, as well as additional derivatives recordedas a result of financings in 2006. The fair value of the derivatives willfluctuate based on; our stock price on the valuation date, the debt conversion price,the volatility of our stock price over a period of time, changes in the valueof the risk free interest rate, and the time to maturity of the outstandingdebt at different points in time. Stock price is the major driver behind themovement in the Company’s balances. In dollar terms, our stock price decreasedless during the 2007 year when compared to the 2006 year, reducing the extentof the movement in value of the derivatives and warrants, and creating lesssubstantial non-cash income.

 

As mentioned in Note Q tothe consolidated financial statements,the balance of unamortized debt discounts, deferred financing charges, andderivatives with respect to the 2004 and 2005 financings were extinguished aspart of the May 2007 debt repayment, as well as the January and August 2006refinancings. Writing off the balance of unamortized debt discount was themajor component of the expense, and for the 2007 year it was significantly lessthan the 2006 balance due to a lower debt base following the August 2006 restructure.  The changes represented non-cash income andexpense charges to the statement of operations, and were classified as loss onextinguishment of debt.

 

**DISCONTINUEDOPERATIONS**

 

On May 22, 2007, wecompleted the sale of our Fire/EMS Services division for $7 million, amountingto a net gain to the Company of approximately $4 million. This business hadpreviously been reported as a separate segment in our financialstatements. For the fiscal years ended 2007 and 2006, $0.4 million and$1.6 million of operating income, respectively, net of tax, were reflected asdiscontinued operations in the accompanying consolidated statements of 

 

 

 

25

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income.  Netsales associated with the discontinued operations were $1.5 million, and $3.5million for 2007 and 2006, respectively. See “Note B — DiscontinuedOperations” for further discussion.

** **

**LIQUIDITY AND CAPITAL RESOURCES**

** **

***OPERATING ACTIVITIES OVERVIEW***

** **

Netcash used in operations during the year ended December 31, 2007 wasapproximately $2,161,000, including approximately $2,737,000 used forcontinuing operations offset by approximately $576,000 provided by thediscontinued Fire/EMS business. The cash used for operating activities of continuingoperations was primarily due to the following items:

 

·              Positive cash flowsrelated to a decrease in accounts receivable, and an increase in deferredrevenue of approximately $749,000, and $743,000, respectively,

 

·              Positive cash flowsrelated to a decrease in costs and earnings in excess of billings on completedcontracts of approximately $920,000,

 

·     Negativecash flows from a decrease in accrued expenses of approximately $501,000 due tothe timing of payments.

 

The following non-cash items reflected in the Company’sstatement of operations are used to reconcile the net loss to the net cash usedin operating activities during the yearended December 31, 2007:

 

·              The Company issued notes in 2004, 2005 and 2006 andpreferred stock in 2006, all of which contained embedded derivatives, andassociated warrants. In 2007, the Company recognized gains of approximately$1,017,000 related to the decrease in value of the derivatives and associatedwarrants. The decrease in value is driven mainly by the decline in value of theunderlying BIO-key stock.

 

·              A debt discount was identified when the 2004, 2005 and2006 notes were initially recorded to reflect the fair market value of theembedded derivatives and warrants associated with the debt. The discount wasamortized using the effective interest method into earnings until theunderlying debt was repaid on May 22, 2007. In 2007, the Company recordednon-cash interest expense related to the amortization of the debt discount ofapproximately $360,000.

 

·              The Company recorded approximately $403,000 of chargesin 2007, for the non-cash expense related to the extinguishment of debt as aresult of the May 2007 repayment. The loss mainly relates to theaccounting for the effect of extinguishing previously recorded deferredfinancing costs and changes in the present value of embedded derivatives andwarrants.

 

·     TheCompany recorded approximately $761,000 of charges in 2007 for the expense ofamortizing intangible assets.

 

·              The Company recorded approximately $658,000 of chargesin 2007 for the expense of issuing options to employees for services.

 

***INVESTING ACTIVITIES OVERVIEW***

 

Netcash provided by investing activities for the year ended December 31, 2007was approximately $7,161,000, including approximately $7,169,000 provided bycontinuing operations, offset by approximately $8,000 used by the discontinuedFire/EMS business. The cash provided by investing activities for continuingoperations was primarily driven by $7,000,000 in proceeds from the disposal ofthe Fire/EMS business and deposit returns of approximately $313,000, offset byapproximately $155,000 of net funds transferred to an escrow account withrespect to the Fire/EMS disposal.

 

***FINANCING ACTIVITIES OVERVIEW***

 

Netcash provided by financing activities during the year ended December 31,2007 was approximately $4,662,000, which was entirely comprised of debtrepayments on May 22, 2007.

 

 

 

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Workingcapital deficit at December 31, 2007 was approximately $5,796,000 ascompared to a deficit of approximately $8,648,000 at December 31, 2006,the improvement of which was driven mainly by the Company’s repayment ofconvertible debt in May 2007.

 

SinceJanuary 7, 1993 (date of inception), our capital needs have beenprincipally met through proceeds from the sale of equity and debt securities.

 

Wedo not expect any material capital expenditures during the next twelve months.

 

Wedo not currently maintain a line of credit or term loan with any commercialbank or other financial institution.

 

***Liquidity outlook***

 

AtDecember 31, 2007, our total of cash and cash equivalents was $964,774, ascompared to $627,167 at December 31, 2006. The 2007 total excludes $153,094of restricted cash, which is currently in escrow in accordance with thesettlement of the Fire/EMS business proceeds from ZOLL. It is expected the escrow balance, lessapplicable adjustments (if approved) shall be remitted to the Company over the nextsix months.

 

Asdiscussed above, the Company has financed itself through access to the capitalmarkets by issuing convertible debt securities, convertible preferred stock andcommon stock. Wecurrently require approximately $950,000 per month to conduct our operations. During the 2007 year, we generatedapproximately $10,000,000 of revenue. While the Company expects to increaserevenue into 2008, there can be no assurance that we will achieve thatgoal.

 

The Company’s Series AConvertible Preferred Stock is redeemable in cash by the stockholders within 10days after December 31, 2008, if certain stock price performance conditions arenot met. This date was deferred from March 31, 2008 by an agreement withthe holders of the Series A Shares on March 24, 2008.

 

In addition, the Company’sSeries B and Series C Convertible Preferred Stock is redeemable incash by the stockholders during the first quarter of 2009, if certain stockprice performance conditions are not met.

 

If we are unable togenerate sufficient revenue to meet our goals, we will need to obtainadditional third-party financing to (i) conduct the sales, marketing andtechnical support necessary to execute our plan to substantially growoperations, increase revenue and serve a significant customer base; and (ii) provideworking capital. Therefore, we will need to obtain additional financing throughthe issuance of debt or equity securities, or to restructure our financialposition through similar transactions to those consummated during 2006 and 2007.

 

Due to several factors,including our history of losses and limited revenue, our former and currentindependent auditors have included an explanatory paragraph in opinions theyhave previously issued related to our annual financial statements as to thesubstantial doubt about our ability to continue as a going concern. Ourlong-term viability and growth will depend upon the successfulcommercialization of our technologies and our ability to obtain adequatefinancing. To the extent that we require such additional financing, noassurance can be given that any form of additional financing will be availableon terms acceptable to us, that adequate financing will be obtained to meet ourneeds, or that such financing would not be dilutive to existing stockholders.If available financing is insufficient or unavailable or we fail to continue togenerate meaningful revenue, we may be required to further reduce operatingexpenses, delay the expansion of operations, be unable to pursue merger oracquisition candidates, or continue as a going concern.

** **

**CONTRACTUAL OBLIGATIONS**

** **

We have variouscontractual obligations impacting our liquidity. The following represents someof our contractual obligations as of December 31, 2007:

 
| ** **                      | ** ** | **Total** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **2011** | ** ** |
|---------------------------------|------------|-----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Non-cancelable operating leases |       | $         | 937,606    |     | $          | 900,059  |       | $        | 36,089     |     | $          | 1,458 |   | — |   |
|                                 |            |           |            |          |            |          |            |          |            |          |            |  |  |  |  |

 

TheCompany does not own any real estate but conducts operations from four leasedpremises. These non-cancelable 

 

 

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operating leases expire avarious dates through 2010. In addition to base rent, the Company pays forproperty taxes, maintenance, insurance and other occupancy expenses accordingto the terms of the individual leases.

 

**OFF-BALANCESHEET ARRANGEMENTS**

 

We do not have anyoff-balance sheet arrangements that have, or are in the opinion of managementreasonably likely to have, a current or future effect on our financialcondition or results of operations.

 

**CRITICALACCOUNTING POLICIES**

 

1.*Basis of Consolidation*

 

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

 

2.*Revenue Recognition*

 

Revenues from softwarelicensing 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 the followingcriteria are met: persuasive evidence of an arrangement exists, delivery hasoccurred, the fee is fixed or determinable, and collectability is probable.

 

The Company intends toenter into arrangements with end users for items which may includesoftware license fees, and services or various combinations thereof. For eacharrangement, revenues will be recognized when evidence of an agreement has beendocumented, the fees are fixed or determinable, collection of fees is probable,delivery of the product has occurred and no other significant obligationsremain.

 

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). 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.

 

License Revenues: Amountsallocated to license revenues are recognized at the time of delivery of thesoftware and all other revenue recognition criteria discussed above have beenmet.

 

Revenue from licensingsoftware, which requires significant customization and modification, isrecognized using the percentage of completion method, based on the hours ofeffort incurred by the company in relation to the total estimated hours tocomplete. In instances where third party hardware, software or servicesform a significant portion of a customer’s contract, the companyrecognizes revenue for the element of software customization by the percentageof completion method described above. Third party hardware, software, andservices are recognized upon shipment or acceptance as appropriate. If thecompany makes different judgments or utilizes different estimates of the totalamount of work expected to be required to customize or modify the software, thetiming and revenue recognition, from period to period, and the margins on theproject in the reporting period, may differ materially from 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.

 

Service Revenues:Revenues from services are comprised of maintenance and consulting andimplementation services. Maintenance revenues include providing for unspecifiedwhen-and-if available product updates and customer telephone 

 

 

 

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support services, and are recognized ratably over theterm of the service period. Consulting services are generally sold on atime-and-materials basis and include a range of services including installationof software and assisting in the design of interfaces to allow the software tooperate in customized environments. Services are generally separable from otherelements under the arrangement since performance of the services are notessential to the functionality of any other element of the transaction and aredescribed in the contract such that the total price of the arrangement would beexpected to vary as the result of the inclusion or exclusion of the services.Revenues from services are generally recognized as the services are performed.

 

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

 

Costs and other expenses: Includes professional compensation andother direct contract expenses, as well as costs attributable to the support ofclient service professional staff, depreciation and amortization costs relatedto assets used in revenue-generating activities, and other costs attributableto serving the Company’s client base. Professional compensation consists ofpayroll costs and related benefits including stock-based compensation andbonuses. Other direct contract expenses include costs directly attributable toclient engagements, such as out-of-pocket costs including travel andsubsistence for client service professional staff, costs of hardware andsoftware and costs of subcontractors. The allocation of lease and facilitiescharges for occupied offices are included in costs of service.

 

3.*Accounting for Acquisitions*

 

Acquisitionsare accounted for under the purchase method of accounting, which resulted inrecording significant goodwill and other intangible asset balances. Thepurchase prices are allocated to assets acquired and liabilities assumed attheir estimated fair values on the date of the acquisitions, as determined bymanagement, and by appraisals with respect to identifiable intangible assets.Accounting for acquisitions involves significant judgments and estimatesregarding fair values of acquired intangible assets, which are based onprojections of future revenues and cash flows, assumptions regarding discountfactors, royalty rates, tax rates, amortization methodologies and relateduseful lives. Developed technology (software), copyrighted software, marketingagreements, customer relationships and trademarks are valued using the incomeapproach.

 

4.*Derivative and Warrant financial instruments*

 

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

 

Theidentification of, and accounting for, derivative instruments is complex. Ourderivative instrument liability is re-valued at the end of each reportingperiod, with changes in the fair value of the derivative liability recorded ascharges or credits to income, in the period in which the changes occur. Foroptions, warrants and bifurcated conversion options that are accounted for asderivative instrument liabilities, we determine the fair value of theseinstruments using the Black-Scholes or Binomial option pricing model. Thatmodel requires assumptions related to the remaining term of the instruments andrisk-free rates of return, our current common stock price and expected dividendyield, and the expected volatility of our common stock price over the life ofthe option. The identification of, and accounting for, derivative instrumentsand the assumptions used to value them can significantly affect our financialstatements.

 

5.*Goodwill and Intangible Assets*

 

Goodwillrepresents the excess of costs of an acquired entity over the net of theamounts assigned to assets acquired and liabilities assumed. The Company hasadopted Statement of Financial Accounting Standards No. 142 (“SFAS 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.

 

 

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Due tothe disposal of the Fire/EMS business in May 2007, the Company allocated agreater proportion of Corporate overhead to its Law and Biometrics segments,which affected the fair value assessment of these two remaining reportingunits. In addition, the Company also repaid the balance of all convertible debtduring the quarter, which increased the net assets of the Company. Accordingly,the Company assessed these events significant enough to trigger the need for aninterim assessment as to the recoverability of goodwill. Based on the Company’sassessment, as of June 30, 2007, the Company believed no impairment togoodwill existed.

 

Asprovided by SFAS No. 142, the Company has elected to perform the annualassessment 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, 2007, 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.

 

6.*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.

 

7.*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 areexpensed as incurred.

 

8.*Earnings Per Share of 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 V- Earnings Per Share “EPS,” for additional information.

 

9.*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 loss ortax credit carryforward from expiring unused. Because of the Companieshistorical performance and estimated future taxable income a full valuationallowance has been established.

 

10.*Accounting for Stock-BasedCompensation*

 

The Company accounts forshare based compensation in accordance with the provisions of SFAS 123R, whichrequires measurement of compensation cost for all stock awards at fair value ondate of grant and recognition of compensation over the service period forawards expected to vest. The majority of our share-based compensationarrangements vest over either a three or four year vesting schedule. TheCompany expenses its share-based compensation under the ratable method, which 

 

 

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treats each vestingtranche as if it were an individual grant. The fair value of stock options isdetermined using the Black-Scholes valuation model, and requires the input ofhighly subjective assumptions. These assumptions include estimating the lengthof time employees will retain their vested stock options before exercising them(the “expected option term”), the estimated volatility of our common stockprice over the option’s expected term, the risk-free interest rate over theoption’s expected term, and the Company’s expected annual dividend yield.Changes in these subjective assumptions can materially affect the estimate offair value of stock-based compensation and consequently, the related amountrecognized as an expense in the consolidated statements of operations. Asrequired under the accounting rules, we review our valuation assumptions ateach grant date and, as a result, are likely to change our valuationassumptions used to value employee stock-based awards granted in future periods.The values derived from using the Black-Scholes model are recognized as expenseover the service period, net of estimated forfeitures (the number ofindividuals that will ultimately not complete their vesting requirements). Theestimation of stock awards that will ultimately vest requires significantjudgment. We consider many factors when estimating expected forfeitures,including types of awards, employee class, and historical experience. Actualresults, and future changes in estimates, may differ substantially from ourcurrent estimates.

 

11.*Use of Estimates*

 

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

 

Estimates and assumptionswhich, in the opinion of management are used in accounting for, among otherthings, 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.

 

**RECENTACCOUNTING STANDARDS**

 

In September 2006,the FASB issued SFAS No. 157, “Fair Value Measurements,” which iseffective for calendar year companies on January 1, 2008. The Statementdefines fair value, establishes a framework for measuring fair value inaccordance with Generally Accepted Accounting Principles, and expandsdisclosures about fair value measurements. The Statement codifies thedefinition of fair value as the price that would be received to sell an assetor paid to transfer a liability in an orderly transaction between marketparticipants at the measurement date. The standard clarifies the principle thatfair value should be based on the assumptions market participants would usewhen pricing the asset or liability and establishes a fair value hierarchy thatprioritizes the information used to develop those assumptions. The Company is currentlyassessing the potential impacts of implementing this standard.

 

InFebruary, 2007, the FASB issued SFAS No. 159, “The Fair Value Option forFinancial Assets and Financial Liabilities,” which is effective for calendaryear companies on January 1, 2008. The statement allows an entity theirrevocable option to elect fair value for the initial and subsequentmeasurement for certain financial assets and liabilities on acontract-by-contract basis. Subsequent changes in fair value of these financialassets and liabilities would be recognized in earnings when they occur. SFAS159 further establishes certain additional disclosure requirements. Managementis currently evaluating the impact and timing of the adoption of SFAS 159 onthe Corporation’s financial condition and results of operations.

 

In December 2007,the FASB issued SFAS No. 141(R), *“BusinessCombinations”*, which replaces SFAS No. 141. SFAS No. 141(R) establishesprinciples and requirements for how an acquirer recognizes and measures in itsfinancial statements the identifiable assets acquired, the liabilities assumed,any non-controlling interest in the acquiree and the goodwill acquired. TheStatement also establishes disclosure requirements which will enable users toevaluate the nature and financial effects of the business combination. SFAS 141(R) iseffective for calendar year companies on January 1, 2009. The adoption ofSFAS 141(R) will have an impact on accounting for business combinationsonce adopted, but the effect is dependent upon acquisitions at that time.

 

In December 2007,the FASB issued SFAS No. 160, “NoncontrollingInterests in Consolidated Financial Statements — an amendment of AccountingResearch Bulletin No. 51”, which establishes accounting andreporting standards for ownership interests in subsidiaries held by partiesother than the parent, the amount of consolidated net income attributable tothe parent 

 

 

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and to the noncontrollinginterest, changes in a parent’s ownership interest and the valuation ofretained non-controlling equity investments when a subsidiary isdeconsolidated. The Statement also establishes reporting requirements thatprovide sufficient disclosures that clearly identify and distinguish betweenthe interests of the parent and the interests of the non-controlling owners.SFAS 160 is effective for calendar year companies on January 1, 2009. TheCompany has not determined the effect that the application of SFAS 160 willhave on its consolidated financial statements.

 

In December 2007,the  SEC issued Staff Accounting Bulletin110. SAB 110 expresses the views of the staff regarding the use of a “simplified”method, as discussed in SAB No. 107 (“SAB 107”), in developing an estimateof expected term of “plain vanilla” share options in accordance with Statementof Financial Accounting Standards No. 123 (revised 2004).  SAB 110 isnot expected to have a significant impact on the entity consolidated financialstatements.

** **

**ITEM 7    FINANCIAL STATEMENTS**

** **

Seefinancial statements appearing at pages 49-79 of this report

 

 

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**ITEM 8.    CHANGES IN AND DISAGREEMENTS WITHACCOUNTANTS ON ACCOUNTING AND FINANCIAL**

                   **DISCLOSURE**

 

On July 24, 2006, the Audit Committee of theBoard of Directors of the Company dismissed DS&B, Ltd. (“DS&B”) as theCompany’s independent registered public accounting firm.  The reportsissued by DS&B on their audit of the Company’s financial statements for the2004 and 2005 fiscal years did not contain an adverse opinion or disclaimer ofopinion, nor were they qualified or modified as to uncertainty, audit scope oraccounting principles, except as follows:

 

(i)                      Thereports issued by DS&B on their audit of the Company’s financial statementsas of and for the fiscal years ended December 31, 2004 and December 31,2005 included an explanatory paragraph in their opinion for such years as tothe substantial doubt about the Company’s ability to continue as a goingconcern, and

 

(ii)                   DS&Binformed the Audit Committee by letter dated May 16, 2006 that theywithdrew their audit report included in the Company’s Annual Report on Form 10-KSBfor the year ended December 31, 2005 related to the Company’s financialstatements for the years ended December 31, 2004 and December 31,2005 and that they would be unable to complete their review of the Company’sQuarterly Report on Form 10-QSB for the quarter ended March 31,2006.  Subsequently, however, DS&B included its audit report to theCompany’s Annual Report on Form 10-KSB/A for the year ended December 31,2005 filed with the Securities and Exchange Commission on June 19, 2006and completed its review of the Company’s Quarterly Report on Form 10-QSB/Afor the quarter ended March 31, 2006 filed with the Securities andExchange Commission on July 18, 2006.

 

During the Company’s 2004 and 2005 fiscal years andthrough the date hereof, there were no disagreements with DS&B on anymatter of accounting principle or practice, financial statement disclosure, orauditing scope or procedure which, if not resolved to DS&B’s satisfaction,would have caused them to make reference to the subject matter in connectionwith their report of the Company’s financial statements for such years; andthere were no reportable events as defined in Item 304(a)(1)(iv) ofRegulation S-B except for:

 

(i)                      Asfirst noted in Item 3 in our 10-QSB filed on May 16, 2005, the AuditCommittee was in receipt of a letter dated April 18, 2005 from DS&Bwhich identified several material weaknesses in the Company’s internal controlover financial reporting and

 

(ii)                   Asnoted above and in our Form 8-K filed on May 18, 2006, the AuditCommittee received a letter dated May 16, 2006 from DS&B that theywithdrew their audit report included in the Company’s Annual Report on Form 10-KSBfor the year ended December 31, 2005.

 

The Audit Committee helddiscussions with DS&B regarding each such event and the Company authorizedDS&B to respond fully to any inquiries of Carlin, Charron & RosenLLP (“CCR”) concerning the subject matter of each such event. The Companyrequested DS&B to provide a letter to the Securities and ExchangeCommission stating whether it agreed with the foregoing disclosures. The letterwas sent by DS&B dated August 9, 2006.

 

On July 24, 2006,the Company engaged CCR to serve as the Company’s independent registered publicaccounting firm for the fiscal year ended December 31, 2006.  TheCompany’s engagement of CCR was approved by the Audit Committee of the Company’sBoard of Directors.

 

During the fiscal yearsended December 31, 2005 and December 31, 2004, and through the datehereof, the Company did not consult with CCR with respect to the application ofaccounting principles to a specified transaction, either completed or proposed,or the type of audit opinion that might be rendered on the Company’sconsolidated financial statements, or any other matters or reportable events asset forth in Items 304(a)(2)(i) and (ii) of Regulation S-K.

 

 

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** **

**ITEM 8A(T).    CONTROLS AND PROCEDURES**

** **

*DisclosureControls and Procedures*

 

An evaluation of theeffectiveness of the Company’s “disclosure controls and procedures” (as suchterm is defined in Rules 13(a)-15(e) of the Securities Exchange Actof 1934, as amended (the “Exchange Act”)), as of December 31, 2007 wascarried out by the Company under the supervision and with the participation ofthe Company’s Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”).

 

During the review of theCompany’s operating results for the period covered by this report, our CEO andCFO determined that, as of December 31, 2007, our disclosure controls andprocedures were effective in providing reasonable assurance that information weare required to disclose in reports we file or submit under the Exchange Act isrecorded, processed, summarized and reported within the time periods specifiedby the Securities and Exchange Commission rules and forms. Our managementreached this conclusion after identifying our system to capture disclosureitems, our internal process of review for account reconciliations, ourdocumentation of internal controls and our internal process for preparing ourannual report on Form 10-KSB for the fiscal year ended December 31,2007 as being adequate to provide such assurance.

 

*Management’sAnnual Report on Internal Control Over Financial Reporting*

 

Our managementis responsible for establishing and maintaining adequate internal control overfinancial reporting, as such term is defined in Exchange Act Rule 13a-15(f).Internal control over financialreporting cannot provide absolute assurance of achieving financial reportingobjectives because of its inherent limitations. Internal control over financialreporting is a process that involves human diligence and compliance and issubject to lapses in judgment and breakdowns resulting from human failures.Internal control over financial reporting also can be circumvented by collusionor improper management override. Because of such limitations, there is a riskthat material misstatements may not be prevented or detected on a timely basisby internal control over financial reporting. However, these inherentlimitations are known features of the financial reporting process. Therefore,it is possible to design into the process safeguards to reduce, though noteliminate, the risk. Also, projections of any evaluation of effectiveness tofuture periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with thepolicies or procedures may deteriorate.

 

Underthe supervision and with the participation of our management, including our CEOand CFO, we have conducted an evaluation of the effectiveness of our internalcontrol over financial reporting as of December 31, 2007, based upon theframework in *Internal Control-IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission. Based on this evaluation, management has concluded thatour internal control over financial reporting was effective as of December 31,2007.

 

Thisannual report does not include an attestation report of the company’sregistered public accounting firm regarding internal control over financialreporting. Management’s report was not subject to attestation by the company’sregistered public accounting firm pursuant to temporary rules of the Securitiesand Exchange Commission that permit the company to provide only management’sreport in this annual report.

 

*Changesin Internal Control Over Financial Reporting*

 

No change in our internalcontrol over financial reporting occurred during the fiscal quarter ended December 31,2007 that has materially affected, or is reasonably likely to materiallyaffect, our internal control over financial reporting.

** **

**ITEM 8B. OTHER INFORMATION**

** **

Not applicable.

 

 

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** **

**PART III**

** **

**ITEM 9.    DIRECTORS, EXECUTIVE OFFICERS, PROMOTERSAND CONTROL 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          |       | 60      |       | Chairman of the Board of Directors                             |
| Michael W. DePasquale        |       | 53      |       | Chief Executive Officer and Director                           |
| Jeffrey J. May (b)      |       | 48      |       | Director                                                       |
| Charles P. Romeo(a) (c) |       | 66      |       | Director                                                       |
| John Schoenherr (b) (c) |       | 55      |       | Director                                                       |
|                         |       |    |       |                                                           |
| Francis J. Cusick            |       | 53      |       | Chief Financial Officer                                        |
| Randy Fodero                 |       | 49      |       | Vice President of Sales                                        |
| Kenneth S. Souza             |       | 53      |       | General Manager, Law Enforcement and Chief  Technology Officer |

 

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

 

(b)            AuditCommittee Member

 

(c)             CompensationCommittee Member

 

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

 

**THOMAS J.COLATOSTI** has served as a Director of the Company since September 2002and as Chairman of the Board since January 3, 2003. He served as Co-ChiefExecutive Officer of the Company from July 2005 to August 2006. Mr. Colatostialso currently serves as the Chief Executive Officer of American SecurityVentures, a Lexington, Massachusetts — based consulting firm he founded whichspecializes in providing strategic management consulting services to emergingand developing companies in the homeland security industry. Since August 18,2005, Mr. Colatosti has served as a Director and President of Good HarborPartners Acquisition Corp., a publicly-traded special purpose acquisitioncompany formed to acquire businesses in the security sectors. From 1997through June 2002, Mr. Colatosti served as the Chief ExecutiveOfficer of Viisage Technology, Inc., a publicly traded biometrictechnology company focusing on biometric face-recognition technology anddelivering highly secure identification documents and systems. Between 1995 and1997, Mr. Colatosti served as President and Chief Executive Officer of CISCorporation, a higher education industry leader that designed and implementedintegrated and flexible systems solutions to manage entire universityadministrative operations. Prior to CIS, Mr. Colatosti had a 21 yearcareer with Digital Equipment Corporation. His most recent responsibility wasVice President and General Manager, Northeast Area, where he was responsiblefor a business unit with annual revenues of more than $1.2 billion and 3,000employees. Mr. Colatosti is considered a security industry authority. Mr. Colatostiearned a Bachelor of Science degree in Management and Finance as well as aMasters degree in Business Administration from Suffolk University.

 

**MICHAELW. DEPASQUALE** has served as the Chief Executive Officer and aDirector of the Company since January 3, 2003. He served as Co-ChiefExecutive Officer of the Company from July 2005 to August 2006. Mr. DePasqualebrings more than 25 years of executive management, sales and marketingexperience to the Company. Prior to joining BIO-key, Mr. DePasquale servedas the President and Chief Executive Officer of Prism eSolutions, Inc., aPennsylvania - based provider of professional consulting services and onlinesolutions for ISO-9001/14000 certification for customers in manufacturing,healthcare and government markets, since February 2001. From December 1999through December 2000, Mr. DePasquale served as Group Vice Presidentfor WRC Media, a New York - based distributor of supplemental educationproducts and software. From January 1996 until December 1999, Mr. DePasqualeserved as Senior Vice President of Jostens Learning Corp., a California - basedprovider of multi media curriculum. Prior to Jostes, Mr. DePasquale heldsales and marketing management positions with McGraw-Hill and Digital EquipmentCorporation. Mr. DePasquale earned a Bachelor of Science degree from theNew Jersey Institute of Technology.

 

 

 

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**JEFFREYJ. MAY **has served as a Director of the Company since October 29,2001. Since December 2006, Mr. May has served as the CEO ofMagnaLynx, a semiconductor company specializing in high speed chip levelcommunications. Since 1997, Mr. May has served as the President ofGideons Point Capital, a Minnesota - based investment and consulting firmfocusing on assisting start-up technology companies. In 1983, Mr. May co-foundAdvantek, Inc., a manufacturer of equipment and materials for thesemiconductor industry, which was sold in 1993. Mr. May continued toserve as a director and Vice-President of Operations of Advantek until 1997,when it had over 600 employees and sales in excess of $100 million. Mr. May earneda Bachelor of Science degree in Electrical Engineering from the University ofMinnesota in 1983.

 

**CHARLESP. ROMEO** has served as a director of the Company since February 28,2005 and from January 29, 2003 to April 19, 2004. From April 2004until February 2005, he served as Vice President of Sales, Public SafetyDivision of the Company. From November 2005 to November 2007, Mr. Romeoserved as the Vice President of Sales and Marketing for UNICOM, a Rhode Islandsystems integrator. From September 2002 until April 2004 Mr. Romeohas served as the President and Chief Executive Officer of FreedomBridgeTechnologies, Inc., a Rhode Island - based consulting firm to technologycompanies in the homeland security industry specializing in implementing directand channel selling programs, strategic alliances and partnerships in the lawenforcement market. Prior to founding FreeedomBridge, Mr. Romeo had a 33year sales and marketing management career with Digital Equipment Corporation,Compaq Computer Corporation and Hewlett Packard. During his career, Mr. Romeoserved as Vice President of Service Sales for a $500 million business unit, andDirector of Public Sector Sales, a $275 million division of Hewlett Packard. Mr. Romeoauthored *The Sales Manager’s Troubleshooter,*Prentice Hall 1998, which was named as one of the “top 10 must reads” by Salesand Marketing Magazine. Mr. Romeo earned a Bachelor of Science degree inMathematics and Economics from the University of Massachusetts and an ExecutiveMBA from Babson College.

 

**JOHNSCHOENHERR** has served as a Director of the Company since December 30,2004. Mr. Schoenherr served as Vice President of Corporate PerformanceManagement for Oracle Corporation from 1995 through 2006.  Prior toOracle he served as Senior Vice President of Business Intelligence andAnalytics at Information Resources, Inc.  Mr. Schoenherr has over 25 years of experience in the area ofbusiness intelligence and strategic planning. His career includes a number of product development and managementpositions.

 

**FRANCISJ. CUSICK** has served as the Chief Financial of the Companysince February 28, 2005. Mr. Cusick joined the Company as theCorporate Controller in September 2004. Mr. Cusick served as anindependent business consultant to public and private companies in a variety ofstrategic and financial executive roles from March 2002 until September 2004.From January 2001 through February 2002, Mr. Cusick was ChiefFinancial Officer for SANgate Systems, a multi-national provider of storagehardware and software. Prior to SANgate Systems, Mr. Cusick held seniorfinancial management positions at Equipe Communications Corp., ParametricTechnology Corp., Cascade Communications Corp. and Synernetics Inc.

 

**RANDYFODERO** has served as the Vice President of Sales since February 1, 2006.From July 2005 until February  2006, he was a sales consultant to theCompany. Between July 2003 and July 2005, Mr. Fodero was theVice President of Sales and Marketing, and from March 2003 to July 2003Mr. Fodero was a member of the Company’s sales organization. Mr. Foderohas more than 20 years of successful executive and sales management experience.Prior to joining the Company, Mr. Fodero served as Director of GlobalAccounts for Veritas Software from February 2002 until January 2003.Between 1999 and February 2002, Mr. Fodero served in executive salescapacities with companies in the enterprise software industry, including AgileSoftware. From 1998 to 1999, Mr. Fodero served as Regional Vice Presidentof Sales for Memco Software, a leading provider of information securitysoftware to Fortune 1000 companies, where he was instrumental in increasingsales and enhancing shareholder value in connection with the sale of Memco toPlatinum Technology. From 1990 through 1998, Mr. Fodero served as VicePresident of Sales of CommVault Systems, where he grew sales from startup toover $36 million and participated in a management buyout.

 

**KENNETHS. SOUZA** has served as Executive Vice President and GeneralManager, Law Enforcement since October 18, 2005. From October 2004 toOctober 2005 Mr. Souza was Chief Technology Officer of the Company.Prior to joining the Company, Mr. Souza was Vice President of IndustrySolutions for EMC Corporation. Prior to joining EMC, he was Vice President fore-Commerce Enterprise Systems Solutions for Compaq Computer Corporation forfour years. His 25-year technology and market career includes serving in anumber of executive positions with Digital Equipment Corporation including VicePresident Worldwide Solutions Services and Training, and Director ofWorkstations Marketing. In the early 1980’s, Mr. Souza held technicalsales management positions with Hewlett Packard and Burroughs. Mr. Souzaalso held executive positions with a venture funded MRP software company.

 

** **

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** **

**Directors’ Terms of Office**

** **

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

 

**IndependentDirectors**

 

The Board applies thedefinition of independent director as set forth in NASDAQ Stock Market Rule 4200(a)(15). In accordance with this guidance, the Board considers Mr. May andMr. Schoenherr to be independent. The Board considers Mr. Romeo, amember of the Company’s Compensation Committee, not to be independent.

 

**Committees of the Board**

 

**Audit Committee**

 

The Audit Committee iscomprised of John Schoenherr and Jeffrey J. May, who may not qualify as “auditcommittee financial experts” under the applicable rules adopted by theSecurities and Exchange Commission. However, the Board believes that each AuditCommittee member has sufficient knowledge in financial and auditing matters toserve on the Audit Committee. Additionally, the Audit Committee has the abilityon its own to retain independent accountants or consultants whenever it deemsappropriate.

 

The Board of Directorshas determined that each member of the Audit Committee qualifies as independentdirector, as required by the Audit Committee Charter. In addition, the membersof the audit committee satisfy the independence requirements of Rule 10A-3under the Securities Exchange Act of 1934, as amended, as well as NASDAQ StockMarket Rule 4200 (a)(15).

 

The primary function ofour audit committee is to assist the Board of Directors in fulfilling itsresponsibilities for oversight of:

 

·                  the integrity of our financial statements;

·                  our compliance with legal and regulatory requirements;

·                  the independent registered public accounting firm’s qualifications andindependence; and

·                  the performance of our independent registered public accounting firm.

 

Specific responsibilitiesof our audit committee include:

 

·                  appointing, retaining, evaluating, terminating, approving the compensationof, and assessing the independence of our independent registered publicaccounting firm;

·                  overseeing the work of our independent registered public accountingfirm, including through the receipt and consideration of certain reports fromthe independent registered public accounting firm;

·                  reviewing and discussing with management and the independent registeredpublic accounting firm our annual and quarterly financial statements andrelated disclosures;

·                  monitoring our internal control over financial reporting, ourdisclosure controls and procedures and our Code of Business Conduct and Ethics;

·                  discussing our risk management policies;

·                  establishing policies regarding hiring employees or former employees ofour independent registered public accounting firm;

·                  establishing procedures for the receipt and retention of accountingrelated complaints and concerns;

·                  meeting independently with our independent registered public accountingfirm and management; and

·                  preparing the audit committee report required by SEC rules andregulations (which is included below).

 

 

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**Reportof the Audit Committee of the Board of Directors**

 

The audit committeeassists the board of directors in overseeing and monitoring the integrity ofour financial reporting process, compliance with the legal and regulatoryrequirements applicable to the company, the qualifications, independence andperformance of our independent registered public accounting firm, and thequality of our internal and external audit processes. The audit committeeoperates under a written charter that sets forth the audit committee’s role andresponsibilities.

 

Management is responsiblefor our financial reporting process, including its system of internal controlover financial reporting, and for the preparation of consolidated financialstatements in accordance with accounting principles generally accepted in theUnited States of America. Our independent registered public accounting firm isresponsible for auditing those financial statements and expressing an opinionon the conformity of the company’s audited financial statements in accordancewith accounting principles generally accepted in the United States of America.The audit committee’s responsibility is to monitor and review these processes.

 

The audit committee hasreviewed and discussed with the independent registered public accounting firmand management the plan and results of the auditing engagement and the auditedfinancial statements for the fiscal year ended December 31, 2007. Theaudit committee reviewed and discussed management’s assessment of theeffectiveness of the company’s internal control over financial reporting. Theaudit committee discussed with the independent registered public accountingfirm the matters required to be discussed by Statement on Auditing Standards No. 61,“Communication With Audit Committees.” Statement on Auditing Standards No. 61requires our independent registered public accounting firm to discuss with theaudit committee, among other things, the following:

 

·                  methods to account for significant unusual transactions;

 

·                  the effect of significant accounting policies in controversial oremerging areas for which there is a lack of authoritative guidance orconsensus;

 

·                  the process used by management in formulating particularly sensitiveaccounting estimates and the basis for the auditors’ conclusions regarding thereasonableness of those estimates; and

 

·                  disagreements with management over the application of accountingprinciples, the basis for management’s accounting estimates and the disclosuresin the financial statements.

 

In addition, the auditcommittee has received from the independent registered public accounting firmthe written disclosures required by Independence Standards Board No. 1, “IndependenceDiscussions With Audit Committees”, and discussed with the independentregistered public accounting firm its independence from the Company and itsmanagement. Independence Standards Board Standard No. 1 requires auditorsannually to disclose in writing all relationships that in the auditor’sprofessional opinion may reasonably be thought to bear on independence, confirmtheir perceived independence, and engage in a discussion of independence. Theaudit committee considered whether the provision of non-audit services by theindependent registered public accounting firm is compatible with maintainingthe independent registered public accounting firm’s independence and concludedthat it is compatible at this time.

 

The audit committee hasalso reported to the board of directors its activities, conclusions andrecommendations. Specifically, in reliance on the reviews and discussionsreferred to above, the audit committee recommended to the board of directorsthat the audited financial statements be included in our Annual Report on Form 10-KSBfor the year ended December 31, 2007, for filing with the SEC. The AuditCommittee has also approved the appointment of Carlin, Charron &Rosen, LLP as the Company’s independent registered public accounting firm forthe fiscal year ending December 31, 2008.

 

Respectfully submitted,

 

**AUDITCOMMITTEE**

 

Jeffrey J. May (Chairman)

John Schoenherr

 

 

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

 

Section 16(a) ofthe U.S. Securities and Exchange Act of 1934, as amended (the “Exchange Act”),requires the Company’s officers and directors and persons who own more than tenpercent (10%) of the Company’s Common Stock to file with the Securities andExchange Commission (“SEC”) initial reports of ownership and reports of changesin ownership of the Company’s Common Stock. Such officers, directors and tenpercent (10%) stockholders are also required by applicable SEC rules tofurnish the Company with copies of all forms filed with the SEC pursuant to Section 16(a) ofthe Exchange Act. Based solely on its review of the copies of such formsreceived by it, or written representations from such persons that no otherreports were required for such persons, the Company believes that during thefiscal year ended December 31, 2007, all Section 16(a) filingrequirements applicable to the Company’s officers, directors and ten percent(10%) stockholders were satisfied in a timely fashion.

 

**Code of Ethics**

 

We have adopted a Code ofEthics that applies to our principal executive officer, principal financialofficer, principal accounting officer or controller, or persons performingsimilar functions. Our Code of Ethics is designed to deter wrongdoing andpromote: (i) honest and ethical conduct, including the ethical handling ofactual or apparent conflicts of interest between personal and professionalrelationships; (ii) full, fair, accurate, timely and understandabledisclosure in reports and documents that we file with, or submit to, the SECand in our other public communications; (iii) compliance with applicablegovernmental laws, rules, and regulations; (iv) the prompt internalreporting of violations of the code to an appropriate person or personsidentified in the code; and (v) accountability for adherence to thecode.  Any person may obtain a copy ofour Code of Ethics free of charge by sending a written request for such to theattention of the Chief Financial Officer of the Company, 3349 Highway 138, Building D Suite B,Wall, NJ 07719.

 

**InternetAddress and SEC Reports**

 

We maintain a websitewith the address www.BIO-key.com. We are not including the informationcontained on our website as a part of, or incorporating it by reference into,this Annual Report on Form 10-KSB. We make available free of chargethrough our website our Annual Reports on Form 10-KSB, Quarterly Reportson Form 10-QSB and Current Reports on Form 8-K, and amendments tothese reports, as soon as reasonably practicable after we electronically filesuch material with, or furnish such material to, the SEC. Our SEC filings arealso available over the internet at the SEC’s website www.sec.gov. Members ofthe public may read and copy any materials the Company files with the SEC atthe SEC’s public reference room at 100 F Street, NE, Washington, DC 20549.Information on the operation of the public reference room is available bycalling the SEC on 1800-SEC-0330.

 

 

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** **

**ITEM10.**             EXECUTIVECOMPENSATION

** **

The following table setsforth a summary of the compensation paid to or accrued by our chief executiveofficer (principal executive officer) and the two most highly compensatedexecutive officers other than the principal executive officer, who were servingas executive officers at the end of December 31, 2007, for the fiscalyears ended December 31, 2007 and 2006:

 

**SUMMARYCOMPENSATION TABLE**

 
| **Name**                                  | ** ** | **Fiscal  Year** | ** ** | **Salary  ($)** | ** ** | **Bonus  ($)** | ** ** | **Stock  Awards  ($)** | ** ** | **Option  Awards  ($)** | ** ** | **Non-Equity  Incentive  Plan  Compensation  ($)** | ** ** | **Nonqualified  Deferred  Compensation  Earnings  ($)** | ** ** | **All  Other  Compensation  ($)** | ** ** | **Total  ($)** | ** ** |
|-------------------------------------------|------------|------------------|------------|-----------------|------------|----------------|------------|------------------------|------------|-------------------------|------------|----------------------------------------------------|------------|---------------------------------------------------------|------------|-----------------------------------|------------|----------------|------------|
|                                      |       |             |       |            |       |           |       |                   |       |                    |       |                                               |       |                                                    |       |                              |       |           |       |
| **Michael  W. DePasquale (1)**       |       | 2007             |       | 250,000         |       | —         |       | —                 |       | 110,545                 | (4)        | —                                             |       | —                                                  |       | 775                               |       | 361,320        |       |
| Chief Executive  Officer                  |       | 2006             |       | 250,000         |       | —         |       | —                 |       | 85,892                  | (4)        | —                                             |       | —                                                  |       | 775                               |       | 336,667        |       |
|                                      |       |             |       |            |       |           |       |                   |       |                    |       |                                               |       |                                                    |       |                              |       |           |       |
| **Randy  Fodero (2)**                     |       | 2007             |       | 170,000         |       | —         |       | —                 |       | 101,768                 | (4)        | 57,755                                             |       | —                                                  |       | 527                               |       | 330,050        |       |
| Vice President Sales                      |       | 2006             |       | 170,000         |       | —         |       | —                 |       | 95,633                  | (4)        | 70,133                                             |       | —                                                  |       | 527                               |       | 336,293        |       |
|                                      |       |             |       |            |       |           |       |                   |       |                    |       |                                               |       |                                                    |       |                              |       |           |       |
| **Kenneth  S.  Souza (3)**                |       | 2007             |       | 200,000         |       | —         |       | —                 |       | 112,392                 | (4)        | —                                             |       | —                                                  |       | 620                               |       | 313,012        |       |
| General Manager,  Law                     |       | 2006             |       | 200,000         |       | 10,000         |       | —                 |       | 114,943                 | (4)        | —                                             |       | —                                                  |       | 620                               |       | 325,563        |       |
| Enforcement and  Chief Technology Officer |       |             |       |            |       |           |       |                   |       |                    |       |                                               |       |                                                    |       |                              |       |           |       |
|                                      |       |             |       |            |       |           |       |                   |       |                    |       |                                               |       |                                                    |       |                              |       |           |       |

 

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

 

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

 

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

 

(4)             The aggregate grant date fair value of the optionawards was estimated using the Black-Scholes option pricing model, with theassumptions listed in Note A to the Company’s financial statements. The amountshown in this column represents the compensation cost of awards recognizedduring the year for financial reporting purposes under FAS 123(R), without regard to estimatedforfeitures related to service-based vesting conditions for option awards.

 

 

**Narrative Disclosure to SummaryCompensation Table**

 

Compensation for BIO-key’sexecutives is comprised of three main components: base salary, annualperformance-based cash bonus and long-term equity awards. We do not target aspecific weighting of these three components or use a prescribed formula toestablish pay levels. Rather, the board of directors and compensation committeeconsiders changes in the business, external market factors and our financialposition each year when determining pay levels and allocating between long-termand current compensation for the named executive officers.

 

Cash compensation iscomprised of base salary and an annual performance-based cash bonusopportunity. The committee generally seeks to set a named executive officer’stargeted total cash compensation opportunity within a range that is the averageof the applicable peer company and/or general industry compensation surveydata, adjusted as appropriate for individual performance and internal payequity and labor market conditions.

 

In setting cashcompensation levels, we favor a balance in which base salaries are generallytargeted at slightly below the peer average and a bonus opportunity that istargeted at slightly above the average. The committee believes that this higheremphasis on performance-based cash bonuses places an appropriate linkagebetween a named executive officer’s pay, his or her individual performance andthe achievement of specific business goals by placing a higher proportion ofannual cash compensation at risk, thereby aligning executive opportunity withthe interests of stockholders.

 

 

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We include an equitycomponent as part of our compensation package because we believe thatequity-based compensation aligns the long-term interests of our named executiveofficers with those of stockholders.

 

These cash and equitycompensation components of pay are supplemented by various benefit plans thatprovide health, life, accident, disability and severance benefits, most of which are the same as the benefits providedto all of our US based employees.

 

***Employment Agreements***

 

On March 28, 2006,the Company entered into a two-year employment agreement with Michael W.DePasquale to serve as the Chief Executive Officer of the Company at an annualbase salary of $250,000, subject to adjustment by the Board of Directors, aswell as an entitlement to $1,000 per month in lieu of participating in theCompany’s medical plan. In addition to the Base Salary and Stock Options, a “DiscretionaryBonus” may be awarded to Mr. DePasquale on the basis of merit performanceon an annual basis in the sole discretion of the Board of Directors. Theemployment agreement also provides for the grant of options to purchase up to400,000 shares of Company common stock payable at the discretion of the Boardof Directors.

 

The employment agreementcontains standard and customary confidentiality, non-solicitation and “workmade for hire” provisions as well as a covenant not to compete which prohibits Mr. DePasqualefrom doing business with any current or prospective customer of the Company orengaging in a business competitive with that of the Company during the term ofhis employment and for the one year period thereafter. This agreement alsocontains a number of termination and change of control provisions as describedin “Termination and Change in Control Arrangements” in this Item.

 

In connection with hisappointment as Senior Vice President and Chief Technology Officer of theCompany on October 4, 2004, we entered into a one year employmentagreement with Kenneth S. Souza. The employment agreement provides for anannual base salary of $200,000 and a performance bonus in the amount of up to$76,000 payable upon achievement of certain performance criteria. Unless noticeof non-renewal is provided to Mr. Souza at least two months prior to theend of the term, the employment agreement automatically renews for successiveone year terms. This agreement also contains a number of termination and changeof control provisions as described in “Termination and Change in ControlArrangements” in this Item.

 

***Stock OptionGrant***

 

On March 23, 2006,Michael DePasquale, Randy Fodero, and Kenneth Souza were granted options topurchase 400,000, 100,000, and 250,000 shares of common stock respectively, atan exercise price of $0.75 per share. These options expire on March 23,2016. The options vest in equal increments over two years, as described in “OutstandingEquity Awards at Fiscal Year End” in this Item.

 

In the event of anychange in the outstanding shares of our common stock by reason of a stockdividend, stock split, combination of shares, recapitalization, merger,consolidation, transfer of assets, reorganization, conversion or what the boarddeems to be similar circumstances, the number and kind of shares subject tothis option and the exercise price of such option shall be appropriatelyadjusted in a manner to be determined in the sole discretion of the board.Furthermore, these option agreements contain a change of control provision asdescribed in “Termination and Change in Control Arrangements” in this Item.

 

 

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**OUTSTANDINGEQUITY AWARDS AT FISCAL YEAR ENDDECEMBER 31, 2007**

 

The following table sets forth for each namedexecutive officer, information regarding outstanding equity awards as at December 31,2007:

 
| **Option Awards** | ** ** | **Stock Awards**                                                               | ** ** |
|------------------------|------------|-------------------------------------------------------------------------------------|------------|
| **Name**               | ** ** | **Number  of  securities  underlying unexercised   options  exercisable  (#)** | ** ** | **Number  of  securities  underlying   unexercised options  unexercisable  (#)** | ** ** | **Equity  incentive**

** plan  awards: Number  of  securities   underlying unexercised unearned  options  (#)** | ** ** | **Option  exercise price  ($)** | ** ** | **Option  expiration date** | ** ** | **Number  of  shares  or  units  of  stock  that  have  not  vested  (#)** | ** ** | **Market  value  of  shares  or  units  of  stock  that  have  not  vested  ($)** | ** ** | **Equity  incentive plan awards: Number  of  unearned shares  or units  or  other  rights   that  have   not  vested  (#)** | ** ** | **Equity  incentive plan awards: Market  or  payout value of unearned shares,  units or other   rights  that have not vested  ($)** | ** ** |
| Michael W.  DePasquale |       | 500,000                                                                             |       | — |   | — |   | 1.32 |   | 12/11/2010 |   | — |   | — |   | — |   | — |   |
|                   |       | 580,000                                                                             |       | — |   |   |   | 0.53 |   | 1/3/2010 |   |   |   |   |   |   |   |   |   |
|                   |       | 200,000                                                                             |       | 200,000 | (1) |   |   | 0.75 |   | 3/23/2013 |   |   |   |   |   |   |   |   |   |
|                   |       |                                                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Randy  Fodero          |       | 466,666                                                                             |       | 133,334 | (2) | — |   | 0.60 |   | 11/11/2012 |   | — |   | — |   | — |   | — |   |
|                   |       | 50,000                                                                              |       | 50,000 | (3) |   |   | 0.75 |   | 3/23/2013 |   |   |   |   |   |   |   |   |   |
|                   |       |                                                                                |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Kenneth S. Souza       |       | 300,000                                                                             |       | — | (4) | — |   | 1.05 |   | 9/15/2011 |   | — |   | — |   | — |   | — |   |
|                   |       | 125,000                                                                             |       | 125,000 | (5) |   |   | 0.75 |   | 3/23/2013 |   |   |   |   |   |   |   |   |   |

 

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(1)             Theoptions vest equally in two annual installments commencing March 23, 2007;200,000 vested on March 23, 2007 and 200,000 vested on March 23,2008.

 

(2)             200,000of the options vested upon grant and the remaining options vest equallythereafter in three annual installments commencing November 11, 2006;133,333 vested on November 11, 2006, 133,333 vested on November 11,2007 and 133,334 will vest on November 11, 2008.

 

(3)             Theoptions vest equally in two annual installments commencing March 23, 2007;50,000 vested on March 23, 2007 and 50,000 vested on March 23, 2008.

 

(4)             Theoptions vest equally in three annual installments commencing October 4,2005;  100,000 vested on October 4,2005; 100,000 vested on October 4, 2006 and 100,000 vested on October 4,2007.

 

(5)             Theoptions vest equally in two annual installments commencing March 23, 2007;125,000 vested on March 23, 2007 and 125,000 vested on March 23,2008.

 

 

**Narrative Disclosure to OutstandingEquity Awards at Fiscal Year End Table**

 

The following are thematerial terms of each agreement, contract, plan or arrangement that providefor payments to one or more of our named executive officers at, following orpursuant to their resignation, retirement or termination, or in connection witha change in control of the Company.

 

***Termination Arrangements***

 

On March 28, 2006,the Company entered into a two-year employment agreement with Michael W.DePasquale to serve as the Chief Executive Officer of the Company. The Companymay terminate the agreement at any time with or without cause. In the event oftermination without cause, Mr. DePasquale shall continue to be paid histhen current base salary for six months from the date of such termination.

 

On October 4, 2007,the Company renewed the annual agreement with Kenneth Souza to serve asExecutive Vice 

 

 

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President and General Manager, Law Enforcement of theCompany. The Company may terminate the agreement at any time with or withoutcause. In the event of termination without cause, Mr. Souza shall continueto be paid his then current base salary for the greater of six months from thedate of such termination or the number of months remaining until the end of theterm of the employment agreement.

 

***Change in Control Provisions***

 

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

 

In the event of a “ChangeIn Control” each Plan provides for the immediate vesting of all options issuedthereunder. The 1999 Plan provides for the Company to deliver written notice toeach optionee under the 1999 Plan fifteen (15) days prior to theoccurrence of a Change In Control during which all options issued under the1999 Plan may be exercised. Thereafter, all options issued under the 1999 Planwhich are neither assumed or substituted in connection with such transaction,automatically expire unless otherwise determined by the Board. The 1996 Planprovides for all options to remain exercisable for the remainder of 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 toexecutive officers outside of the Plans contain change in control provisionssubstantially similar to those contained in the 1999 Plan.

 

 

43

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**DIRECTORCOMPENSATION FOR THE FISCAL YEAR ENDEDDECEMBER 31, 2007**

 

The following table sets forth for each director,information regarding their compensation for the year ended December 31,2007:

 

| **Name**                 | ** ** | **Fees Earned or  Paid in Cash  ($)** | ** ** | **Stock  Awards  ($)** | ** ** | **Option  Awards  ($)** | ** ** | **Non-Equity  Incentive Plan  Compensation  ($)** | ** ** | **Nonqualified  Deferred  Compensation  Earnings  ($)** | ** ** | **All Other  Compensation  ($)** | ** ** | **Total  ($)** | ** ** |
|--------------------------|------------|-----------------------------------------------------------|------------|------------------------|------------|-------------------------|------------|--------------------------------------------------------|------------|---------------------------------------------------------|------------|---------------------------------------|------------|----------------|------------|
| Thomas J. Colatosti      |       | —                                                    |       | —                 |       | —                  |       | —                                                 |       | —                                                  |       | —                                |       | —         |       |
| Michael W. DePasquale(1) |       | —                                                    |       | —                 |       | —                  |       | —                                                 |       | —                                                  |       | —                                |       | —         |       |
| Jeffrey J. May           |       | —                                                    |       | —                 |       | —                  |       | —                                                 |       | —                                                  |       | —                                |       | —         |       |
| Charles P. Romeo         |       | —                                                    |       | —                 |       | 34,921                  | (2)        | —                                                 |       | —                                                  |       | —                                |       | 34,921         |       |
| John Schoenherr          |       | —                                                    |       | —                 |       | —                  |       | —                                                 |       | —                                                  |       | —                                |       | —         |       |

 

----

 

(1)             Refer to Narrative Disclosure To Summary CompensationTable for information pertaining to Mr. DePasquale’s employment agreement.

 

(2)             The aggregate grant date fair value of the optionawards was estimated using the Black-Scholes option pricing model, with theassumptions listed in Note A to the Company’s financial statements. The amountshown in this column represents the compensation cost of awards recognizedduring the year for financial reporting purposes under FAS 123(R), without regard to estimatedforfeitures related to service-based vesting conditions for option awards.

 

 

**Narrative Disclosure to DirectorCompensation Table**

 

**Directors who are also officers ofthe Company receive no additional compensation for serving on the Board ofDirectors, other than reimbursement of reasonable expenses incurred inattending meetings. The Company’s current policy is to issue options to purchase50,000 shares of common stock to each non-employee director on an annual basis.No options were issued during 2007.**

** **

In connection with hisappointment to the Board of Directors in September 2002, the Company hasentered into a number of consulting arrangements with Thomas J. Colatosti.Under the most recent arrangement, which was entered into on July 12,2007, Mr. Colatosti, provided services to the Company and its subsidiariesand affiliates for the year ended December 31, 2007 at a rate of $12,000per month. This agreement expired on December 31, 2007 and has not beenrenewed.

 

We reimburse each of ournon-employee directors for their reasonable expenses incurred in connectionwith attending meetings of the board of directors and related committees.

 

 

44

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**ITEM11. SECURITY OWNERSHIP OF CERTAINBENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS**

** **

The following table setsforth, as of March 1, 2008, 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                                               |       | 1,530,000                                                      | (2)        | 2.4                               | %          |
|                                                              |       |                                                           |       |                              |       |
| Michael W. DePasquale                                             |       | 1,500,000                                                      | (3)        | 2.4                               | %          |
|                                                              |       |                                                           |       |                              |       |
| Francis J. Cusick                                                 |       | 350,000                                                        | (4)        |                              | *          |
| Jeffrey May                                                       |       | 250,000                                                        | (5)        |                              | *          |
| Charles P. Romeo                                                  |       | 400,000                                                        | (6)        |                              | *          |
| John Schoenherr                                                   |       | 50,000                                                         | (7)        |                              | *          |
| Randy Fodero                                                      |       | 566,666                                                        | (8)        |                              | *          |
| Kenneth S. Souza                                                  |       | 550,000                                                        | (9)        |                              | *          |
| Trellus Management Company, LLC                                   |       | 9,661,039                                                      |       | 15.5                              | %          |
| 350 Madison Avenue 9th Floor New York, NY  10017                  |       |                                                           |       |                              |       |
| All officers and directors as a group  (8) persons           |       | 5,196,666                                                      |       | 8.3                               | %          |

 

----

 

*                    Lessthan 1%

 

(1)             Thesecurities “beneficially owned” by an individual are determined in accordancewith the definition of “beneficial ownership” set forth in the regulationspromulgated under the Securities Exchange Act of 1934 and, accordingly, mayinclude securities owned by or for, among others, the spouse and/or minorchildren of an individual and any other relative who has the same home as suchindividual, as well as, other securities as to which the individual has orshares voting or investment power or which each person has the right to acquirewithin 60 days through the exercise of options or otherwise. Beneficialownership may be disclaimed as to certain of the securities. This table hasbeen prepared based on 62,511,172 shares of common stock outstanding as of March 1,2008.

 

(2)             Includes550,000 shares assumable upon exercise of options and 875,000 shares issuableupon conversion of Series A Preferred Stock.

 

(3)             Includes1,480,000 shares issuable upon exercise of options.

 

(4)             Consistsof shares issuable upon exercise of options.

 

(5)             Consistsof shares issuable upon exercise of options.

 

(6)             Consistsof shares issuable upon exercise of options.

 

(7)             Consistsof shares issuable upon exercise of options.

 

(8)             Includes566,666 shares issuable upon exercise of options. Does not include 133,334shares issuable upon exercise of options subject to vesting.

 

(9)             Consistsof shares issuable upon exercise of options.

 

 

45

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The following table setsforth, as of December 31, 2007, information with respect to securitiesauthorized for issuance under equity compensation plans.

 

**EQUITYCOMPENSATION PLAN INFORMATION**

 
| ** **                                                  | ** ** | **Number of   securities to be   issued upon   exercise of   outstanding options, warrants   and rights  (a)** | ** ** | **Weighted-  average  exercise price   of outstanding  options,   warrants   and rights  (b)** | ** ** | **Number of   securities  remaining   available for  future issuance   under equity   compensation   plans (excluding   securities reflected in   column (a))  (c)** | ** ** |
|-------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity compensation plans approved by security  holders     |       | 80,000                                                                                                                                                                |       | $                                                                                                                            | 0.47       |                                                                                                                                                                                                                             | —     |   |
| Equity compensation plans not approved by security  holders |       | 6,969,415                                                                                                                                                             |       | $                                                                                                                            | 0.86       |                                                                                                                                                                                                                             | 2,857,842  |   |
| Total                                                       |       | 7,049,415                                                                                                                                                             |       | $                                                                                                                            | 0.85       |                                                                                                                                                                                                                             | 2,857,842  |   |

 

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. The1996 Plan expired in May 2005.

 

As of December 31,2007, there were outstanding options under the 1996 Plan to purchase 80,000shares of common stock, and no shares were available for future grants.

 

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

 

The 1999 Plan iscurrently administered by the Board of Directors of the Company (the “PlanAdministrator”). The Plan Administrator is authorized to construe the 1999 Planand any option issued under the 1999 Plan, select the persons to whom optionsmay be granted, and determine the number of shares to be covered by any option,the exercise price, vesting schedule and other material terms of such option.The 1999 Plan expires in August 2009.

 

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

 

The 1999 Plan providesfor the immediate vesting of all options in the event of a “Change In Control”of the Company. In the event of a Change In Control, the Company is required todeliver written notice to each optionee under the 1999 Plan fifteen(15) days prior to the occurrence of a Change in Control, during whichtime all options issued under 1999 Plan may be exercised. Thereafter, alloptions issued under the 1999 Plan which are neither assumed or substituted inconnection with such transaction, automatically expire, unless otherwisedetermined by the Board. Under the 1999 Plan, a “Change In Control” is definedto include (i) a sale or transfer of substantially all of the Company’sassets; (ii) the dissolution or liquidation of the Company; (iii) amerger or consolidation to which the Company is a party and after which theprior shareholders of the Company hold less than 50% of the combined votingpower of the surviving corporation’s outstanding securities; (iv) theincumbent directors cease to constitute at least a majority of the Board ofDirectors; or (v) a change in control of the Company which would otherwisebe reportable under Section 13 or 15(d) of the Exchange Act. The 1999Plan expires in August 2009.

 

 

46

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As of December 31,2007, there were outstanding options under the 1999 Plan to purchase 805,000shares of common stock, and options to purchase an aggregate of 904,257 shareswere available for future grants.

 

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

 

As of December 31,2007, there were outstanding options under the 2004 Plan to purchase 2,221,415shares of common stock, and options to purchase an aggregate of 1,778,585shares were available for future grants.

 

In addition to optionsissued under the 1996, 1999 and 2004 Plans, the Company has issued options toemployees, officers, directors and consultants to purchase common stock underthe non plan. As of December 2007, there were outstanding options underthe non plan to purchase 3,943,000 shares of common stock. The terms of theseoptions are substantially similar to the provisions of the 1999 Plan andoptions issued thereunder.

 

 

**ITEM 12.**             CERTAIN RELATIONSHIPSAND RELATED TRANSACTIONS

** **

**Employment Arrangements**

 

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

 

**Consulting Arrangement withThomas J. Colatosti**

 

In connection with hisappointment to the Board of Directors in September 2002, the Company hasentered into a number of consulting arrangements with Thomas J. Colatosti.Under the most recent arrangement, which was entered into on July 12,2007, Mr. Colatosti, provided services to the Company and its subsidiariesand affiliates for the year ended December 31, 2007 at a rate of $12,000per month.

 

**DirectorIndependence**

 

For our description ofdirector independence, see **“DIRECTORS, EXECUTIVEOFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH SECTION 16(a) OFTHE EXCHANGE ACT — Independent Directors.”**

 

 

47

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**ITEM 13.**             EXHIBITS

** **

(a) The following documents are filed aspart of this Report. Portions of Item 13 are submitted as separatesections of this Report:

 

(1)          Financial statements filed as part of thisReport:

 

****Report ofIndependent Registered Public Accounting Firm****

 

Balance Sheet at December 31,2007

 

Statements ofOperations—Years ended December 31, 2007 and 2006

 

Statement ofStockholders’ Equity (Deficit)—Years ended December 31, 2007 and 2006

 

Statements of CashFlows—Years ended December 31, 2007 and 2006

 

Notes to FinancialStatements—December 31, 2007 and 2006

 

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

 

 

**ITEM 14.**             PRINCIPAL ACCOUNTANTFEES AND SERVICES

** **

The following table showsfees for professional audit services billed to us by Carlin, Charron &Rosen, LLP (“CCR”)  and DS&B, Ltd. (“DS&B”)for the audit of our annual consolidated financial statements for the yearsended December 31, 2007 and December 31, 2006, and fees billed to usby CCR and DS&B for other services during 2007 and 2006:

 

| ** **  | ** ** | **2007** | ** ** | **2006** | ** ** |
|-------------|------------|----------|------------|----------|------------|
| Audit Fees: |       |     |       |     |       |
| CCR         |       | $        | 187,718    |     | $          | 169,768 |   |
| DS&B    |       | 2,148    |       | 108,584  |       |
|        |       | 189,866  |       | 278,352  |       |
| Tax Fees:   |       |     |       |     |       |
| CCR         |       | 32,004   |       | —   |       |
| DS&B    |       | 459      |       | 33,823   |       |
|        |       | 32,463   |       | 33,823   |       |
|        |       |     |       |     |       |
| Total Fees  |       | $        | 222,329    |     | $          | 312,175 |   |

 

*AuditFees*consist offees billed for professional services rendered for the audit of our financialstatements and review of the interim financial statements included in quarterlyreports and services that are normally provided by CCR and DS&B, Ltd. inconnection with statutory and regulatory filings or engagements. Audit feesalso include fees for services provided in connection with registration ofsecurities, comfort letters, and review of documents filed with the SEC.

 

*TaxFees*consists offees billed for professional services for tax compliance assistance renderedduring the fiscal year.

 

**Audit Committee Pre-ApprovalProcedures**

 

The Audit Committee ofour Board of Directors consists of John Schoenherr and Jeffrey J. May. TheAudit Committee approves the engagement of our independent auditors to renderaudit and non-audit services before they are engaged. All of the fees for 2007and 2006 shown above were pre-approved by the Audit Committee.

 

The Audit Committeepre-approves all audit and other permitted non-audit services provided by ourindependent 

 

 

48

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auditors. Pre-approval is generally provided for up toone year, is detailed as to the particular category of services and is subjectto a monetary limit. Our independent auditors and senior managementperiodically report to the Audit Committee the extent of services provided bythe independent auditors in accordance with the pre-approval, and the fees forthe services performed to date. The Audit Committee may also pre-approveparticular services on a case-by-case basis.

 

Our audit committee willnot approve engagements of our independent registered public accounting firm toperform non-audit services for us if doing so will cause our independentregistered public accounting firm to cease to be independent within the meaningof applicable SEC rules. In other circumstances, our audit committee considers,among other things, whether our independent registered public accounting firmis able to provide the required services in a more or less effective andefficient manner than other available service providers.

 

 

**ITEM7—FINANCIAL STATEMENTS**

 

The following financialstatements of BIO-key International, Inc. are included herein at the indicatedpage numbers:

 
| Report of Independent Registered Public Accounting  Firm, Carlin, Charron, & Rosen, LLP   | 50    |
|----------------------------------------------------------------------------------------------------|-------|
| Balance Sheet at December 31, 2007                                                            | 51    |
| Statements of Operations—Years ended  December 31, 2007 and 2006                         | 52    |
| Statement of Stockholders’ Equity (Deficit)—Years  ended December 31, 2007 and 2006 | 53    |
| Statements of Cash Flows—Years ended  December 31, 2007 and 2006                         | 54    |
| Notes to the Financial Statements—December 31,  2007 and 2006                            | 55-79 |

 

 

49

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**Report of Independent RegisteredPublic Accounting Firm**

 

The Board of Directorsand StockholdersBIO-key International, Inc.

Marlborough, MA

 

We have audited theaccompanying consolidated balance sheet of BIO-key International, Inc. andSubsidiary as of December 31, 2007, and the related consolidatedstatements of operations, stockholders’ equity (deficit) and cash flows foreach of the years in the two-year period ended December 31, 2007. Theseconsolidated financial statements are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these consolidatedfinancial statements based on our audits.

 

We conducted our auditsin accordance with the standards of the Public Company Accounting OversightBoard (United States). Those standards require that we plan and perform theaudits to obtain reasonable assurance about whether the financial statementsare free of material misstatement. The Company is not required to have, norwere we engaged to perform, an audit of its internal control over financialreporting. Our audits included consideration of internal control over financialreporting as a basis for designing audit procedures that are appropriate in thecircumstances, but not for the purpose of expressing an opinion on the effectivenessof the Company’s internal control over financial reporting. Accordingly, weexpress no such opinion. An audit also includes examining, on a test basis,evidence supporting the amounts and disclosures in the financial statements,assessing the accounting principles used and significant estimates made bymanagement as well as evaluating the overall financial statement presentation.We believe our audits provide a reasonable basis for our opinion.

 

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of BIO-key International, Inc.and Subsidiary as of December 31, 2007, and the consolidated results ofits operations and its cash flows for each of the years in the two-year periodended December 31, 2007, in conformity with accounting principlesgenerally accepted in the United States of America.

 

The accompanyingconsolidated financial statements have been prepared assuming that the Companywill continue as a going concern. As disclosed in the consolidated financialstatements, the Company has suffered substantial net losses in recent years,and has an accumulated deficit at December 31, 2007, which raisesubstantial doubt about the Company’s ability to continue as a going concern.Management’s plans regarding these matters are disclosed in Note A. Theconsolidated financial statements do not include any adjustments that mightresult from the outcome of this uncertainty.

 
| /s/ Carlin, Charron, & Rosen, LLP. |   |
|---------------------------------------------|--------|
|                                        |   |
| Westborough, Massachusetts                  |   |
| March 26, 2008                         |   |

 

 

50

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**BIO-key International, Inc andSubsidiary****CONSOLIDATED BALANCE SHEET**

 
| ** **                                                                                                                                                                                     | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                     | ** ** | **2007**              | ** ** |
| **ASSETS:**                                                                                                                                                                                    | ** ** | ** **            | ** ** |
| Cash and cash equivalents                                                                                                                                                                      |       | $                     | 964,774    |   |
| Restricted cash                                                                                                                                                                                |       | 153,094               |       |
| Accounts receivable, net of allowance for doubtful  accounts of $113,771                                                                                                                       |       | 2,129,797             |       |
| Costs and earnings in excess of billings on  uncompleted contracts                                                                                                                             |       | 233,805               |       |
| Inventory                                                                                                                                                                                      |       | 4,879                 |       |
| Prepaid expenses                                                                                                                                                                               |       | 119,068               |       |
| Total current  assets                                                                                                                                                                          |       | 3,605,417             |       |
| Equipment and leasehold improvements, net                                                                                                                                                      |       | 177,282               |       |
| Deposits                                                                                                                                                                                       |       | 487,815               |       |
| Intangible assets—less accumulated amortization                                                                                                                                           |       | 1,324,269             |       |
| Goodwill                                                                                                                                                                                       |       | 7,836,986             |       |
| Total  non-current assets                                                                                                                                                                      |       | 9,826,352             |       |
| **TOTAL ASSETS**                                                                                                                                                                               |       | $                     | 13,431,769 |   |
| **LIABILITIES:**                                                                                                                                                                               | ** ** | ** **            | ** ** |
| Accounts payable                                                                                                                                                                               |       | 1,162,690             |       |
| Accrued liabilities                                                                                                                                                                            |       | 3,401,749             |       |
| Deferred rent                                                                                                                                                                                  |       | 367,986               |       |
| Deferred revenue                                                                                                                                                                               |       | 4,468,748             |       |
| Total current  liabilities                                                                                                                                                                     |       | 9,401,173             |       |
| Warrants                                                                                                                                                                                       |       | 64,520                |       |
| Redeemable preferred stock derivatives                                                                                                                                                         |       | 41,295                |       |
| Deferred revenue                                                                                                                                                                               |       | 34,518                |       |
| Total  non-current liabilities                                                                                                                                                                 |       | 140,333               |       |
| **TOTAL LIABILITIES**                                                                                                                                                                          |       | 9,541,506             |       |
| ** **                                                                                                                                                                                     | ** ** | ** **            | ** ** |
| Commitments and contingencies                                                                                                                                                                  |       |                  |       |
|                                                                                                                                                                                           |       |                  |       |
| Series B  redeemable convertible preferred stock: authorized, 1,000,000 shares  (liquidation preference of $1 per share); issued and outstanding 970,612  shares of $.0001 par value, net |       | 881,340               |       |
| Series C  redeemable convertible preferred stock: authorized, 600,000 shares  (liquidation preference of $10 per share); issued and outstanding 592,032  shares of $.0001 par value, net  |       | 5,776,231             |       |
|                                                                                                                                                                                           |       | 6,657,571             |       |
|                                                                                                                                                                                           |       |                  |       |
| **STOCKHOLDERS’  EQUITY/(DEFICIT):**                                                                                                                                                      | ** ** | ** **            | ** ** |
| Series A convertible  preferred stock: authorized, 100,000 shares (liquidation preference of $100  per share); issued and outstanding 30,557 shares of $.0001 par value, net         |       | 3                     |       |
| Common stock — authorized, 170,000,000 shares;  issued and outstanding; 61,153,202 of $.0001 par value                                                                                    |       | 6,115                 |       |
| Additional paid-in capital                                                                                                                                                                     |       | 52,126,595            |       |
| Accumulated deficit                                                                                                                                                                            |       | (54,900,021           | )          |
| **TOTAL STOCKHOLDERS’ EQUITY/(DEFICIT)**                                                                                                                                                  |       | (2,767,308            | )          |
| **TOTAL LIABILITIES AND STOCKHOLDERS’  EQUITY/(DEFICIT)**                                                                                                                                 |       | $                     | 13,431,769 |   |

 

The accompanying notesare an integral part of these statements.

 

** **

**51**

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** **

**BIO-key International, Inc. and SubsidiarySTATEMENTS OF OPERATIONS**

 
| ** **                                                               | ** ** | **Years ended December 31,** | ** ** |
|--------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                               | ** ** | **2007**                                    | ** ** | **2006** | ** ** |
| ** **                                                               | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| **Revenues**                                                             | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Services                                                                 |       | $                                           | 6,965,706  |   | $ | 8,148,470 |   |
| License fees and  other                                                  |       | 3,022,750                                   |       | 3,139,568 |   |
|                                                                     |       | 9,988,456                                   |       | 11,288,038 |   |
| **Costs and other expenses**                                             | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Cost of services                                                         |       | 1,493,341                                   |       | 2,167,849 |   |
| Cost of license  fees and other                                          |       | 291,435                                     |       | 657,660 |   |
|                                                                     |       | 1,784,776                                   |       | 2,825,509 |   |
| Gross Profit                                                             |       | 8,203,680                                   |       | 8,462,529 |   |
|                                                                     |       |                                        |       |   |   |
| **Operating expenses**                                                   | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Selling, general  and administrative                                     |       | 8,573,863                                   |       | 9,762,751 |   |
| Research,  development and engineering                                   |       | 4,994,799                                   |       | 5,372,320 |   |
|                                                                     |       | 13,568,662                                  |       | 15,135,071 |   |
| **Operating  loss**                                                      |       | (5,364,982                                  | )          | (6,672,542 | ) |
| **Other income (deductions)**                                            | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Interest income                                                          |       | 3,097                                       |       | — |   |
| Interest expense                                                         |       | (832,457                                    | )          | (5,730,712 | ) |
| Derivative and  warrant fair value adjustments                           |       | 1,016,845                                   |       | 7,542,666 |   |
| Loss on  extinguishment of debt                                          |       | (403,940                                    | )          | (7,815,717 | ) |
| Other income  (expense)                                                  |       | 12,102                                      |       | (48,637 | ) |
|                                                                     |       | (204,353                                    | )          | (6,052,400 | ) |
| Loss from  continuing operations                                         |       | (5,569,335                                  | )          | (12,724,942 | ) |
| Income from  discontinued operations                                     |       | 440,105                                     |       | 1,644,091 |   |
| Gain on disposal  of discontinued operations, net of expected tax of $0. |       | 4,072,006                                   |       | — |   |
| Net Loss                                                                 |       | $                                           | (1,057,224 | ) | $ | (11,080,851 | ) |
| ** **                                                               | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| **Basic and Diluted Earnings per Common Share:**                         | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Loss from  continuing operations                                         |       | $                                           | (0.13      | ) | $ | (0.27 | ) |
| Income from  discontinued operations                                     |       | 0.01                                        |       | 0.03 |   |
| Gain on disposal  of discontinued operations                             |       | 0.07                                        |       | — |   |
| Net loss                                                                 |       | $                                           | (0.05      | ) | $ | (0.24 | ) |
| ** **                                                               | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| **Weighted Average Shares Outstanding:**                                 | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Basic                                                                    |       | 58,692,979                                  |       | 50,232,961 |   |
| Diluted                                                                  |       | 58,692,979                                  |       | 50,232,961 |   |

 

The accompanyingnotes are an integral part of these statements.

 

 

52

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**BIO-keyInternational, Inc. and SubsidiarySTATEMENT OF STOCKHOLDERS’ EQUITY (DEFICIT)**

 
| ** **                                                                                                  | ** ** | **Series B  15%**   | ** ** | **Series C 15%** | ** **  | **Series A 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, 2005 (As Restated)**                                                     | ** ** | **—**               | ** ** | **$**                      | **—**  | ** **                | **—**  | ** **            | **$**      | **—**      | ** ** | **44,557**      | ** ** | **$**      | **4**      | ** ** | **46,306,589** | ** ** | **$** | **4,632** | ** ** | **$** | **48,921,316** | ** ** | **$** | **(42,761,946)** | ** ** | **$** | **6,164,006** | ** ** |
| ** **                                                                                                  | ** ** | ** **               | ** ** | ** **                 | ** **  | ** **                | ** **  | ** **            | ** ** | ** **      | ** ** | ** **      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Exchange of  convertible debt for preferred stock                                                           |       | 1,000,000                |       | 1,000,000                  |        | 592,032                   |        | 5,920,320             |       | —          |       | —          |       | —     |       | — |   | — |   | — |   | — |   |
| Discount on preferred stock                                                                                 |       | —                   |       | (360,467                   | )           | —                    |        | (1,073,537            | )          | —          |       | —          |       | —     |       | — |   | — |   | — |   | — |   |
| Accretion of  preferred stock discount                                                                      |       | —                   |       | 107,508                    |        | —                    |        | 174,648               |       | —          |       | —          |       | —     |       | — |   | (282,156 | ) | — |   | (282,156 | ) |
| Accretion of  preferred stock dividends                                                                     |       | —                   |       | 130,000                    |        | —                    |        | 356,370               |       | —          |       | —          |       | —     |       | — |   | (486,370 | ) | — |   | (486,370 | ) |
| Dividends  declared on preferred stock                                                                      |       | —                   |       | (52,603                    | )           | —                    |        | (51,093               | )          | —          |       | —          |       | —     |       | — |   | (606,968 | ) | — |   | (606,968 | ) |
| Stock issuance costs                                                                                        |       | —                   |       | —                     |        | —                    |        | (110,453              | )          | —          |       | —          |       | —     |       | — |   | 110,453 |   | — |   | 110,453 |   |
| Accretion of stock issuance costs                                                                           |       | —                   |       | —                     |        | —                    |        | 17,959                |       | —          |       | —          |       | —     |       | — |   | (17,959 | ) | — |   | (17,959 | ) |
| Conversion of  series A preferred stock and cumulative dividends in arrears into common  stock         |       | —                   |       | —                     |        | —                    |        | —                |       | (14,000         | )          | (1              | )          | 2,801,343  |       | 280 |   | 117,072 |   | — |   | 117,351 |   |
| Conversion of  convertible notes, accrued interest and related discounts and derivatives  into common stock |       | —                   |       | —                     |        | —                    |        | —                |       | —          |       | —          |       | 1,724,632  |       | 172 |   | 414,791 |   | — |   | 414,963 |   |
| Issuance of  common stock and warrants                                                                      |       | —                   |       | —                     |        | —                    |        | —                |       | —          |       | —          |       | 4,000,000  |       | 400 |   | 1,999,600 |   | — |   | 2,000,000 |   |
| Issuance of  shares in exchange for debt payment delay                                                      |       | —                   |       | —                     |        | —                    |        | —                |       | —          |       | —          |       | 300,000    |       | 30 |   | 188,970 |   | — |   | 189,000 |   |
| Exercise of  warrants into common stock                                                                     |       | —                   |       | —                     |        | —                    |        | —                |       | —          |       | —          |       | 26,250     |       | 2 |   | 8,398 |   | — |   | 8,400 |   |
| Share-based compensation                                                                                    |       | —                   |       | —                     |        | —                    |        | —                |       | —          |       | —          |       | —     |       | — |   | 726,772 |   | — |   | 726,772 |   |
| Net loss                                                                                                    |       | —                   |       | —                     |        | —                    |        | —                |       | —          |       | —          |       | —     |       | — |   | — |   | (11,080,851 | ) | (11,080,851 | ) |
| ** **                                                                                                  | ** ** | ** **               | ** ** | ** **                 | ** **  | ** **                | ** **  | ** **            | ** ** | ** **      | ** ** | ** **      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Balance as of December 31, 2006**                                                                    | ** ** | **1,000,000**            | ** ** | **$**                      | **824,438** | ** **                | **592,032** | ** **            | **$**      | **5,234,214**   | ** ** | **30,557**      | ** ** | **$**      | **3**      | ** ** | **55,158,814** | ** ** | **$** | **5,516** | ** ** | **$** | **51,093,919** | ** ** | **$** | **(53,842,797** | **)** | **$** | **(2,743,359** | **)** |
| ** **                                                                                                  | ** ** | ** **               | ** ** | ** **                 | ** **  | ** **                | ** **  | ** **            | ** ** | ** **      | ** ** | ** **      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Accretion of  preferred stock discount                                                                      |       | —                   |       | 126,480                    |        | —                    |        | 449,444               |       | —          |       | —          |       | —     |       | — |   | (575,924 | ) | — |   | (575,924 | ) |
| Accretion of preferred stock dividends                                                                      |       | —                   |       | 149,341                    |        | —                    |        | 903,243               |       | —          |       | —          |       | —     |       | — |   | (1,052,584 | ) | — |   | (1,052,584 | ) |
| Accretion of stock issuance costs                                                                           |       | —                   |       | —                     |        | —                    |        | 46,248                |       | —          |       | —          |       | —     |       | — |   | (46,248 | ) | — |   | (46,248 | ) |
| Conversion of  preferred stock and cumulative dividends in arrears into common stock                        |       | (29,388                  | )          | (218,919                   | )           | —                    |        | (856,918              | )          | —          |       | —          |       | 4,576,206  |       | 457 |   | 1,119,773 |   | — |   | 1,120,230 |   |
| Conversion of  principal and accrued interest on convertible notes into common stock                        |       | —                   |       | —                     |        | —                    |        | —                |       | —          |       | —          |       | 1,418,182  |       | 142 |   | 772,623 |   | — |   | 772,765 |   |
| Fair market  adjustment on equity issuance and warrant modification                                         |       | —                   |       | —                     |        | —                    |        | —                |       | —          |       | —          |       | —     |       | — |   | 124,999 |   |   |   | 124,999 |   |
| Share-based compensation                                                                                    |       | —                   |       | —                     |        | —                    |        | —                |       | —          |       | —          |       | —     |       | — |   | 690,037 |   | — |   | 690,037 |   |
| Net loss                                                                                                    |       | —                   |       | —                     |        | —                    |        | —                |       | —          |       | —          |       | —     |       | — |   | — |   | (1,057,224 | ) | (1,057,224 | ) |
| ** **                                                                                                  | ** ** | ** **               | ** ** | ** **                 | ** **  | ** **                | ** **  | ** **            | ** ** | ** **      | ** ** | ** **      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Balance as of December 31, 2007**                                                                    | ** ** | **970,612**              | ** ** | **$**                      | **881,340** | ** **                | **592,032** | ** **            | **$**      | **5,776,231**   | ** ** | **30,557**      | ** ** | **$**      | **3**      | ** ** | **61,153,202** | ** ** | **$** | **6,115** | ** ** | **$** | **52,126,595** | ** ** | **$** | **(54,900,021** | **)** | **$** | **(2,767,308** | **)** |

 

The accompanying notes arean integral part of these statements.

 

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**BIO-key International, Inc. and SubsidiarySTATEMENTS OF CASH FLOWS**

 
| ** **                                                                            | ** ** | **Years ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                            | ** ** | **2007**                                    | ** ** | **2006** | ** ** |
| ** **                                                                            |       |                                        |       | ** ** |   |   |
| **CASH  FLOW FROM OPERATING ACTIVITIES:**                                             |       |                                        |       |   |   |   |
| Net Loss                                                                              |       | $                                           | (1,057,224 | ) | $ | (11,080,851 | ) |   |
| Less:                                                                                 |       |                                        |       |   |   |   |
| Income from discontinued  operations                                                  |       | (440,105                                    | )          | (1,644,091 | ) |   |
| Gain on disposal of  discontinued operations                                          |       | (4,072,006                                  | )          | — |   |   |
| Loss from continuing  operations                                                      |       | (5,569,335                                  | )          | (12,724,942 | ) |   |
| **Adjustments to reconcile net loss to cash used in operating  activities:**          |       |                                        |       |   |   |   |
| Derivative and warrant fair  value adjustments                                        |       | (1,016,845                                  | )          | (7,542,666 | ) |   |
| Loss on extinguishment of  debt                                                       |       | 403,003                                     |       | 7,815,717 |   |   |
| Depreciation                                                                          |       | 252,678                                     |       | 260,354 |   |   |
| Amortization                                                                          |       |                                        |       |   |   |   |
| Intangible assets                                                                     |       | 761,258                                     |       | 730,045 |   |   |
| Deferred financing costs                                                              |       | 83,871                                      |       | 227,348 |   |   |
| Discounts on convertible debt  related to warrants and beneficial conversion features |       | 360,245                                     |       | 2,774,177 |   |   |
| Allowance for doubtful  receivables                                                   |       | (27,856                                     | )          | 31,694 |   |   |
| Deferred rent                                                                         |       | (499,864                                    | )          | (443,603 | ) |   |
| Fair market value  adjustment on equity issuance and warrant modification             |       | 124,999                                     |       | — |   |   |
| Share-based compensation                                                              |       | 657,599                                     |       | 699,232 |   |   |
| **Change in assets and liabilities:**                                                 | ** ** | ** **                                  | ** ** | ** ** | ** ** |   |
| Accounts receivable trade                                                             |       | 748,647                                     |       | (1,976,791 | ) |   |
| Costs and earnings in  excess of billings on uncompleted contracts                    |       | 920,054                                     |       | 3,099,347 |   |   |
| Inventory                                                                             |       | 6,488                                       |       | (2,605 | ) |   |
| Prepaid expenses and other                                                            |       | 1,162                                       |       | (7,980 | ) |   |
| Accounts payable                                                                      |       | (174,394                                    | )          | 374,414 |   |   |
| Billings in excess of costs  and earnings on uncompleted contracts                    |       | (11,429                                     | )          | 13,289 |   |   |
| Accrued liabilities                                                                   |       | (500,812                                    | )          | (9,192 | ) |   |
| Deferred revenue                                                                      |       | 742,931                                     |       | 589,383 |   |   |
| Net cash used for  continuing operations                                              |       | (2,737,600                                  | )          | (6,092,779 | ) |   |
| Net cash provided by  discontinued operations                                         |       | 576,383                                     |       | 2,541,324 |   |   |
| Net cash used for operating  activities                                               |       | (2,161,217                                  | )          | (3,551,455 | ) |   |
| **CASH  FLOWS FROM INVESTING ACTIVITIES:**                                            |       |                                        |       |   |   |   |
| Capital expenditures                                                                  |       | (49,211                                     | )          | (118,234 | ) |   |
| Deposits                                                                              |       | 312,538                                     |       | 1,028,207 |   |   |
| Proceeds from the sale of  the Fire/EMS business                                      |       | 7,000,000                                   |       | — |   |   |
| Transfer of funds to  restricted cash, net                                            |       | (153,094                                    | )          | — |   |   |
| Patent costs                                                                          |       | 58,164                                      |       | (72,443 | ) |   |
| Net cash provided by  continuing operations                                           |       | 7,168,397                                   |       | 837,530 |   |   |
| Net cash used for  discontinued operations                                            |       | (7,615                                      | )          | (37,678 | ) |   |
| Net cash provided by  investing activities                                            |       | 7,160,782                                   |       | 799,852 |   |   |
| **CASH  FLOW FROM FINANCING ACTIVITIES:**                                             |       |                                        |       |   |   |   |
| Issuance of long-term  obligations                                                    |       | —                                      |       | 988,000 |   |   |
| Repayment of long term  obligations                                                   |       | (4,661,958                                  | )          | (353,037 | ) |   |
| Preferred stock dividends  paid                                                       |       | —                                      |       | (55,868 | ) |   |
| Issuance of common stock                                                              |       | —                                      |       | 1,500,000 |   |   |
| Proceeds from exercise of  options and warrants                                       |       | —                                      |       | 8,400 |   |   |
| Financing costs                                                                       |       | —                                      |       | (131,552 | ) |   |
| Net cash used for  continuing operations                                              |       | (4,661,958                                  | )          | 1,955,943 |   |   |
| Net cash used for  discontinued operations                                            |       | —                                      |       | — |   |   |
| Net cash used for financing  activities                                               |       | (4,661,958                                  | )          | 1,955,943 |   |   |
| **NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS**                              |       | 337,607                                     |       | (795,660 | ) |   |
| **CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD**                                    |       | 627,167                                     |       | 1,422,827 |   |   |
| **CASH  AND CASH EQUIVALENTS, END OF PERIOD**                                         |       | $                                           | 964,774    |   | $ | 627,167 |   |   |
|                                                                                       |            |                                             |            |  |  |  |  |  |  |  |

 

The accompanying notesare an integral part of these statements.

 

54

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**BIO-key International, Inc. and SubsidiaryNOTES TO THE FINANCIAL STATEMENTSDecember 31, 2007 and 2006**

** **

**NOTE A—THE COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

*Nature of Business*

 

The Company, founded in1993, made two strategic acquisitions in 2004. The Company acquired PublicSafety Group Inc. (“PSG”) in March, 2004, and the Mobile Governmentdivision of Aether Systems, Inc. (“AMG” or “Mobile Government”) inSeptember, 2004.

 

BIO-key develops andmarkets proprietary fingerprint identification biometric technology andsoftware 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.

 

*Basis of Presentation*

 

Wehave only recently begun to generate significant revenues and have incurredsignificant losses to date, and at December 31, 2007, we had anaccumulated deficit of approximately $55 million. In addition, broad commercialacceptance of our technology is critical to the Company’s success and abilityto generate future revenues.

 

If theCompany is unable to generate sufficient revenue to meet our goals, we willneed to obtain additional third-party financing to (i) conduct the sales,marketing and technical support necessary to execute our plan to substantiallygrow operations, increase revenue and serve a significant customer base; and (ii) provideworking capital. No assurance can be given that any form of additionalfinancing will be available on terms acceptable to the Company, that adequatefinancing will be obtained by the Company in order to meet its needs, or thatsuch financing would not be dilutive to existing shareholders.

 

The accompanyingfinancial statements have been prepared in conformity with accountingprinciples generally accepted in the United States, which contemplatecontinuation of the Company as a going concern, and assumes continuity ofoperations, realization of assets and the satisfaction of liabilities andcommitments in the normal course of business. The matters described in thepreceding paragraphs raise substantial doubt about the Company’s ability tocontinue as a going concern. Recoverability of a major portion of the recordedasset amounts shown in the accompanying balance sheet is dependent upon theCompany’s ability to meet its financing requirements on a continuing basis, andbecome profitable in its future operations. The accompanying consolidatedfinancial statements do not include any adjustments relating to therecoverability and classification of recorded assets or the amounts andclassification of liabilities that might be necessary should the Company beunable to continue in existence.

 

*Summary of Significant AccountingPolicies*

 

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

 

1.*Basis of Consolidation*

 

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

 

55

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2.*Revenue Recognition*

 

Revenues from softwarelicensing 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 the followingcriteria are met: persuasive evidence of an arrangement exists, delivery hasoccurred, the fee is fixed or determinable, and collectability is probable.

 

The Company intends toenter into arrangements with end users for items which may include softwarelicense fees, and services or various combinations thereof. For eacharrangement, revenues will be recognized when evidence of an agreement has beendocumented, the fees are fixed or determinable, collection of fees is probable,delivery of the product has occurred and no other significant obligationsremain.

 

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). 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.

 

License Revenues: Amountsallocated to license revenues are recognized at the time of delivery of thesoftware and all other revenue recognition criteria discussed above have beenmet.

 

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

 

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

 

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

 

Costs and other expenses: Includes professional compensation andother direct contract expenses, as well as costs attributable to the support ofclient service professional staff, depreciation and amortization costs relatedto assets used in revenue-generating activities, and other costs attributableto serving the Company’s client base. Professional compensation consists ofpayroll costs and related benefits including stock-based compensation andbonuses. Other direct contract expenses include costs directly attributable toclient engagements, such as out-of-pocket costs including travel andsubsistence for client service professional staff, costs of hardware andsoftware and costs of subcontractors. The allocation of lease and facilitiescharges for occupied offices are included in costs of service.

 

56

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3.*Cash and CashEquivalents*

 

Cash equivalents consistof certificates of deposit and all other liquid investments with originalmaturities of three months or less. The Company maintains its cash balances ina financial institution in Nevada. These balances are insured by the FederalDeposit Insurance Corporation up to $100,000.

 

4.*Accounts Receivable*

 

Accounts receivablebilled and unbilled are carried at original amount less an estimate made fordoubtful receivables based on a review of all outstanding amounts on a monthlybasis. 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 accounts receivablepreviously written off are recorded when received.

 

5.*Accounting for Acquisitions*

 

Acquisitionsare accounted for under the purchase method of accounting, which resulted inrecording significant goodwill and other intangible asset balances. Thepurchase prices are allocated to assets acquired and liabilities assumed attheir estimated fair values on the date of the acquisitions, as determined bymanagement, and by appraisals with respect to identifiable intangible assets.Accounting for acquisitions involves significant judgments and estimatesregarding fair values of acquired intangible assets, which are based onprojections of future revenues and cash flows, assumptions regarding discountfactors, royalty rates, tax rates, amortization methodologies and relateduseful lives. Developed technology (software), copyrighted software, marketingagreements, customer relationships and trademarks are valued using the incomeapproach.

 

6.*Depreciation andAmortization*

 

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

 

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

 

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

 

 

57

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The estimated aggregateamortization expense of intangible assets for the five years following December 31,2007 is approximately as follows:

 

| **Year ending December 31,** | ** ** | **($)** | ** ** |
|---------------------------------------------|------------|---------|------------|
| 2008                                        |       | 757,631 |       |
| 2009                                        |       | 358,672 |       |
| 2010                                        |       | 28,384  |       |
| 2011                                        |       | 28,384  |       |
| 2012                                        |       | 28,384  |       |

 

7.*Derivative and Warrant FinancialInstruments*

 

In connection with thesale of debt or equity instruments, we may sell options or warrants topurchase our common stock. In certain circumstances, these options or warrantsmay be classified as derivative liabilities, rather than as equity.Additionally, the debt or equity instruments may contain embeddedderivative instruments, such as conversion options, which in certain circumstancesmay be required to be bifurcated from the associated host instrument andaccounted for separately as a derivative instrument asset or liability.

 

The identification of,and accounting for, derivative instruments is complex. Our derivativeinstrument liability is re-valued at the end of each reporting period, withchanges in the fair value of the derivative liability recorded as charges orcredits to income, in the period in which the changes occur. For options,warrants and bifurcated conversion options that are accounted for as derivativeinstrument liabilities, we determine the fair value of these instruments usingthe Black-Scholes or Binomial option pricing model. That model requiresassumptions related to the remaining term of the instruments and risk-freerates of return, our current common stock price and expected dividend yield,and the expected volatility of our common stock price over the life of theoption. The identification of, and accounting for, derivative instruments andthe assumptions used to value them can significantly affect our financialstatements.

 

8.*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 No. 142 (“SFAS 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 ofeach year using a number of criteria, including the value of the overallenterprise. As of December 31, 2007, 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.

 

9.*Impairment ofLong-Lived Assets*

 

The Company has adoptedSFAS No. 144, Accounting for the Impairment or Disposal of Long-LivedAssets. In accordance with SFAS No. 144, long-lived assets subject todepreciation and amortization are reviewed for impairment whenever events orchanges in circumstances indicate the carrying amount of an asset may notbe recoverable. The Company’s long-lived assets consist primarily of itsequipment and leasehold improvements and its intangible assets. Upon indicationof possible impairment, the Company evaluates the recovery of held-for-uselong-lived assets by measuring the carrying value of the assets against therelated estimated undiscounted future cash flows. When an evaluation indicatesthat the future undiscounted cash flows are not sufficient to recover thecarrying value of the asset, the asset is adjusted to its estimated fair value.The following circumstances would be considered important and could lead to animpairment review; significant changes in the manner of our using the asset,negative industry or economic trends and underperformance relative to projectedoperating results.

 

10.*Advertising Expense*

 

The Company expenses thecosts of advertising as incurred. Advertising expenses for the years ended December 31,2007 and 2006, were approximately $144,000 and $216,000, respectively.

 

 

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11.*DeferredRevenue*

 

Deferred revenue includescustomer advances and amounts that have been billed per the contractual termsbut have not been recognized as revenue. The majority of these amounts arerelated to maintenance contracts for which the revenue is recognized ratablyover the applicable term, which generally is 12 months from the date thecustomer accepts the products.

 

12.*Research andDevelopment Expenditures*

 

Research and developmentexpenses include costs directly attributable to the conduct of research anddevelopment programs primarily related to the development of our softwareproducts 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 areexpensed as incurred.

 

13.*Earnings Per Share Common Stock*

 

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

 

14.*Accounting for Stock-BasedCompensation*

 

The Company accounts forshare based compensation in accordance with the provisions of SFAS 123R, whichrequires measurement of compensation cost for all stock awards at fair value ondate of grant and recognition of compensation over the service period forawards expected to vest. The majority of our share-based compensationarrangements vest over either a three or four year vesting schedule. TheCompany expenses its share-based compensation under the ratable method, whichtreats each vesting tranche as if it were an individual grant. The fair valueof stock options is determined using the Black-Scholes valuation model, andrequires the input of highly subjective assumptions. These assumptions includeestimating the length of time employees will retain their vested stock optionsbefore exercising them (the “expected option term”), the estimated volatilityof our common stock price over the option’s expected term, the risk-freeinterest rate over the option’s expected term, and the Company’s expectedannual dividend yield. Changes in these subjective assumptions can materiallyaffect the estimate of fair value of stock-based compensation and consequently,the related amount recognized as an expense in the consolidated statements ofoperations. As required under the accounting rules, we review our valuationassumptions at each grant date and, as a result, are likely to change ourvaluation assumptions used to value employee stock-based awards granted infuture periods. The values derived from using the Black-Scholes model arerecognized as expense over the service period, net of estimated forfeitures(the number of individuals that will ultimately not complete their vesting requirements).The estimation of stock awards that will ultimately vest requires significantjudgment. We consider many factors when estimating expected forfeitures,including types of awards, employee class, and historical experience. Actualresults, and future changes in estimates, may differ substantially from ourcurrent estimates.

 

The compensation expenserecognized under SFAS 123R increased the Company’s loss from continuingoperations by $657,599 and $699,232 with a $0.01 effect per share (basic anddiluted), for the years ended December 31, 2007 and 2006 respectively.

 

 

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The following tablepresents share-based compensation expenses for continuing operations includedin the Company’s consolidated statements of operations:

 

| ** **                             | ** ** | **Year ended  December 31,** | ** ** |
|----------------------------------------|------------|----------------------------------------|------------|
| ** **                             | ** ** | **2007**                               | ** ** | **2006** | ** ** |
|                                   |       |                                   |       |   |   |
| Cost of services                       |       | $                                      | 18,842     |   | $ | 60,834 |   |
| Selling, general and  administrative   |       | 467,583                                |       | 485,110 |   |
| Research, development  and engineering |       | 171,174                                |       | 153,288 |   |
|                                   |       | $                                      | 657,599    |   | $ | 699,232 |   |

 

*ValuationAssumptions for Stock Options*

 

For the years ended December 31,2007 and 2006, 290,000 and 2,382,669 stock options were granted, respectively.The fair value of each option was estimated on the date of grant using theBlack-Scholes option-pricing model with the following assumptions:

 

| ** **                          | ** ** | **Year ended  December 31,** | ** ** |
|-------------------------------------|------------|----------------------------------------|------------|
| ** **                          | ** ** | **2007**                               | ** ** | **2006** | ** ** |
| Risk free interest rate             |       | 4.58-4.68                              | %          | 4.53-5.08 | % |
| Expected life of options (in years) |       | 4.5                                    |       | 4.0-7.0 |   |
| Expected dividends                  |       | 0                                      | %          | 0 | % |
| Volatility of stock price           |       | 86-88                                  | %          | 92-129 | % |

 

The stock volatility foreach grant is determined based on the review of the experience of the weightedaverage of historical daily price changes of the Company’s common stock overthe expected option term. The expected term was determined using the simplifiedmethod for estimating expected option life, which qualify as “plain-vanilla”options; and the risk-free rate is based on the U.S. Treasury yield curve ineffect at the time of grant for periods corresponding with the expected life ofthe option.

 

15.*Income Taxes*

 

The provision for, orbenefit from, income taxes includes deferred taxes resulting from the temporarydifferences in income for financial and tax purposes using the liabilitymethod. Such temporary differences result primarily from the differences in thecarrying value of assets and liabilities. Future realization of deferred incometax assets requires sufficient taxable income within the carryback,carryforward period available under tax law. The Company evaluates, on aquarterly basis whether, based on all available evidence, if it is probablethat the deferred income tax assets are realizable. Valuation allowances areestablished when it is more likely than not that the tax benefit of thedeferred tax asset will not be realized. The evaluation, as prescribed byStatement of Financial Accounting Standards No. 109, “Accounting forIncome Taxes,” includes the consideration of all available evidence, bothpositive and negative, regarding historical operating results including recentyears with reported losses, the estimated timing of future reversals ofexisting taxable temporary differences, estimated future taxable incomeexclusive of reversing temporary differences and carryforwards, and potentialtax planning strategies which may be employed to prevent an operating lossor tax credit carryforward from expiring unused. Because of the Company’shistorical performance and estimated future taxable income a full valuationallowance has been established.

 

16.*Use of Estimates*

 

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

 

Estimates and assumptionswhich, in the opinion of management are used in accounting for, among otherthings, long-

 

 

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term contracts, allowances for uncollectiblereceivables, recoverability of goodwill and other long-lived assets,depreciation and amortization, valuation of deferred income taxes, convertiblenotes and related discounts, embedded derivates, preferred stock, share-basedcompensation, and warrants outstanding.

 

17.*Comprehensive Loss*

 

Comprehensive lossconsists of net loss and other gains and losses affecting shareholders’equity/(deficit) that, under generally accepted accounting principles, areexcluded from net loss in accordance with Statement of Financial AccountingStandards No. 130, “Reporting Comprehensive Income.” The Company, however,does not have any components of other comprehensive loss as defined by SFAS No. 130and therefore, for the years ended December 31, 2007 and 2006,comprehensive loss is equivalent to the Company’s reported net loss.Accordingly, a separate statement of comprehensive loss is not presented.

 

18.*Recent Accounting Pronouncements*

 

In September 2006,the FASB issued SFAS No. 157, “Fair Value Measurements,” which iseffective for calendar year companies on January 1, 2008. The Statementdefines fair value, establishes a framework for measuring fair value inaccordance with Generally Accepted Accounting Principles, and expandsdisclosures about fair value measurements. The Statement codifies thedefinition of fair value as the price that would be received to sell an assetor paid to transfer a liability in an orderly transaction between marketparticipants at the measurement date. The standard clarifies the principle thatfair value should be based on the assumptions market participants would usewhen pricing the asset or liability and establishes a fair value hierarchy thatprioritizes the information used to develop those assumptions. In February 2008,the FASB issued a Staff Position that will (1) partially defer theeffective date of SFAS 157 for one year for certain nonfinancial assetsand nonfinancial liabilities and (2) remove certain leasing transactionsfrom the scope of SFAS 157. The Company is currently assessing thepotential impacts of implementing this standard.

 

InFebruary, 2007, the FASB issued SFAS No. 159, “The Fair Value Option forFinancial Assets and Financial Liabilities,” which is effective for calendaryear companies on January 1, 2008. The statement allows an entity theirrevocable option to elect fair value for the initial and subsequentmeasurement for certain financial assets and liabilities on acontract-by-contract basis. Subsequent changes in fair value of these financialassets and liabilities would be recognized in earnings when they occur. SFAS159 further establishes certain additional disclosure requirements. Managementis currently evaluating the impact and timing of the adoption of SFAS 159 onthe Corporation’s financial condition and results of operations.

 

In December 2007,the FASB issued SFAS No. 141(R), *“BusinessCombinations”*, which replaces SFAS No. 141. SFAS No. 141(R) establishesprinciples and requirements for how an acquirer recognizes and measures in itsfinancial statements the identifiable assets acquired, the liabilities assumed,any non-controlling interest in the acquiree and the goodwill acquired. TheStatement also establishes disclosure requirements which will enable users toevaluate the nature and financial effects of the business combination. SFAS 141(R) iseffective for calendar year companies on January 1, 2009. The adoption ofSFAS 141(R) will have an impact on accounting for business combinationsonce adopted, but the effect is dependent upon acquisitions at that time.

 

In December 2007,the FASB issued SFAS No. 160, “NoncontrollingInterests in Consolidated Financial Statements — an amendment of AccountingResearch Bulletin No. 51”, which establishes accounting andreporting standards for ownership interests in subsidiaries held by partiesother than the parent, the amount of consolidated net income attributable tothe parent and to the noncontrolling interest, changes in a parent’s ownershipinterest and the valuation of retained non-controlling equity investments whena subsidiary is deconsolidated. The Statement also establishes reportingrequirements that provide sufficient disclosures that clearly identify anddistinguish between the interests of the parent and the interests of thenon-controlling owners. SFAS 160 is effective for calendar year companies on January 1,2009. The Company has not determined the effect that the application of SFAS160 will have on its consolidated financial statements.

 

In December 2007,the  SEC issued Staff Accounting Bulletin110. SAB 110 expresses the views of the staff regarding the use of a “simplified”method, as discussed in SAB No. 107 (“SAB 107”), in developing an estimateof expected term of “plain vanilla” share options in accordance with Statementof Financial Accounting Standards No. 123 (revised 2004).  SAB 110 isnot expected to have a significant impact on the entity consolidated financialstatements.

 

 

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**NOTE B—DISCONTINUED OPERATIONS**

 

On May 22, 2007, theCompany and ZOLL Data Systems, Inc. (“ZOLL”), a subsidiary of ZOLL MedicalCorporation, entered into an Asset Purchase Agreement (the “Purchase Agreement”),pursuant to which ZOLL acquired substantially all of the assets related to theCompany’s Fire/EMS Services division (the “Fire Segment” or “Fire”).

 

At the closing of thesale, the Company received approximately $1.8 million in cash, whichrepresented the purchase price of $7 million, less closing adjustments ofapproximately $4.3 million, which was paid to the Senior Noteholder (see NoteL), approximately $450,000, which was paid to the leaseholder of the Company’spremises, $400,000, which was placed in escrow pursuant to the PurchaseAgreement, and approximately $40,000 credited to ZOLL on the assumption ofcertain liabilities.

 

During the period ended December 31,2007, $250,000 of the escrow balance was released to ZOLL. It is expected theremaining escrow balance, less applicable adjustments (if approved) shall beremitted to the Company over the next six months.

 

The Company recorded anet gain on the sale of the Fire Segment of $4,072,006, or $0.07 per dilutedshare.

 

Prior to the sale, Firehad been reported as a separate segment. The Company sold its Fire operatingsegment to better focus on its other core lines of business. The Fire businesshas been reported as a discontinued operation in accordance with SFAS No. 144,*“Accounting for the Impairment or Disposalof Long-Lived Assets,”*and all periods presented have been recastaccordingly to reflect these operations as discontinued.

 

Revenues and net income(loss) for the Fire Segment for the years ended December 31, 2007 and 2006were as follows:

 

| ** **        | ** ** | **Year Ended  December 31,** | ** ** |
|-------------------|------------|----------------------------------------|------------|
| ** **        | ** ** | **2007**                               | ** ** | **2006** | ** ** |
|              |       |                                   |       |   |   |
| Revenues          |       | 1,546,746                              |       | 3,905,587 |   |
| Net income (loss) |       | 440,105                                |       | 1,644,091 |   |

 

 

**NOTE C—ACQUISITIONS**

 

*Acquisition of Public Safety Group, Inc.*

 

On March 30, 2004,we acquired all of the outstanding capital stock of Public Safety Group, Inc.(PSG), a privately-held leader in wireless solutions for law enforcement andpublic safety markets based in Winter Park, Florida, in exchange for anaggregate of 2,416,108 shares of our common stock issued to the formershareholders of PSG, 6,000 shares of our common stock issued to HarwardInvestments, Inc. (“Harward”), $500,000 in cash, and our assumption of$600,000 in aggregate net liabilities of PSG, for an aggregate purchase priceof $4,108,941.

 

The 2,416,108 sharesissued to the PSG shareholders were subject to the provisions contained in theMerger Agreement and a related escrow agreement, which provided for periodicreleases of the shares from escrow on a schedule determined by therevenues achieved by the Public Safety Division. As at December 31, 2007,all Merger Shares had been released from escrow under the Merger Agreement.

 

*Acquisition of Mobile Government*

 

On September 30,2004, we acquired certain assets and assumed certain liabilities of the MobileGovernment division of Aether Systems, Inc (Aether). The aggregate purchaseprice of the acquisition was $12,198,171.

 

In conjunction with theacquisition of the Mobile Government division, the Company was required toplace funds into escrow, which comprised of the following as at December 31,2007:

 

 

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·                  There is approximately $479,000 in escrow which isavailable to Aether in the event the Company defaults on the subleaseagreement. The funds will not be available for use by the company until thetermination of the lease in August 2008.

 

Also, in connection withthis acquisition, the Company issued a subordinated secured promissory note toAether in the face amount of $6,884,588 (the “Aether Note”), which was amendedon January 23, 2006 to $7,884,588. The Aether Note evidenced a contingentreimbursement obligation of the Company to Aether and a surety fee payable bythe Company to Aether, in each case with respect to a letter of creditmaintained by Aether for the Company’s benefit in connection with theacquisition. The letter of credit expired on December 31, 2006, and wasnot renewed by Aether. Pursuant to the amended Aether Note agreement, BIO-key’sobligations under the Aether Note ended on January 30, 2007, representing30 days following the expiration of the letter of credit. BIO-key’s remainingobligations to Aether as at December 31, 2007 relate to the subleaseagreement, which expires in August 2008.

 

**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 receivables and costs and earnings inexcess of billings on uncompleted contracts at the end of each reporting periodand to establish allowances where appropriate. The Company analyzes historicalbad debts and contract losses, customer concentrations, and customer credit-worthinesswhen evaluating the adequacy of the allowances.

 

As of December 31,2007, five customers accounted for approximately 53% of the Company’soutstanding accounts receivable balance. As of December 31, 2007 onecustomer accounted for 100% of the balance in the account costs and earnings inexcess of billings on uncompleted contracts. No single customer accounted formore than 10% of revenue for the year ended December 31, 2007. Onecustomer, accounted for approximately 12% of revenue for the year ended December 312006.

 

Approximately 91% and 90%of our total revenues for the years ended December 31, 2007, and 2006,respectively,  and approximately 75% ofthe balance in our outstanding accounts receivable as at December 31,2007, were derived from governmental entities, sourced from either our directsales efforts, or through our network of resellers.

 

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

 

The components ofuncompleted contracts consisted of the following as of December 31, 2007:

 

| ** **                                                         | ** ** | **2007**   | ** ** |
|--------------------------------------------------------------------|------------|------------|------------|
| ** **                                                         | ** ** | ** ** | ** ** |
| Cost and  earnings incurred on uncompleted contracts               |       | $          | 7,338,571  |   |
|                                                               |       |       |       |
| Less billings to  date                                             |       | (7,104,766 | )          |
|                                                               |       |       |       |
|                                                               |       | $          | 233,805    |   |
|                                                               |       |       |       |
| Costs and earnings in excess of billings on  uncompleted contracts |       | $          | 233,805    |   |
|                                                               |       |       |       |
| Billings in excess of costs and earnings on  uncompleted contracts |       | —     |       |
|                                                               |       |       |       |
|                                                               |       | $          | 233,805    |   |

 

 

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**NOTE F—PREPAID EXPENSES**

 

Prepaid expensesconsisted of the following as of December 31, 2007:

 

| ** **                      | ** ** | **2007**   | ** ** |
|---------------------------------|------------|------------|------------|
| ** **                      | ** ** | ** ** | ** ** |
| Insurance and software licenses |       | $          | 113,968    |   |
| Other                           |       | 5,100      |       |
|                            |       |       |       |
| Total                           |       | $          | 119,068    |   |

 

**NOTE G—EQUIPMENT AND LEASEHOLDIMPROVEMENTS**

 

Equipment andleasehold improvements consisted of the following as of December 31, 2007:

 

| ** **                                     | ** ** | **2007**   | ** ** |
|------------------------------------------------|------------|------------|------------|
| ** **                                     | ** ** | ** ** | ** ** |
| Equipment                                      |       | $          | 517,658    |   |
| Furniture and fixtures                         |       | 187,984    |       |
| Software                                       |       | 136,355    |       |
| Leasehold improvements                         |       | 198,889    |       |
|                                           |       | 1,040,886  |       |
|                                           |       |       |       |
| Less accumulated depreciation and amortization |       | (863,604   | )          |
|                                           |       |       |       |
| Total                                          |       | $          | 177,282    |   |

 

**NOTE H—OTHER ASSETS**

 

*Goodwill*

 

TheCompany’s goodwill resulted from the acquisition of Public Safety Group, Inc.and certain assets and assumed liabilities of the Mobile Government Division ofAether Systems, Inc. in 2004. As provided by SFAS No. 142, theCompany has elected to perform the annual assessment of the carrying value ofall goodwill as of September 30th of each year using a numberof criteria, including the value of the overall enterprise. As of September 30,2007, the Company believes no material impairment exists. Future impairmentcharges from existing operations or other acquisitions, if any, will bereflected as an operating expense in the statement of operations in the periodin which the impairment is identified. As of December 31, 2007 goodwilltotaled $7,836,986.

 

Thechanges in the carrying amount of goodwill for the year ended December 31,2007, were as follows:

 

| ** **                                               | ** ** | **Law Segment** | ** ** | **Fire Segment** | ** ** | **Total**  | ** ** |
|----------------------------------------------------------|------------|-----------------|------------|------------------|------------|------------|------------|
| ** **                                               | ** ** | ** **      | ** ** | ** **       | ** ** | ** ** | ** ** |
| Balance as of January 1, 2007                       |       | $               | 7,836,986  |             | $          | 3,552,668  |       | $ | 11,389,654 |   |
| Goodwill included in gain on disposal of reporting  unit |       | —          |       | (3,552,668       | )          | (3,552,668 | )          |
|                                                     |       |            |       |             |       |       |       |
| Balance as of December 31, 2007                     |       | $               | 7,836,986  |             | $          | —     |       | $ | 7,836,986 |   |

 

 

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*Intangible Assets*

 

Intangible assetsconsisted of the following as of December 31, 2007:

 
| ** **                  | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net Carrying  Amount** | ** ** |
|-----------------------------|------------|-----------------------------|------------|-------------------------------|------------|-------------------------------|------------|
| ** **                  | ** ** | ** **                  | ** ** | ** **                    | ** ** | ** **                    | ** ** |
| Copyrighted software        |       | $                           | 1,181,429  |                          | $          | (886,071                      | )          | $ | 295,358 |   |
| Customer relationships      |       | 617,271                     |       | (401,225                      | )          | 216,046                       |       |
| Trademarks                  |       | 807,872                     |       | (563,099                      | )          | 244,773                       |       |
| Developed technology        |       | 434,353                     |       | (282,330                      | )          | 152,023                       |       |
| Marketing agreements        |       | 605,340                     |       | (454,005                      | )          | 151,335                       |       |
| Patents and patents pending |       | 298,059                     |       | (33,325                       | )          | 264,734                       |       |
|                        |       |                        |       |                          |       |                          |       |
| Total                       |       | $                           | 3,944,324  |                          | $          | (2,620,055                    | )          | $ | 1,324,269 |   |

 

Aggregate amortizationexpense for the year ended December 31, 2007 and 2006, was $761,258 and$730,045 respectively.

 

#### *Deferred financing costs*

####  

Deferred financing costsare amortized based upon the lives of the respective debt obligations.  Due to the repayment of all convertible debtduring the year, the net book value of the associated deferred financing costswas written off to Loss on Extinguishment of Debt (see Note Q).

 

Amortization of deferredfinancing costs prior to the repayment of convertible debt was included ininterest expense, and was $83,871 and $227,348 for the years ended December 31,2007 and 2006 respectively.

 

*Deferred Offering Costs*

 

The Company 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,the fair market value of which was amortized over the life of the associateddebt. During 2005, approximately $266,000 was charged to non-cash interestexpense. As the associated debt was extinguished in January 2006, thebalance of the warrants was written off at that time.

 

*Deposits*

 

Deposits consistedof the following as of December 31, 2007:

 

| ** **                | ** ** | **2007**   | ** ** |
|---------------------------|------------|------------|------------|
| ** **                | ** ** | ** ** | ** ** |
| Lease deposit with Aether |       | $          | 479,403    |   |
| Property deposits         |       | 8,412      |       |
|                      |       |       |       |
| Total                     |       | $          | 487,815    |   |

 

Leaseand property deposits are held over three of the Company’s premises as securityfor contractual performance under certain operating leases. At the conclusionof these lease arrangements, which is expected to occur over a number of datesthrough August 2009, the lease and property deposits shall be returned tothe Company.

 

 

 

 

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**NOTE I—ACCRUED LIABILITIES**

 

Accruedliabilities consisted of the following as of December 31, 2007:

 

| ** **                                 | ** ** | **2007**   | ** ** |
|--------------------------------------------|------------|------------|------------|
| ** **                                 | ** ** | ** ** | ** ** |
| Contract costs not yet invoiced by vendors |       | $          | 2,185,610  |   |
| Compensation                               |       | 140,314    |       |
| Compensated absences                       |       | 367,731    |       |
| Royalties                                  |       | 371,158    |       |
| Interest                                   |       | 176,083    |       |
| Other                                      |       | 160,853    |       |
|                                       |       |       |       |
| Total                                      |       | $          | 3,401,749  |   |

 

 

**NOTE J—RELATED PARTY**

 

**Consulting Arrangement with Thomas J.Colatosti**

 

In connection with hisappointment to the Board of Directors in September 2002, the Companyentered into a number of consulting arrangements with Thomas J. Colatosti.Under the most recent arrangement, which was entered into on November 1,2004, and extended on February 7, 2006, and again on July 12, 2007, Mr. Colatosti,provided services to the Company and its subsidiaries and affiliates for theyears ended December 31, 2007 and 2006, at a rate of $12,000 and $14,500per month, respectively.

 

Mr. Colatosti hassubstantial experience in the biometric industry and in addition to his role asthe Chairman of the Board of Directors of the Company, provides extensiveservice to the Company in the areas of strategic planning and corporatefinance. During the years ended December 31, 2007 and 2006, the Companypaid Mr. Colatosti approximately $144,000 and $174,000, respectively. Asat December 31, 2007, the Company owed Mr. Colatosti $72,000.

 

In March 2004, Mr. Colatostientered into a three year consulting arrangement with the Shaar Fund Ltd., aprincipal creditor and long-term shareholder of the Company. Under the terms ofthe 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%convertible preferred stock to Mr. Colatosti in conversion of the $375,000secured convertible note.

 

**NOTE K—DEFERRED REVENUE**

 

The components of DeferredRevenue are as follows as of December 31, 2007:

 

| ** **                                                   | ** ** | **2007**   | ** ** |
|--------------------------------------------------------------|------------|------------|------------|
| ** **                                                   | ** ** | ** ** | ** ** |
| **Current Portion**                                          | ** ** | ** ** | ** ** |
| Maintenance contracts                                        |       | $          | 3,638,988  |   |
| Fully deferred systems, installation and acceptance  revenue |       | 829,760    |       |
|                                                         |       | 4,468,748  |       |
| **Long-Term Portion**                                        | ** ** | ** ** | ** ** |
| Maintenance contracts                                        |       | 34,518     |       |
|                                                         |       |       |       |
| **Total**                                                    |       | $          | 4,503,266  |   |

 

Maintenancecontracts include provisions for unspecified when-and-if available productupdates and customer telephone 

 

 

 

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support services, and arerecognized ratably over the term of the service period. Fully deferred systems,installation and acceptance revenue relates to projects that have been billedper the contractual terms, however because of undelivered elements oracceptance criteria, revenue has not yet been recognized. These amounts areexpected to be completed within the next 12 months and are classified ascurrent liabilities.

 

Long-termmaintenance contracts are recognized ratably over the applicable term. The termfor these contracts begin upon the completion and acceptance of the long-termprojects, which can be delayed based on various criteria ranging from customerconstraints to project change orders. Because of the uncertainty of the timingof acceptance on these long-term projects this deferred revenue has beenclassified as a long-term liability.

 

**NOTE L—CONVERTIBLE DEBT FINANCING /WARRANTS**

 

Long-termobligations consisted of the following as of December 31, 2007:

 

| ** **      | ** ** | **2007**   | ** ** |
|-----------------|------------|------------|------------|
| ** **      | ** ** | ** ** | ** ** |
| **2004**        | ** ** | ** ** | ** ** |
| FMV of warrants |       | $          | 11,663     |   |
| **2005**        | ** ** | ** ** | ** ** |
| FMV of warrants |       | 34,644     |       |
| **2006**        | ** ** | ** ** | ** ** |
| FMV of warrants |       | 18,213     |       |
| **Total**       |       | $          | 64,520     |   |

 

***Senior Convertible Term Notes***

 

**2004 and 2005 Senior Notes**

 

On September 29,2004, we entered into a Securities Purchase Agreement (the “2004 SeniorPurchase Agreement”) with Laurus Master Fund, Ltd. (“Laurus”) to issuesecured convertible term notes in the aggregate principal amount of$5,050,000.  On June 8, 2005, weentered into a second Securities Purchase Agreement (the “2005 Senior PurchaseAgreement”) with Laurus to issue secured convertible term notes in theaggregate principal amount of $2,000,000.

 

On May 22,2007, the Company used approximately $4,300,000 of the net cash proceeds receivedin connection with the sale of the Fire Segment (see Note B) to repay in fullits obligations to Laurus under the 2004 and 2005 Senior Notes.

 

The account balance shownrepresents the fair market value of warrants issued in conjunction with debtofferings undertaken from the 2004 to 2006 fiscal years. The Warrants areclassified as liabilities and were valued as of December 31, 2007, usingthe Black Scholes Option Pricing model with the following assumptions: dividendyield of 0%; annual volatility of 84% to 92% and risk-free interest rate of3.0% to 4.0%.

 

**2004 and2005 Senior Note Derivatives and Discounts**

 

The 2004 and 2005 SeniorNotes contained features that were considered embedded derivative financialinstruments, such as: Principal’s conversion option, Monthly PaymentsConversion Option, Interest Rate Adjustment provision, and the Defaultprovision. These features were bifurcated and recorded on the Company’s balancesheet at their fair value.

 

Following the repaymentof the 2004 and 2005 Senior Notes on May 22, 2007, the value of theembedded derivatives and amortized discounts related to the Notes were writtenoff to Loss on Extinguishment of Debt (see Note Q).

 

 

 

67

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**Conversionof Default Interest Payable on 2004 and 2005 Senior Notes**

 

With respect to theconvertible notes issued in 2004 and 2005, the Company was required to makeinterest payments or issue registered shares in lieu of interest payments on amonthly basis.

 

Due to the previous defaultson Senior and Subordinated Notes held by the Company, obligations totaling$622,765 were accrued in prior periods. Effective April 18, 2007, theCompany entered into an agreement with Laurus to satisfy these default interestobligations in full by issuing shares of the Company’s restricted common stockto Laurus. This agreement was subject to a condition that the Company wouldconsummate a business transaction on or before May 18, 2007, or such laterdate as the parties agreed, which would raise sufficient proceeds to repay allof the Company’s obligations under the 2004 and 2005 Senior Notes, as notedabove.

 

On May 22, 2007, inaccordance with the agreement with Laurus, the Company converted the balance ofthe default interest payable into shares of restricted common stock.

 

**NOTE M—SEGMENT INFORMATION**

** **

The Company’s consolidated operations are divided intotwo segments: Law and Biometric. The Company evaluates performance andallocates resources based on revenues and operating income (loss). Operatingincome (loss) for each segment includes selling, general and administrativeexpenses directly attributable to the segment in addition to those allocated asa percentage based on the segment’s budgeted revenues. The segmentation ofoperating income (loss) 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.

 

Prior to the sale of theFire business in May 2007, Fire had been reported as a separate segment.Prior periods presented have been recast accordingly to reflect theseoperations as discontinued. Geographically, North American sales accounted forapproximately 100% of the Company’s total sales for fiscal years 2007 and 2006.

 

Summarized financial information concerning ourreportable segments is shown in the following table:

 

| ** **                                    | ** ** | **For the Years Ended December 31,** | ** ** |
|-----------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                    | ** ** | **2007**                                                      | ** ** | **2006** | ** ** |
| ** **                                    | ** ** | ** **                                                    | ** ** | ** ** | ** ** |
| **Revenue:**                                  | ** ** | ** **                                                    | ** ** | ** ** | ** ** |
| Law                                           |       | $                                                             | 9,073,200  |   | $ | 10,426,984 |   |
| Biometrics                                    |       | 915,256                                                       |       | 861,054 |   |
| Consolidated  Revenue                         |       | 9,988,456                                                     |       | 11,288,038 |   |
| **Segment operating income (loss)**           | ** ** | ** **                                                    | ** ** | ** ** | ** ** |
| Law                                           |       | (3,610,922                                                    | )          | (4,013,959 | ) |
| Biometrics                                    |       | (1,754,060                                                    | )          | (2,658,583 | ) |
| Total Segment  Operating Income (Loss)        |       | (5,364,982                                                    | )          | (6,672,542 | ) |
| **Reconciliation to net loss**                | ** ** | ** **                                                    | ** ** | ** ** | ** ** |
| Interest income                               |       | 3,097                                                         |       | — |   |
| Interest expense                              |       | (832,457                                                      | )          | (5,730,712 | ) |
| Derivative and warrant fair value adjustments |       | 1,016,845                                                     |       | 7,542,666 |   |
| Loss on extinguishment of debt                |       | (403,940                                                      | )          | (7,815,717 | ) |
| Other expense                                 |       | 12,102                                                        |       | (48,637 | ) |
| **Net loss from continuing operations**       |       | (5,569,335                                                    | )          | (12,724,942 | ) |
| Income (loss)  from discontinued operations   |       | 440,105                                                       |       | 1,644,091 |   |
| Gain on disposal  of discontinued operations  |       | 4,072,006                                                     |       | — |   |
| **Net  loss**                                 |       | $                                                             | (1,057,224 | ) | $ | (11,080,851 | ) |

 

 

 

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**NOTE N—COMMITMENTS AND CONTINGENCIES**

 

*Operating Leases*

 

The Company does not own any real estate but conductsoperations from four leased premises. These non-cancelable operating leases expireat various dates through 2009. In addition to base rent, the Company pays forproperty taxes, maintenance, insurance and other occupancy expenses accordingto the terms of the individual leases. The Company also leases equipment, witha non-cancelable operating lease expiring in 2010.

 

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

 

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

 

| **Years ending December 31,** | ** ** | ** ** | ** ** |
|----------------------------------------------|------------|------------|------------|
| 2008                                         |       | $          | 900,059    |   |
| 2009                                         |       | 36,089     |       |
| 2010                                         |       | 1,458      |       |
| 2011                                         |       | —     |       |
| 2012                                         |       | —     |       |
|                                         |       |       |       |
|                                         |       | $          | 937,606    |   |

 

Rental expense was approximately $942,000 and $853,000during 2007 and 2006, respectively.

 

*Employment Agreements*

 

The Company has employment agreements with threeemployees. These agreements allow the continuation of the employee’s salary inthe event of termination without cause. The agreements also acknowledge theemployee’s eligibility to participate in the Company’s bonus and option plans,the terms of which have not yet been established. As of December 31, 2007,the aggregate commitment under these agreements was approximately $352,000.

 

*Legal Proceedings*

 

         In the normal course of business, the Company periodically becomes involved in litigation. As of December 31, 2007, in the opinion of management, the Company had no pending litigation that would have a material adverse effect on the Company’s financial position, results of operations or cash flows.

 

*Accrued Royalties*

 

From time to time, the Company licenses or sellsproducts which may include technology obtained from third parties under aroyalty agreement. These agreements obligate the company to pay the third partya fixed fee, or in some instances, a percentage of the associated revenue. Thefees are generally due and payable only when software has been installed andaccepted by the customer. For the years ended December 31, 2007 and 2006,royalty expense was approximately $102,000 and $192,000, respectively.

 

*LiquidatedDamages*

 

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

 

The Company’s mostsignificant exposure to liquidated and other damages is with its largestuncompleted contract with 

 

 

 

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Hamilton County, Ohio (“Hamilton”). The Hamiltoncontract limits the Company’s liability for damage to approximately$10,000,000. Management believes the contract will be completed within contractterm including defined specification for performance, and accordingly, paymentof damages under the contract is not likely. However, the project is notcomplete and there can be no assurances damages will not be incurred in thefuture. If damages are incurred there can be no assurance that any amountsrequired to be paid will not be material to the financial statements.

 

*Warranty Reserve*

 

In some instances the Company may make commitments toprovide additional products or services to customers beyond those obligationsspecified in the contract or those provided in standard maintenance agreementsor ordinary upgrades. These commitments usually arise in complex customer installationsand are granted to help ensure customer satisfaction. As of December 31,2007, there was no material requirement for an accrued warranty liabilityreserve.

 

**NOTE O— EQUITY**

 

1.Mezzanine Equity

 

*RedeemablePreferred Stock*

 

**Series B Convertible Preferred Stock**

 

TheCompany issued 1,000,000 shares of redeemable Series B ConvertiblePreferred Stock on February 23, 2006, upon the conversion of the 2006Convertible Notes. Each share of Series B preferred stock has an OriginalIssue Price of $1.00 per share. The holder has the option to redeem the sharesof Series B preferred stock at any time for a number of shares of theCompany’s common stock equal to the Original Issue Price plus accumulated andunpaid dividends divided by the fixed conversion price of $0.30 per share ofCommon Stock. The conversion price is subject to adjustment if common stock isissued by the Company subsequent to the original issue date of the Series Bpreferred stock, except for other conversions, options, warrants, dividendspaid in stock or pursuant to an acquisition by the Company, at a price lessthan the conversion price. Mandatory conversion of all Series B shareswill be automatic if, for the 30 trading days prior to January 1, 2009,the average closing bid price for one share of common stock is at least $1.10.The shares shall be converted at the conversion price then in effect. If theaverage bid price for the 30 trading days prior to January 1, 2009 percommon share is less than $1.10 the Company shall mandatorily redeem allremaining outstanding Series B preferred stock by paying cash equal to$1.00 per share with all accrued and unpaid dividends.  The Company may, at its election, redeem anyor all of the remaining outstanding Series B shares in cash at aconversion price equal to $1.20 per share, together with all accrued and unpaiddividends upon giving 30 day notice. Holders of the Series B preferredstock are entitled to cumulative, prior and in preference to holders of commonstock dividends equal to 15% per annum of the Original Purchase Price stilloutstanding, payable quarterly commencing April 1, 2006. In anyliquidation of the Company, each share of preferred stock is entitled to aliquidation preference on a pari passu basis with the Series A and Series CPreferred stock before any distribution may be made on the Company’s commonstock.

 

As of December 31,2007, 1,000,000 preferred stock shares were authorized, 970,612 of which wereissued and outstanding, at a par value of $0.0001 and a liquidation preferenceof $1.00 with accumulated dividends in arrears of $37,207, which have beenaccreted to the principal balance of the Series B preferred stock.

 

The Preferred Stockcontains features that are considered embedded derivative financialinstruments:  Preferred Stock’sconversion option:  The Preferred Stockis convertible at the Holder’s option at any time at the fixed conversion priceof $0.30 per share; Quarterly Dividends Conversion Option:  Holders have the option to convert the Stock’squarterly dividend payment at a conversion price of the average 10 days closingprice prior to the dividend record date. These features have been bifurcated and recorded on the Company’sbalance sheet as liabilities, at their fair value.

 

As of December 31,2007, the derivatives were valued at $6,005. Conversion related derivatives were valued using the Binomial OptionPricing Model with the following assumptions: dividend yield of 15%; annualvolatility of 54%; and risk free annual interest rate of 3.3% as well asprobability analysis related to trading volume restrictions.

 

 

 

 

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Anamount equal to the original value of the derivatives was recorded as adiscount to the Preferred Stock.  Thediscount is being accreted to the principal balance of the Preferred Stock,using the effective interest method, over the expected term of the term of thePreferred Stock.  At December 31,2007, the unamortized discount on the Preferred Stock was $126,480.

 

**Series CConvertible Preferred Stock**

 

TheCompany issued 592,032 shares of redeemable Series C Convertible PreferredStock on August 10, 2006, upon the exchange of certain 2004 and 2005Subordinated Notes. Each share of Series C preferred stock has an OriginalIssue Price of $10.00 per share. The holder has the option to redeem the sharesof Series C preferred stock at any time for a number of shares of theCompany’s common stock equal to the Original Issue Price plus accumulated andunpaid dividends divided by the fixed conversion price of $0.30 per share ofCommon Stock. The conversion price is subject to adjustment if common stock isissued by the Company subsequent to the original issue date of the Series Cpreferred stock, except for other conversions, options, warrants, dividendspaid in stock or pursuant to an acquisition by the Company, at a price lessthan the conversion price. Mandatory conversion of all Series C shareswill be automatic if, for the 30 trading days prior to January 1, 2009,the average closing bid price for one share of common stock is at least $1.20.The shares shall be converted at the conversion price then in effect. If theaverage bid price for the 30 trading days prior to January 1, 2009 percommon share is less than $1.20 the Company shall mandatorily redeem allremaining outstanding Series C preferred stock by paying cash equal to$10.00 per share with all accrued and unpaid dividends.  The Company may, at its election, redeem anyor all of the remaining outstanding Series C shares in cash at aconversion price equal to $12.00 per share, together with all accrued andunpaid dividends upon giving 30 day notice. Holders of the Series Cpreferred stock are entitled to cumulative, prior and in preference to holdersof common stock dividends equal to 15% per annum of the Original Purchase Pricestill outstanding, payable quarterly commencing September 1, 2006. In anyliquidation of the Company, each share of preferred stock is entitled to aliquidation preference on a pari passu basis with the Series A and Series BPreferred stock before any distribution may be made on the Company’s commonstock.

 

As of December 31,2007, 600,000 preferred stock shares were authorized, 592,032 of which wereissued and outstanding, at a par value of $0.0001 and a liquidation preferenceof $10.00 with accumulated dividends in arrears of $351,601, which have beenaccreted to the principal balance of the Series C preferred stock.

 

The Preferred Stockcontains features that are considered embedded derivative financialinstruments:  Preferred Stock’sconversion option:  The Preferred Stockis convertible at the Holder’s option at any time at the fixed conversion priceof $0.30 per share; Quarterly Dividends Conversion Option:  Holders have the option to convert the Stock’squarterly dividend payment at a conversion price of the average 10 days closingprice prior to the dividend record date. These features have been bifurcated and recorded on the Company’sbalance sheet as liabilities, at their fair value.

 

As of December 31,2007 the derivatives were valued at $35,290. Conversion related derivatives were valued using the Binomial OptionPricing Model with the following assumptions: dividend yield of 15%; annualvolatility of 54%; and risk free annual interest rate of 3.3% as well asprobability analysis related to trading volume restrictions.

 

Anamount equal to the original value of the derivatives was recorded as discountto the Preferred Stock.  The discount isbeing accreted to the principal balance of the Preferred Stock, using theeffective interest method, over the expected term of the term of the PreferredStock.  At December 31, 2007, theunamortized discount on the Preferred Stock was $449,444.

 

Togetherwith the above transaction, the terms of certain warrants held by the Company’sinvestment bankers and their associates were modified. The incremental value ofthe modification was calculated to be $110,453, and was allocated against theproceeds of the Series C Convertible Preferred Stock as a cost offinancing, and will be accreted to the principal balance of the PreferredStock, using the effective interest method, over the expected term of the termof the Preferred Stock.  At December 31,2007, the net amount remaining to be accreted was $46,249.

 

2. Permanent Equity

 

**CommonStock**

 

The Company is authorizedto issue 170,000,000 shares of common stock, $.0001 par value per share, of which61,153,202 were outstanding as of December 31, 2007.

 

 

 

71

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Holders of common stockhave equal rights to receive dividends when, as and if declared by the Board ofDirectors, out of funds legally available therefor. Holders of common stockhave one vote for each share held of record and do not have cumulative votingrights.

 

Holders of common stockare entitled, upon liquidation of the Company, to share ratably in the netassets available for distribution, subject to the rights, if any, of holders ofany preferred stock then outstanding. Shares of common stock are not redeemableand have no preemptive or similar rights. All outstanding shares of commonstock are fully paid and nonassessable.

 

Duringthe year ended December 31, 2007, preferred stockholders convertedprincipal of $29,388 and accumulated dividends of $1,090,842 into 4,576,206shares of the Company’s common stock. In addition accrued default interest of$622,765 on the 2004 and 2005 Senior Notes with Laurus was converted into850,000 shares of restricted common stock, and convertible debt principle of$150,000 was converted into 568,182 shares of common stock. The Companyrecorded a non-cash interest expense of approximately $91,000, which representedthe value of additional common shares issued to Laurus as consideration forexchanging convertible debt for equity instead of paying the outstandingprincipal payment in cash.

 

**Series AConvertible Preferred Stock**

 

Within the limits andrestrictions provided in the Company’s Certificate of Incorporation, the Boardof Directors has the authority, without further action by the shareholders, toissue up to 5,000,000 shares of preferred stock, $.0001 par value per share, inone or more series, and to fix, as to any such series, any dividend rate,redemption price, preference on liquidation or dissolution, sinking fund terms,conversion rights, voting rights, and any other preference or special rightsand qualifications.

 

In March 2004, wedesignated 100,000 shares of preferred stock as Series C ConvertiblePreferred Stock. In connection with the Company’s reincorporation in Delawareon January 1, 2005, each share of Series C Convertible PreferredStock was automatically converted into one share of Series A ConvertiblePreferred Stock (the “Series A Shares”), of which 30,557 were issued andoutstanding as at December 31, 2007.

 

The Series A Sharesaccrue a cumulative annual dividend of 7% on the $100 face amount of suchshares payable June 15 and December 15 each year in shares of commonstock. In the event of a liquidation, dissolution or winding up of the Company,the Series A shares have a liquidation preference of $100 per share (plusall accrued and unpaid dividends thereon) prior to any payment or distributionto holders of our common stock. The Series A Shares are convertible intocommon stock at a conversion price of $0.30 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 Shares, the conversion price shall belowered to such lesser price. In the event that the average closing bid priceof our common stock is less than $1.00 per share for thirty(30) consecutive trading days at any time after November 17, 2008, we willbe required to redeem the Series A Shares by payment of $100 per shareplus all accrued and unpaid dividends due thereon. See Note X.

 

We are required to obtainthe consent of the holders of a majority of the Series A Shares in orderto, among other things, issue any shares of preferred stock that are equal toor have a preference over the Series A 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 500,000 shares of common stock. We are also required to obtain suchconsent in order to, among other things, complete a sale or other dispositionof any material assets, complete an acquisition of a material amount of assets,engage in a merger, reorganization or consolidation, or incur or guaranty anyindebtedness in excess of $50,000.

 

As of December 31,2007, cumulative dividends in arrears related to the Series A preferredstock were approximately $243,953, which have been accreted to the principalbalance of the Series A preferred stock.

 

 

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3. Warrants

 

The Company has issuedwarrants to certain creditors, investors, investment bankers and consultants. Asummary of warrant activity is as follows:

 
| ** **                                                | ** ** | **Total Warrants** | ** ** | **Weighted  average  exercise   price** | ** ** | **Weighted  average  remaining  contractual  term  (in years)** | ** ** | **Aggregate  intrinsic  value** | ** ** |
|-----------------------------------------------------------|------------|--------------------|------------|----------------------------------------------|------------|----------------------------------------------------------------------|------------|---------------------------------|------------|
| Outstanding, as of December 31, 2006                 |       | 10,566,375         |       | $                                            | 1.00       |                                                                 |       |                            |       |   |
|                                                      |       |               |       |                                         |       |                                                                 |       |                            |       |
| Granted                                                   |       | —             |       | —                                       |       |                                                                 |       |                            |       |
| Exercised                                                 |       | —             |       | —                                       |       |                                                                 |       |                            |       |
| Expired                                                   |       | —             |       | —                                       |       |                                                                 |       |                            |       |
| **Outstanding, as of December 31, 2007**             | ** ** | **10,566,375**     | ** ** | **0.95**                                     | ** ** | **2.02**                                                             | ** ** | **$**                           | **—** | ** ** |
| **Vested or expected to vest at December 31,  2007** | ** ** | **10,566,375**     | ** ** | **0.95**                                     | ** ** | **2.02**                                                             |       | —                          |       |
| **Exercisable at December 31, 2007**                 | ** ** | **10,566,375**     | ** ** | **0.95**                                     | ** ** | **2.02**                                                             |       | —                          |       |
|                                                           |            |                    |            |                                              |            |                                                                      |            |                                 |            |  |  |

 

The warrants outstandingand exercisable at December 31, 2007 were in the following exercise priceranges:

 

| ** **                                  | ** ** | **Warrants  outstanding and Exercisable** | ** ** |
|---------------------------------------------|------------|-------------------------------------------|------------|
| **Range of exercise prices** | ** ** | **Number of  warrants**              | ** ** | **Weighted  average  remaining life (in years)** | ** ** |
| ** **                                  | ** ** | ** **                                | ** ** | ** ** | ** ** |
| $ 0.30                                 |       | 2,798,014                                 |       | 3.11 |   |
|    0.75                           |       | 533,333                                   |       | 3.61 |   |
|    0.97                           |       | 150,000                                   |       | 1.54 |   |
|    1.00                           |       | 2,655,552                                 |       | 1.87 |   |
|    1.35                           |       | 4,429,476                                 |       | 1.25 |   |
| $ 0.30-1.35                            |       | 10,566,375                                |       |   |   |

 

The estimated fair value of the warrants granted during2007 and 2006 was $0 and $423,287, respectively. The fair value of warrants isestimated as of the grant date using the Black-Scholes pricing model utilizingthe following assumptions: dividend yield of 0%; annual volatility of 72% to99%; and risk free annual interest rate of 4.3% to 4.5% for 2006.

 

As part of sale of the Fire business to ZOLL, andrepayment of the Company’s convertible debt, both in May 2007, theexercise price of certain warrants was adjusted to $0.30 per share.  The incremental fair value of themodification of $33,817 was allocated to interest expense as a cost offinancing.

 

 

**NOTE P—STOCK-BASED COMPENSATION**

 

*1996Stock Option 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 expired in May 2005.

 

 

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*1999Stock Option 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 option agreements with the recipients. In the event of a changein control, as defined, all options outstanding vest immediately. The 1999 Planexpires in August 2009.

 

*2004Stock Option 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 expires 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.

 

*StockOption Activity*

 

Information summarizingoption activity is as follows:

 
| ** **                                                | ** ** | **Number of Options** | ** ** | ** **         | ** ** | ** **         | ** ** | ** **        | ** ** |
|-----------------------------------------------------------|------------|---------------------------------|------------|--------------------|------------|--------------------|------------|-------------------|------------|
| ** **                                                | ** ** | **1996 Plan**              | ** ** | **1999 Plan** | ** ** | **2004 Plan** | ** ** | **Non Plan** | ** ** | **Total** | ** ** | **Weighted  average  exercise   price** | ** ** | **Weighted  average  remaining  contractual  term  (in years)** | ** ** | **Aggregate  intrinsic  value** | ** ** |
| Outstanding, as  of December 31, 2006                |       | 125,000                         |       | 995,000            |       | 2,896,419          |       | 4,118,000         |       | 8,134,419 |   | $ | 0.85 |   |   |   |   |   |
|                                                      |       |                            |       |               |       |               |       |              |       |   |   |   |   |   |   |   |   |
| Granted                                                   |       | —                          |       | —             |       | 290,000            |       | —            |       | 290,000 |   | 0.41 |   |   |   |   |   |
| Exercised                                                 |       | —                          |       | —             |       | —             |       | —            |       | — |   | — |   |   |   |   |   |
| Forfeited                                                 |       |                            |       |               |       | (468,355           | )          | (50,000           | )          | (518,355 | ) | 0.55 |   |   |   |   |   |
| Expired                                                   |       | (45,000                         | )          | (190,000           | )          | (496,649           | )          | (125,000          | )          | (856,649 | ) | 0.88 |   |   |   |   |   |
| **Outstanding,  as of December 31, 2007**            | ** ** | **80,000**                      | ** ** | **805,000**        | ** ** | **2,221,415**      | ** ** | **3,943,000**     | ** ** | **7,049,415** | ** ** | **0.85** | ** ** | **3.63** | ** ** | **$** | **—** | ** ** |
| **Vested  or expected to vest at December 31, 2007** | ** ** | ** **                      | ** ** | ** **         | ** ** | ** **         |       |              |       | **6,703,246** | ** ** | **0.87** | ** ** | **3.54** |   | — |   |
| **Exercisable  at December 31, 2007**                | ** ** | ** **                      | ** ** | ** **         | ** ** | ** **         |       |              |       | **5,929,047** | ** ** | **0.89** | ** ** | **3.32** |   | — |   |
|                                                           |            |                                 |            |                    |            |                    |            |                   |            |  |  |  |  |  |  |  |  |  |  |

 

 

 

74

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The options outstandingand exercisable at December 31, 2007 were in the following exercise priceranges:

 
| ** **                                  | ** **      | **Options Outstanding** | ** ** | **Options Exercisable**                | ** ** |
|---------------------------------------------|-----------------|------------------------------|------------|----------------------------------------|------------|
| **Range of exercise prices** | ** **      | **Number of  shares**   | ** ** | **Weighted  average  exercise  price** | ** ** | **Weighted average remaining life (in years)** | ** ** | **Number  exercisable** | ** ** | **Weighted  average  exercise  price** | ** ** |
| ** **                                  | ** **      | ** **                   | ** ** | ** **                             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| $                                           |  0.15-0.21 |                         | 67,000     |                                   | $          | 0.18 |   | 6.49 |   | — |   | $ | — |   |
|     0.22-0.40                |            | 890,999                      |       | 0.33                                   |       | 2.02 |   | 817,329 |   | 0.33 |   |
|     0.41-0.68                |            | 2,119,497                    |       | 0.56                                   |       | 3.39 |   | 1,666,467 |   | 0.55 |   |
|     0.69-1.11                |            | 2,252,419                    |       | 0.90                                   |       | 4.58 |   | 1,777,419 |   | 0.94 |   |
|     1.12-6.42                |            | 1,719,500                    |       | 0.33                                   |       | 1.44 |   | 1,667,832 |   | 1.45 |   |
| $                                           |  0.15-6.42 |                         | 7,049,415  |                                   |       |   |   |   | 5,929,047 |   |   |   |
|                                             |                 |                              |            |                                        |            |  |  |  |  |  |  |  |  |  |

 

The aggregate intrinsicvalue in the table above represents the total intrinsic value, based on theCompany’s closing stock price of $0.11 as of December 31, 2007, whichwould have been received by the option holders had all option holders exercisedtheir options as of that date. The total number of in-the-money options exercisableas of December 31, 2007 was 0.

 

The weighted average fairvalue of options granted during the year ended December 31, 2007 and December 31,2006 was $0.13 and $0.52 per share, respectively. The total intrinsic value ofoptions exercised during the year ended December 31, 2007 and December 31,2006 was $0 and $0, respectively.

 

As of December 31,2007 future compensation cost related to nonvested stock options isapproximately $238,529 and will be recognized over an estimated weightedaverage period of approximately 0.8 years.

 

**NOTE Q— EXTINGUISHMENT OF DEBT**

** **

To address certainliquidity issues, on January 23, 2006, the Company issued convertibledebt, common stock and warrants in consideration for certain modifications ofits outstanding 2004 and 2005 Senior Notes.

 

Furthermore, on August 10,2006, the Company exchanged convertible debt for preferred stock, and issuedcommon stock and warrants in consideration for certain modifications of itsoutstanding 2004 and 2005 Senior Notes.

 

On May 22,2007, the Company used approximately $4,300,000 of the net cash proceedsreceived in connection with the sale of the Fire Segment (see Note B) to repayin full its obligations to Laurus under the 2004 and 2005 Senior Notes.

 

In accordance with theEmerging Issues Task Force of the FASB No. 96-19, Debtor’s Accounting forModification or Exchange of Debt Terms (“EITF 96-19”), and AccountingPrinciples Board Opinion No. 26, Early Extinguishment of Debt (“APB 26”),the Company treated the above transactions as extinguishments of debt, andrecorded a non-operating “loss on extinguishment of debt” of $2,322,016 for theJanuary 2006 transaction, $5,493,701 for the August 2006 transaction,and $403,940 for the May 2007 transaction.

 

**NOTE R—INCOME TAXES**

** **

On January 1, 2007, the Company adopted theprovisions of Financial Accounting Standards Board Interpretation No. 48 “Accountingfor the Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109”(“FIN No. 48”). FIN No. 48 requires that the impact of tax positionsbe recognized in the financial statements if they are more likely than not ofbeing sustained based on the technical merits of the position. The Company hasa valuation allowance against the full amount of its net deferred taxes. TheCompany currently provides a valuation allowance against deferred taxes when itis more likely than not that some portion, or all of its deferred tax assetswill not be realized.

 

 

 

 

75

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As a result of the implementation of FIN No. 48,the Company reduced its deferred tax assets and the associated valuationallowance for gross unrecognized tax affected benefits by approximately$4,000,000. There was no adjustment to accumulated deficit as a result of theseunrecognized tax benefits since there was a full valuation allowance againstthe related deferred tax assets. If these unrecognized tax benefits areultimately recognized, they would have no impact on the effective tax rate dueto the existence of the valuation allowance.

 

The Company has not been audited by the InternalRevenue Service (“IRS”) or any states in connection with income taxes. TheCompany files income tax returns in the U.S. federal jurisdiction and variousstate jurisdictions. The periods from 2000-2006 remain open to examination bythe IRS and state jurisdictions. The Company believes it is not subject to anytax risk beyond the preceding discussion. The Company’s policy is to recognizeinterest and penalties accrued on any unrecognized tax benefits as a componentof income tax expense. As of the date of adoption of FIN No. 48, theCompany did not have any accrued interest or penalties associated with anyunrecognized tax benefits, nor was any significant interest expense recognizedduring the year ended December 31, 2007.

 

The Company has deferred taxes due to income taxcredits, net operating loss carryforwards, and the effect of temporarydifferences between the carrying values of certain assets and liabilities forfinancial reporting and income tax purposes. Significant components of deferredtaxes are as follows at December 31:

 

| ** **                             | ** ** | **2007**    | ** ** |
|----------------------------------------|------------|-------------|------------|
| ** **                             | ** ** | ** **  | ** ** |
| **Current asset:**                     | ** ** | ** **  | ** ** |
| Accrued compensation                   |       | $           | 168,000    |   |
| Accounts receivable allowance          |       | 45,000      |       |
| **Non-current asset:**                 | ** ** | ** **  | ** ** |
| Basis differences in fixed assets      |       | (92,000     | )          |
| Basis differences in intangible assets |       | 456,000     |       |
| Accrued interest and other             |       | 70,000      |       |
| Income tax credits                     |       | 1,459,000   |       |
| Net operating loss carryforwards       |       | 15,548,000  |       |
| Valuation allowances                   |       | (17,654,000 | )          |
|                                   |       | $           | —     |   |

 

As of December 31, 2007 the Company has federaland state net operating loss carryforwards of approximately $42,878,000 and$18,364,000, respectively, subject to expiration between 2012 and 2027.

 

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

 

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

 

A reconciliation of the effective income tax rate onoperations reflected in the Statements of Operations to the US Federalstatutory income tax rate is presented below.

 

| ** **                           | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|--------------------------------------|------------|------------|------------|------------|------------|
| ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| US Federal statutory income tax rate |       | (34        | )%         | (34        | )%         |
| State taxes, net                     |       | 0          |       | 0          |       |
| Permanent differences                |       | 36         |       | 8          |       |
| Temporary differences                |       | (22        | )          | 1          |       |
| Change in valuation allowance        |       | 20         |       | 25         |       |
|                                 |       |       |       |       |       |
| Effective tax rate                   |       | 0          | %          | 0          | %          |

 

 

 

76

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**NOTE S—FAIR VALUES OF FINANCIALINSTRUMENTS**

 

The Company’s derivative financial instruments as at December 31,2007 consisted of embedded derivatives related to the Series B and Series CConvertible Preferred Stock. These embedded derivatives include certain conversionfeatures on preferred principal and accumulated and unpaid dividends. TheCompany also issued warrants to purchase shares of the Company’s Common stockas part of various debt financings. The accounting treatment of thesederivatives and warrants required the Company to record the instruments asliabilities 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 is recorded as non-operating, non-cash income or expenseat each reporting date. If the fair value of the derivatives or the warrant ishigher 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 31,2007, the derivatives and warrants classified as liabilities were valued at$41,295 and $64,520 respectively. Conversion related derivatives were valuedusing the Binomial Option Pricing Model with the following assumptions:dividend yield of 15%; annual volatility of 54%; and risk free annual interestrate of 3.3% as well as probability analysis related to trading volumerestrictions. The Warrants issued with the 2004, 2005 and 2006 debt financingsclassified as liabilities were valued using the Black Scholes Option Pricingmodel with the following assumptions: dividend yield of 0%; annual volatilityof 84% to 92% and risk-free interest rate of 3.0% to 4.0%.

 

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

 
| ** **                                                                                                                                              | ** ** | **Years ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                                                                                              | ** ** | **2007**                                    | ** ** | **2006** | ** ** |
| ** **                                                                                                                                              | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| **Cash paid for:**                                                                                                                                      | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Interest                                                                                                                                                |       | $                                           | 370,090    |   | $ | 1,369,723 |   |
| **Noncash Financing Activities:**                                                                                                                       | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Conversion of  convertible notes and related obligations, net of discount, and accrued  interest into common stock                                      |       | 772,765                                     |       | 894,123 |   |
| Issuance of Series B redeemable preferred stock  in exchange for debt, and related obligations                                                     |       | —                                      |       | 988,000 |   |
| Issuance of Series C redeemable preferred stock  in exchange for debt, and related obligations                                                     |       | —                                      |       | 5,920,320 |   |
| Issuance of common stock in conjunction with  financing                                                                                                 |       | —                                      |       | 189,000 |   |
| Modification of warrants in conjunction with  financing                                                                                                 |       | —                                      |       | 110,453 |   |
| Issuance of  common stock in exchange for Series A, Series B, and Series C  preferred stock and cumulative dividends in arrears, thereon |       | 1,120,230                                   |       | 2,193,665 |   |
| Origination of warrants in conjunction with debt  financing                                                                                             |       | —                                      |       | 308,376 |   |
| Origination of warrants in conjunction with equity  financing                                                                                           |       | —                                      |       | 103,229 |   |
| Origination of embedded derivatives and debt  discounts with debt financing                                                                             |       | —                                      |       | 679,624 |   |
| Origination of embedded derivatives with preferred  stock                                                                                               |       | —                                      |       | 1,434,004 |   |
|                                                                                                                                                         |            |                                             |            |  |  |  |  |

 

**NOTEU—PROFIT SHARING PLAN**

 

The Company has established a savings plan undersection 401(k) of the Internal Revenue Code. All employees of theCompany, after completing one day of service are eligible to enroll in the 401(k) plan.Participating employees may elect to defer a portion of their salary on apre-tax basis up to the limits as provided by the IRS Code. The Company is notrequired to match employee contributions but may do so at its discretion. TheCompany made no contributions during the two years ended December 31,2007.

 

 

 

77

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**NOTEV—EARNINGS PER SHARE “EPS”**

 

The Company’s basic EPS is calculated using net income(loss) available to common shareholders and the weighted-average number ofshares outstanding during the reporting period. Diluted EPS includes the effectfrom potential 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. For the years ended December 31,2007 and 2006, diluted per share computations are not presented since thiseffect would be antidilutive.

 

The reconciliation of the numerator of the basic anddiluted EPS calculations, due to the inclusion of preferred stock dividends andaccretion was as follows for the following fiscal years ended December 31:

 
| ** **                                                     | ** ** | **2007**   | ** ** | **2006**   | ** ** |
|----------------------------------------------------------------|------------|------------|------------|------------|------------|
| **Numerator:**                                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
|                                                           |       |       |       |       |       |
| Loss from continuing operations                                |       | $          | (5,569,335 | )          | $          | (12,724,942 | ) |
| Convertible  preferred stock dividends and accretion           |       | (1,891,624 | )          | (1,042,069 | )          |
| Loss available to common stockholders (basic and  diluted EPS) |       | $          | (7,460,959 | )          | $          | (13,767,011 | ) |
|                                                           |       |       |       |       |       |

 

The followingtable summarizes the potential weighted average shares of common stock thatwere excluded from the diluted per share calculation, because the effect ofincluding these potential shares was anti-dilutive.

 

| ** **                  | ** ** | **Years ended December 31,** | ** ** |
|-----------------------------|------------|---------------------------------------------|------------|
| ** **                  | ** ** | **2007**                                    | ** ** | **2006** | ** ** |
|                        |       |                                        |       |   |   |
| Preferred Stock             |       | 28,018,775                                  |       | 11,971,430 |   |
| Convertible Debt            |       | 3,397,957                                   |       | 12,228,852 |   |
| Stock Options               |       | 10,058                                      |       | 443,784 |   |
| Warrants                    |       | —                                      |       | 151,416 |   |
|                        |       |                                        |       |   |   |
| Potentially dilutive shares |       | 31,426,790                                  |       | 24,795,482 |   |

 

Items excluded fromthe diluted per share calculation because the exercise price was greater thanthe average market price of the common shares:

 

| ** **    | ** ** | **Years ended December 31,** | ** ** |
|---------------|------------|---------------------------------------------|------------|
| ** **    | ** ** | **2007**                                    | ** ** | **2006** | ** ** |
| ** **    | ** ** | ** **                                  | ** ** | ** ** | ** ** |
| Stock options |       | 7,012,415                                   |       | 6,506,419 |   |
| Warrants      |       | 10,566,375                                  |       | 7,779,472 |   |
|          |       |                                        |       |   |   |
| Total         |       | 17,578,790                                  |       | 14,285,891 |   |

 

**NOTEW—RECLASSIFICATIONS**

 

Certain amounts in the 2006 financial statements havebeen reclassified to conform to the 2007 presentation. These reclassificationshad no effect on the previously reported net loss or stockholders’ equity(deficit).

 

 

 

78

----

 

 

**NOTEX—EVENTS OCCURRING SUBSEQUENT TO DECEMBER 31, 2007**

 

a) Redemption of Series A Convertible PreferredStock

 

As at December 31, 2007, the redemption clause ofthe Company’s Series A Convertible Preferred Stock stated that if in theevent the average closing bid price of our common stock is less than $1.00 pershare for thirty (30) consecutive trading days at any time after March 3,2008, we will be required to redeem the Series A Convertible PreferredStock (“Series A Shares”) by payment of $100 per share plus all accruedand unpaid dividends due thereon.  OnMarch 24, 2008, the Company entered into an agreement with the holders of theSeries A Shares, such that they agreed to defer the measurement date of anysuch redemption until November 17, 2008.

 

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

 

The following tablepresents selected unaudited financial information for the eight quarters in theperiod ended December 31, 2007. The results for any quarter are notnecessarily indicative of future quarterly results and, accordingly,period-to-period comparisons should not be relied upon as an indication offuture performance.

 
| ** **

** **                        | ** ** | **For the  Quarters Ended** | ** ** |
|-----------------------------------------------|------------|-----------------------------|------------|
| ** **                                    | ** ** | **March 31,  2006**    | ** ** | **June 30,  2006** | ** ** | **September 30,  2006** | ** ** | **December 31,  2006** | ** ** | **March 31,  2007** | ** ** | **June 30,  2007** | ** ** | **September 30,  2007** | ** ** | **December 31,  2007** | ** ** |
|                                          |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Revenue                                       |       | $                           | 2,443,883  |   | $ | 3,034,461 |   | $ | 2,967,816 |   | $ | 2,841,878 |   | $ | 2,715,240 |   | $ | 2,462,859 |   | $ | 2,168,091 |   | $ | 2,642,266 |   |
| Gross profit                                  |       | 1,809,940                   |       | 2,352,131 |   | 2,341,530 |   | 1,958,928 |   | 2,236,441 |   | 1,999,587 |   | 1,706,480 |   | 2,261,172 |   |
| Income (loss)  from continuing operations     |       | (3,993,403                  | )          | (1,325,030 | ) | (6,875,851 | ) | (530,658 | ) | (1,386,864 | ) | (2,373,202 | ) | (1,190,615 | ) | (618,654 | ) |
| Income (loss)  from discontinued operations   |       | 197,123                     |       | 252,046 |   | 643,119 |   | 551,803 |   | 474,490 |   | (34,385 | ) | — |   | — |   |
| Gain on disposal  of discontinued operations  |       | —                      |       | — |   | — |   | — |   | — |   | 4,070,859 |   | 1,147 |   | — |   |
| Net income (loss)                             |       | $                           | (3,796,280 | ) | $ | (1,072,984 | ) | $ | (6,232,732 | ) | $ | 21,145 |   | $ | (912,374 | ) | $ | 1,663,272 |   | $ | (1,189,468 | ) | $ | (618,654 | ) |
| Basic and diluted  earnings per common share: |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Loss from  continuing operations              |       | $                           | (0.08      | ) | $ | (0.03 | ) | $ | (0.14 | ) | $ | (0.02 | ) | $ | (0.03 | ) | $ | (0.05 | ) | $ | (0.03 | ) | $ | (0.02 | ) |
| Income (loss)  from discontinued operations   |       | 0.00                        |       | 0.01 |   | 0.01 |   | 0.01 |   | 0.01 |   | 0.00 |   | — |   | — |   |
| Gain on disposal  of discontinued operations  |       | —                      |       | — |   | — |   | — |   | — |   | 0.07 |   | 0.00 |   | — |   |
| Net loss                                      |       | $                           | (0.08      | ) | $ | (0.02 | ) | $ | (0.13 | ) | $ | (0.01 | ) | $ | (0.02 | ) | $ | 0.02 |   | $ | (0.03 | ) | $ | (0.02 | ) |
|                                          |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Weighted average  shares outstanding:         |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Basic and diluted                             |       | 47,026,773                  |       | 48,442,365 |   | 50,733,960 |   | 54,624,774 |   | 56,634,523 |   | 58,067,198 |   | 59,413,729 |   | 60,604,914 |   |

 

 

 

 

79

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**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) ofthe Securities Exchange Act of 1934, the Registrant has duly caused this reportto be signed on its behalf by the undersigned, thereunto duly authorized.

 

 
|                 |   | BIO-KEY INTERNATIONAL, INC.      |
|----------------------|--------|----------------------------------|
|                 |   |                             |
| Date: March 26, 2008 | By:    |  /s/ MICHAEL  W. DEPASQUALE |
|                 |   | Michael W. DePasquale            |
|                 |   | CHIEF EXECUTIVE OFFICER          |
|                      |        |                                  |  |

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, this report has been signed below by the followingpersons on behalf of the Registrant and in the capacities on the datesindicated.

 

| **Signature**                         | ** ** | **Title**                                              | ** ** | **Date**            |
|---------------------------------------|------------|--------------------------------------------------------|------------|---------------------|
|                                  |       |                                                   |       |                |
| /s/  MICHAEL  W. DEPASQUALE |       | Chief Executive Officer and Director                   |       | March 26, 2008 |
| Michael W. DePasquale                 |       |                                                   |       |                |
|                                  |       |                                                   |       |                |
| /s/  FRANCIS  J. CUSICK     |       | Chief Financial Officer, Principal Accounting  Officer |       | March 26, 2008 |
| Francis J. Cusick                     |       |                                                   |       |                |
|                                  |       |                                                   |       |                |
| /s/  THOMAS  J. COLATOSTI   |       | Chairman of the Board of Directors                     |       | March 26, 2008 |
| Thomas J. Colatosti                   |       |                                                   |       |                |
|                                  |       |                                                   |       |                |
| /s/  JEFFREY  J. MAY        |       | Director                                               |       | March 26, 2008 |
| Jeffrey J. May                        |       |                                                   |       |                |
|                                  |       |                                                   |       |                |
| /s/  CHARLES  P. ROMEO      |       | Director                                               |       | March 26, 2008 |
| Charles P. Romeo                      |       |                                                   |       |                |
|                                  |       |                                                   |       |                |
| /s/  JOHN  SCHOENHERR       |       | Director                                               |       | March 26, 2008 |
| John Schoenherr                       |       |                                                   |       |                |

 

 

80

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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                                                                                                                                                  |
| 3.6 (21)             |       | Certificate of Designation of the Series C  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)             |       | Option to Purchase 580,000 Shares of Common Stock  issued to Michael W. DePasquale                                                                                                                                                           |
| 10.11(7)             |       | Securities Exchange Agreement dated March 3,  2004 by and between BIO-key International, Inc. and The Shaar Fund Ltd.                                                                                                              |
| 10.12(7)             |       | Registration Rights Agreement dated March 3,  2004 by and between BIO-key International, Inc. and The Shaar Fund Ltd.                                                                                                              |
| 10.13(7)             |       | Option to Purchase 500,000 Shares of Common Stock  issued to Michael W. DePasquale                                                                                                                                                           |
| 10.14(7)             |       | Option to Purchase 150,000 Shares of Common Stock  issued to Thomas J. Colatosti                                                                                                                                                             |
| 10.15(7)             |       | Option to Purchase 50,000 Shares of Common Stock  issued to Thomas J. Colatosti                                                                                                                                                              |
| 10.16(7)             |       | Option to Purchase 50,000 Shares of Common Stock  issued to Jeff May                                                                                                                                                                         |
| 10.17(7)             |       | Option to Purchase 50,000 Shares of Common Stock  issued to Charles Romeo                                                                                                                                                                    |
| 10.18(7)             |       | Option to Purchase 300,000 Shares of Common Stock  issued to Randy Fodero                                                                                                                                                                    |
| 10.19(10)            |       | Amendment Agreement dated March 30, 2004 by and  between BIO-key International, Inc. and The Shaar Fund Ltd.                                                                                                                       |
| 10.20(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                           |
| 10.21(11)            |       | Form of Warrant issued by BIO-key  International, Inc. pursuant to the March Securities Purchase  Agreement                                                                                                                   |
| 10.22(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 |
| 10.23(2)             |       | Form of Common Stock Purchase Warrant issued by  BIO-key International, Inc. pursuant to the Laurus Securities Purchase  Agreement                                                                                                 |
| 10.24(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                                                         |
| 10.25(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      |
| 10.26(2)             |       | Form of Common Stock Purchase Warrant issued by  BIO-key International, Inc. pursuant to the Shaar Securities Purchase  Agreement                                                                                                  |
| 10.27(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                                                             |

 

 

81

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| 10.28(10) | Option to Purchase 300,000 shares of common stock  issued to Kenneth Souza                                                                                                                                                                                                                             |
|-----------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.29(10) | Employment Agreement dated as of October 4,  2004 by and between BIO-key International, Inc. and Kenneth Souza                                                                                                                                                                               |
| 10.30(10) | BIO-key International, Inc. 2004 Stock  Incentive Plan                                                                                                                                                                                                                                            |
| 10.31(10) | Warrant to purchase 10,000 shares of Common Stock  issued to Krieger & Prager LLP on November 26, 2001                                                                                                                                                                                   |
| 10.32(10) | Warrant to purchase 100,000 shares of Common Stock  issued to The November Group Ltd. on July 14, 2004                                                                                                                                                                                       |
| 10.33(10) | Warrant to purchase 230,000 shares of Common Stock  issued to Jesup & Lamont Securities Corp. on March 31, 2004                                                                                                                                                                          |
| 10.34(10) | Warrant to purchase 105,000 shares of Common Stock  issued to Douglass Bermingham on March 31, 2004                                                                                                                                                                                               |
| 10.35(10) | Warrant to purchase 60,000 shares of Common Stock  issued to Mason Sexton on March 31, 2004                                                                                                                                                                                                       |
| 10.36(10) | Warrant to purchase 22,000 shares of Common Stock  issued to David Moss on March 31, 2004                                                                                                                                                                                                         |
| 10.37(10) | Warrant to purchase 22,000 shares of Common Stock  issued to Patrick Gaynes on March 31, 2004                                                                                                                                                                                                     |
| 10.38(10) | Warrant to purchase 5,000 shares of Common Stock  issued to Tom DuHamel on March 31, 2004                                                                                                                                                                                                         |
| 10.39(11) | Option to Purchase 155,000 shares of common stock  issued to Francis J Cusick                                                                                                                                                                                                                          |
| 10.40(11) | Option to Purchase 50,000 shares of common stock  issued to Charles P. Romeo                                                                                                                                                                                                                           |
| 10.41(12) | Securities Purchase Agreement, dated as of  June 8, 2005, by and between the Company and Laurus Fund, Ltd.                                                                                                                                                                                        |
| 10.42(12) | 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.                                                                                                                       |
| 10.43(12) | Registration Rights Agreement, dated as of  June 8, 2005, by and between the Company and Laurus Fund, Ltd.                                                                                                                                                                                        |
| 10.44(12) | 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                                                                                                                                     |
| 10.45(12) | 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                                                                |
| 10.46(12) | 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                                                                                                          |
| 10.47(20) | Escrow Agreement, dated as of May 31, 2005, by  and among the Company, Jesup & Lamont Securities Corp.and Thelen,  Reid & Priest LLP.                                                                                                                                           |
| 10.48(13) | Amendment and Waiver, dated as of August 31,  2005, by and between the Company and Laurus Master Fund, Ltd.                                                                                                                                                                                       |
| 10.49(13) | Amendment and Waiver, dated as of August 31,  2005, by and between the Company and The Shaar Fund, Ltd.                                                                                                                                                                                           |
| 10.50(15) | Amendment and Waiver, dated as of August 31,  2005, by and between the Company and Longview Special Finance                                                                                                                                                                                       |
| 10.51(13) | Amendment and Waiver, dated as of August 31,  2005, by and between the Company and Etienne Des Roys                                                                                                                                                                                               |
| 10.52(13) | Amendment and Waiver, dated as of August 31,  2005, by and between the Company and Eric Haber                                                                                                                                                                                                     |
| 10.53(13) | Amendment and Waiver, dated as of August 31,  2005, by and between the Company and Investors Management Corporation                                                                                                                                                                               |
| 10.54(13) | Amendment and Waiver, dated as of August 31,  2005, by and between the Company and The Tocqueville Fund                                                                                                                                                                                           |
| 10.55(13) | Amendment and Waiver, dated as of August 31,  2005, by and between the Company and The Tocqueville Amerique Value Fund                                                                                                                                                                            |
| 10.56(13) | 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. |
| 10.57(14) | Amendment and Waiver, dated as of January 23,  2006, by and between the Company and Laurus Master Fund, Ltd.                                                                                                                                                                                      |
| 10.58(14) | Registration Rights Agreement, dated as of  January 23, 2006, by and between the Company and Laurus Master Fund,  Ltd.                                                                                                                                                                            |
| 10.59(14) | 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                                                                                                                                        |
| 10.60(14) | 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                                                                                                                                    |
| 10.61(14) | 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                                                                         |

 

 

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| 10.62(14)  | 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                     |
|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.63(14)  | 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                                                                                        |
| 10.64(14)  | Amendment No. 1 to Subordinated Secured Promissory  Note, dated as of January 23, 2006, by and between the Company and  Aether Systems, Inc.                                                                                                |
| 10.65(15)  | Compensation Agreement by and between the Company  and Thomas J. Colatosti dated February 7, 2006                                                                                                                                                     |
| 10.66(16)  | Employment Agreement by and between the Company and  Michael DePasquale dated March 28, 2006                                                                                                                                                          |
| 10.67(18)  | Form of Option Agreement used to grant a total  of 900,000 options to Purchase common stock to Francis J. Cusick, Michael W.  DePasquale, Randy Fodero, and Kenneth S. Souza                                                                          |
| 10.68(19)  | Amendment and Waiver, dated as of August 10,  2006, by and between the Company and Laurus Master Fund, Ltd.                                                                                                                                           |
| 10.69(19)  | Registration Rights Agreement, dated as of  August 10, 2006, by and between the Company and Laurus Master Fund, Ltd.                                                                                                                                  |
| 10.70(19)  | Securities Exchange Agreement, dated as of  August 10, 2006, by and among the Company, The Shaar Fund Ltd., Longview  Fund, L.P., Longview Special Finance and certain other holders of the  Company’s Subordinated Convertible Promissory Notes |
| 10.71(19)  | Registration Rights Agreement, dated as of  August 10, 2006, by and among the Company, The Shaar Fund Ltd., Longview  Fund, L.P., Longview Special Finance and certain other holders of the  Company’s Subordinated Convertible Promissory Notes |
| 10.72(19)  | Securities Purchase Agreement, dated as of  August 10, 2006, by and between the Company and Trellus Partners, L.P.                                                                                                                                    |
| 10.73(19)  | Form of Common Stock Purchase Warrant issued  pursuant to the Securities Purchase Agreement, dated as of August 10,  2006, by and between the Company and Trellus Partners, L.P.                                                                 |
| 10.74(19)  | Registration Rights Agreement, dated as of  August 10, 2006, by and between the Company and Trellus Partners, L.P.                                                                                                                                    |
| 10.75(19)  | Securities Purchase Agreement, dated as of  August 10, 2006, by and between the Company and The Shaar Fund Ltd.                                                                                                                                       |
| 10.76(19)  | Form of Common Stock Purchase Warrant to be  issued pursuant to the Securities Purchase Agreement, dated as of  August 10, 2006, by and between the Company and The Shaar Fund Ltd.                                                              |
| 10.77(19)  | Registration Rights Agreement, dated as of  August 10, 2006, by and between the Company and The Shaar Fund Ltd.                                                                                                                                       |
| 10.78 (21) | Sublease Agreement, dated as of September 20,  2004, by and between the Company and Aether Systems, Inc.                                                                                                                                         |
| 10.79 (21) | Amendment and Waiver, dated as of December 29,  2006, by and between the Company and Laurus Master Fund, Ltd.                                                                                                                                         |
| 10.80 (22) | Amendment and Waiver, dated as of April 18,  2007, by and between the Company and Laurus Master Fund, Ltd.                                                                                                                                            |
| 10.81 (23) | Purchase and Sale Agreement, dated as of  May 22, 2007, by and between the Company and ZOLL Data Systems, Inc                                                                                                                                         |
| 10.82 (24) | Compensation Agreement, dated July 12, 2007, by  and between the Company and Mr. Colatosti                                                                                                                                                       |
| 21.1(20)   | List of subsidiaries of BIO-key  International, Inc.                                                                                                                                                                                                  |
| 23.1(8)    | Consent of Carlin, Charron & Rosen, LLP.                                                                                                                                                                                                          |
| 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  18 U.S.C. Section 1350, as amended                                                                                                                                                              |
| 32.2(8)    | Certificate of CFO of Registrant required under  18 U.S.C. Section 1350, as amended                                                                                                                                                              |

 

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

 

(2)           Filed as anexhibit to the registrant’s current report on Form 8-K filed with theSecurities and Exchange Commission on October 5, 2004 and incorporatedherein by reference.

 

 

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| (3)    | Filed as an exhibit to the registrant’s current  report on Form 8-K filed with the Securities and Exchange Commission on  January 5, 2005 and incorporated herein by reference.   |
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|   |                                                                                                                                                                                                  |
| (4)    | Filed as an exhibit to the registrant’s  registration statement on Form SB-2, File No. 333-16451 dated  February 14, 1997 and incorporated herein by reference.              |
|   |                                                                                                                                                                                                  |
| (5)    | Filed as an exhibit to the registrant’s annual  report on Form 10-KSB filed with the Securities and Exchange Commission  on April 14, 2000 and incorporated herein by reference.  |
|   |                                                                                                                                                                                                  |
| (6)    | Filed as an exhibit to the registrant’s current  report on Form 8-K filed with the Securities and Exchange Commission on  November 26, 2001 and incorporated herein by reference. |
|   |                                                                                                                                                                                                  |
| (7)    | Filed as an exhibit to the registrant’s annual  report on Form 10-KSB filed with the Securities and Exchange Commission  on March 26, 2004 and incorporated herein by reference.  |
|   |                                                                                                                                                                                                  |
| (8)    | Filed herewith.                                                                                                                                                                                       |
|   |                                                                                                                                                                                                  |
| (9)    | Filed as an exhibit to the registrant’s annual  report on Form 10-KSB filed with the Securities and Exchange Commission  on March 31, 2003 and incorporated herein by reference.  |
|   |                                                                                                                                                                                                  |
| (10)   | Filed as an exhibit to the registrant’s  registration statement on Form SB-2, File No. 333-120104 dated  October 29, 2004 and incorporated herein by reference.              |
|   |                                                                                                                                                                                                  |
| (11)   | Filed as an exhibit to the registrant’s current  report on Form 8-K filed with the Securities and Exchange Commission on  March 4, 2005 and incorporated herein by reference.     |
|   |                                                                                                                                                                                                  |
| (12)   | Filed as an exhibit to the registrant’s current  report on Form 8-K filed with the Securities and Exchange Commission on  June 14, 2005 and incorporated herein by reference.\    |
|   |                                                                                                                                                                                                  |
| (13)   | Filed as an exhibit to the registrant’s current  report on Form 8-K filed with the Securities and Exchange Commission on  September 7, 2005 and incorporated herein by reference. |
|   |                                                                                                                                                                                                  |
| (14)   | Filed as an exhibit to the registrant’s current  report on Form 8-K filed with the Securities and Exchange Commission on  January 25, 2006 and incorporated herein by reference.  |
|   |                                                                                                                                                                                                  |
| (15)   | Filed as an exhibit to the registrant’s current  report on Form 8-K filed with the Securities and Exchange Commission on  February 9, 2006 and incorporated herein by reference.  |
|   |                                                                                                                                                                                                  |
| (16)   | Filed as an exhibit to the registrant’s current  report on Form 8-K filed with the Securities and Exchange Commission on  March 29, 2006 and incorporated herein by reference.    |
|   |                                                                                                                                                                                                  |
| (17)   | Filed as an exhibit to the registrant’s proxy  statement filed with the Securities and Exchange Commission on  January 18, 2006 and incorporated herein by reference.                       |
|   |                                                                                                                                                                                                  |
| (18)   | Filed as an exhibit to the registrant’s annual  report on Form 10-KSB filed with the Securities and Exchange Commission  on March 29, 2006 and incorporated herein by reference.  |
|   |                                                                                                                                                                                                  |
| (19)   | Filed as an exhibit to the registrant’s current  report on Form 8-K filed with the Securities and Exchange Commission on  August 16, 2006 and incorporated herein by reference.   |
|   |                                                                                                                                                                                                  |
| (20)   | Previously filed                                                                                                                                                                                      |
|   |                                                                                                                                                                                                  |
| (21)   | Filed as an exhibit to the registrant’s annual  report on Form 10-KSB filed with the Securities and Exchange Commission  on March 30, 2007 and incorporated herein by reference.  |
|   |                                                                                                                                                                                                  |
| (22)   | Filed as an exhibit to the registrant’s current  report on Form 8-K filed with the Securities and Exchange Commission on                                                               |

 

 

 

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|   | April 24, 2007 and incorporated herein by  reference. |
|--------|------------------------------------------------------------|

 
| (23)   | Filed as an exhibit to the registrant’s current  report on Form 8-K filed with the Securities and Exchange Commission on  May 25, 2007 and incorporated herein by reference.  |
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|   |                                                                                                                                                                                              |
| (24)   | Filed as an exhibit to the registrant’s current  report on Form 8-K filed with the Securities and Exchange Commission on  July 18, 2007 and incorporated herein by reference. |

 

 

 

 

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